Without invoking the name, the Journal leader did more to educate the American public about Austrian economic theory than anything published in recent years. To most readers, Hayek probably means Salma, but to adherents of the Austrian school, Friedrich von Hayek and his professor, Ludwig von Mises, are the most prominent figures.
In the Austrians’ staunchly free-market ideal, if central banks peg the cost of credit below its natural rate, it results in an excessive credit expansion and inflation, which includes asset prices. Rising asset prices result in bubbles and malinvestments, which invariably lead to busts in direct proportion the preceding bubble. The only solution to the bust is to ride it out, allowing prices to fall and the assets to liquidate, permitting the capital that has been misallocated to be put to more productive uses.
UP AND DOWN WALL STREET DAILY | Online Exclusive
By RANDALL W. FORSYTH
As Ben Demurs, Hillary Looks to Bail Out Mortgage Market
IF BENNIE AND THE FEDS won’t bail out the mortgage market, how about Hillary and the Dems?
While the Federal Open Market Committee deliberated over the cosmic question of our age — where to fix the price of overnight money — the leading contender for the Democratic nomination for president was urging increased federal oversight of the home-loan industry and a $1 billion bailout to help feckless borrowers to avoid foreclosure.
The symmetry was perfect. Government interference with the market created the housing bubble, so government obviously is the solution to this problem.
To the surprise of absolutely no one, the Fed’s policy-setting panel held its target for federal funds (overnight loans between banks, the cost of the financial system’s basic material, money) at 5.25%. That’s been the Fed’s target since June 2006, when the central bank completed its 17-step program of quarter-point rate hikes, which started two years earlier with the fed-funds rate at the preternaturally low level of 1%.
Our colleagues at the Wall Street Journal Tuesday provided an excellent primer on the impact of the Fed’s past policies (”How Credit Got So Easy and Why It’s Tightening,” Aug. 7), which outlined the history of the “Greenspan Put,” replete with the former Fed chairman’s smiling visage. Put simply, the Greenspan’s practice of easing during every financial market crisis during his tenure — from the October 1987 crash to the 1998 LTCM debacle to the bursting of the Nasdaq bubble in 2000 — created an increasing moral hazard. Meaning, that market participants assumed if they got into trouble, the Fed would provide a “get-out-of-jail-free card” in the form of rate cuts.
Without invoking the name, the Journal leader did more to educate the American public about Austrian economic theory than anything published in recent years. To most readers, Hayek probably means Salma, but to adherents of the Austrian school, Friedrich von Hayek and his professor, Ludwig von Mises, are the most prominent figures.
In the Austrians’ staunchly free-market ideal, if central banks peg the cost of credit below its natural rate, it results in an excessive credit expansion and inflation, which includes asset prices. Rising asset prices result in bubbles and malinvestments, which invariably lead to busts in direct proportion the preceding bubble. The only solution to the bust is to ride it out, allowing prices to fall and the assets to liquidate, permitting the capital that has been misallocated to be put to more productive uses.
To move from the theoretical to the concrete, it’s easy to see how the 1% money-market rates imposed to offset the effects of the tech bust led to the real-estate and mortgage bubble. Ultra-cheap mortgages put homeownership within the reach of many more folks. Meanwhile, the collapse of interest rates made investors the world over desperate for assets that paid better than the 3% plus that Treasury notes yielded at their nadir in 2003. The market naturally filled that vacuum, channeling cheap money from the Fed to mortgage borrowers whose main qualification was a pulse and the willingness to pay higher yields than Uncle Sam.
As the Austrians predicted, many borrowed well but not wisely and now are coming a cropper. Some have defaulted after making just a payment or two. Others who borrowed at low initial teaser rates two years ago are facing sharply higher monthly “nuts.” And so foreclosures are soaring and the subprime crisis is deepening.
The stock market popped Monday on speculation that Fannie Mae and Freddie Mac, the big government sponsored enterprises to support the mortgage market, might ride to the rescue of borrowers shut out of the market and, improbably, that the Fed might provide some relief. Neither was forthcoming Tuesday.
As expected, the FOMC held the funds rate target unchanged at 5.25%, but did note “financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses,” which we already knew. But the Fed kept its eye on the inflation ball, sticking to its previous statement that rising prices remain the main economic threat. With data released earlier in the day showing that unit labor costs rose at a 4.5% year-on-year rate in the second quarter because of slowing productivity growth, the central bank properly remains on inflation alert.
Moreover, credit is getting tighter but remains available — at a price. Bear Stearns, the Wall Street firm hit hardest by the mortgage meltdown, was able to sell $2.25 billion of five-year notes Tuesday at 2.45 percentage points over comparable Treasuries, or about 7.05%.
For Bear to be able to raise that money is a positive, notes Richard X. Bove, the veteran financial analyst at Punk Ziegel & Co. But single-A-rated Bear had to pay a yield comparable to junk-rated GMAC (Ba1 by Moody’s, double-B-plus by Standard & Poor’s) to raise the capital. Nevertheless, the market still provided credit to Bear, which means the market is functioning.
Meanwhile, Sen. Hillary Clinton proposed $1 billion in federal money be funneled to state programs to rescue borrowers facing foreclosures. The Democratic senator from New York also proposed restrictions on prepayment penalties for mortgage borrowers and regulation of mortgage brokers at a campaign stop Tuesday in New Hampshire, the site of the first presidential primary. Clinton vowed to introduce legislation to crack down on “fly-by-night mortgage lenders” when Congress returns from its summer recess.
No matter that mortgage lenders to borrowers with less-than-perfect credit are dropping like flies. American Home Mortgage, one of the nation’s largest mortgage lenders, filed for bankruptcy Monday. The business of opportunistic lenders providing loans to unqualified borrowers has been shut down by the market. That depended on the ability of originators to offload loans to Wall Street, which would repackage and resell them to investors such as hedge funds and foreign central banks. Now, it’s “Game Over.”
Despite all the noise, the fallout really hasn’t begun to be felt. But once old teaser rates are raised, foreclosures are certain to rise further. The pace of resets will pick up in the fall and reaches a peak early next year, just before the new primary schedule peaks.
How will this intersection of politics and home economics play out? What candidate (other than libertarian Ron Paul, the Texas Republican) would be willing to stand up and oppose government action to ease the mortgage crisis? More importantly, will the Bernanke Fed decline to intervene until it truly is a lender of last resort?
Comments: randall.forsyth@barrons.com
