QE(III) with a twist?

As the markets are starting to contemplate a new helping hand from the Fed with the upcoming symposium at Jackson Hole being a potential launchpad (as it was last year) I thought about what they can do apart from just buying more treasuries…

I have long argued that in the US the economic problems are not over before the housing and job markets stabilize. This is more than in part due to the fact that the drivers of the economy have been consumption (70% of GDP) and a lot of that was financed by increasing ‘wealth’ stemming from the housing market.

With this process now firmly in reverse, house prices declining, repossessions at very elevated levels even if they are currently subdued do to an administrative backlog. House building is at historic low levels – and all the economic activity that comes form people moving houses, doing them up, hiring contractors etc has also come to a virtual standstill.

So perhaps instead of targeting the S&P500 as some have suggested is what the Fed is really doing, perhaps they should focus on the housing market?

There are added benefits to stabilizing the housing markets as a stable housing market would make the banks healthier – it wouldn’t necessarily get the off the hook for previous misdemeanors and outright fraud, but it would help the banking system as a whole. It would enable them to start lending to prospective buyers – and prospective buyers would be more willing to buy if the fear that what they are buying shortly depreciates even further in value. Houses in many local markets are ‘cheap’, but as we know cheap don’t mean it can’t become even cheaper. This is part of the mentality – the other part is that ironically now the market has fallen banks have tightened their lending criteria, so it has become very hard bordering on impossible to get a mortgage, certainly one that isn’t FHA sponsored.

Of course the whole US mortgage market needs to be re-developed along the Danish balance principle model, but that is a topic for another day.

There are some 1.7 million houses in various stages of foreclosure and a total of 6 million mortgages that are delinquent in some form. Falling prices makes this even worse as even homeowners who can afford to pay their mortgage make tactical defaults when they give up hope that their house ever will be worth what they owe on it – and they walk away, because they can.

This is a very vicious circle, which needs intervention on a large scale just to stabilize the current levels of house prices – something that only the Fed, or the government can do.

As the US government has underwritten the GSEs who have assets (and liabilities) on a scale of the US government, so any assistance that would require less tax-payer assistance in the future would clearly be beneficial in several ways.

What would it take? Who knows, but a quick back-of-the envelope calculation suggests that $500 billion would buy 2.5 million houses, or more than are currently in the foreclosure process. This would in my opinion stabilize the market to a degree and make private buyers more comfortable committing.

Maybe the market would improve without all this capital being put to work? Parts of the mortgage market would benefit and this would help as well, both for banks with their existing lending, but for new lending as well?

What would the Fed do with the houses? Alan Greenspan suggested something along these lines which included tearing them all down, as in to help re-start the house-building industry. This may be a solution in some cases, but simply renting them out, perhaps even to people who were foreclosed on, if they can afford to pay some rent would be another option.

Exit strategy is another common question as the Fed embarks on ‘unusual’ programs? Turn the whole thing into a REIT, float it on the stock market and let the Fed be the senior lender until private lending can be arranged, with 20% equity and 80% debt. There are a lot of investors around the world who think that US property is cheap, but do not buy for various reasons: financing is not available, management and maintenance is difficult from afar. Some do buy for cash and for their own use, but many more would be potential investors if most of the hassles were removed and the ticket size reduced (it’s difficult to buy less than a whole house) and it’s much safer to buy a well diversified portfolio as opposed to just one or two houses.

I think there are so many advantages to this approach over buying another stack of treasuries, that it should be something the governors should consider.