There have been many concerns expressed on the internet about the eventual necessity of reversing the Fed’s cheap-money policies, which include “quantitative easing,” as well as a near-zero federal funds rate.

One idea some have is that there are “too many bonds” in the Fed’s portfolio, and that problems will occur with insufficient demand whenever the Fed attempts to reduce its holdings. This doomsday scenario often seems to vex public discussion but is unlikely to materialize, given that the Fed can always make use of its ability to “make a market” for Treasury securities.

An alternative way of looking at the same situation is that there is a huge amount of money and money-equivalents on bank balance sheets and in nonfinancial corporate coffers, and that the tendency of the modern economy toward financial fragility will eventually lead to risky loans and investments using these funds. (Jeremy Siegel adopts this view in the FT, with, however, an unfortunate emphasis on the possibility of a takeoff of inflation. Inflation remains below the Fed’s 2-percent approximate objective, and the greater risk by far is still recession. An Alphaville comment on his column makes the point that the threat of fragility remains regardless of whether banks have excess reserves on hand.) Concerns have already emerged about “junk” bonds, so-called leveraged loans, and other effervescent areas of finance. Of course, the problem then becomes for the authorities to implement an appropriate restraint on financial excesses. One conventional method would be to increase interest rates using open-market operations, which would of course probably entail the sale of securities. This scenario unfortunately might lead to some serious threats to financial stability, including problems that short-term and/or variable-rate borrowers might have meeting payment commitments on their debts, if the Fed were to raise interest rates sharply.

One big historical example of this kind of fragility is the rise in short-term interest rates that occurred in the late 1970s and early 1980s at the behest of the Fed. The resulting delta-R effect helped to bankrupt Mexico, among other disastrous impacts. Many years before that, the Fed was more inclined to use direct controls on credit, restricting the amount of money banks could lend out.

Key to the situation today, efforts are ongoing in Washington to formulate and implement appropriate rules to insure that various kinds of bank lending do not get out of hand in the first place. Efforts of this type would be unlikely to completely prevent future crises, but, if effective, would act to reduce fragility. Among other benefits, this approach might also permit the recovery in housing investment—currently only in a fledgling phase—to continue. Given the problems that sharp interest-rate increases can bring, it would also be helpful to keep the effects of moderate inflation in perspective, and to cope with inflation in non-destabilizing ways.

Local government officials in San Bernardino county have apparently heard enough about how the overhang of mortgage debt is holding back the recovery, and they’re considering taking matters into their own hands.  Reuters‘ Matthew Goldstein and Jennifer Ablan report on the background discussions leading up to a proposal that is being considered by officials in San Bernardino, California—a county where almost half of all mortgages are “underwater.”  The general idea is to use eminent domain as a kind of mortgage debt forgiveness program:  principal reduction would be achieved by forcing the sale of mortgages that have been packaged into securities; the mortgages would then be restructured on more favorable terms.  Homeowners with underwater mortgages who are current on their payments would be able to participate.

Randall Wray and Paul McCulley are quoted in the piece, with the latter describing the program as “[a] legal system-midwifed, modern-day jubilee.”  Read the article here.

We may not have a high degree of success at predicting precisely when a financial crisis will occur or exactly how big it will be, but what we can and should do, says Éric Tymoigne, is develop effective ways of detecting and measuring the growth of financial fragility in a system.  “[S]ignificant economic and financial crises do not just happen,” he writes, “there is a long process during which the economic and financial system becomes more fragile.”

One of the purposes of the Financial Stability Oversight Council (FSOC) that was created by Dodd-Frank is to provide regulators with an early warning system regarding threats to financial stability.  In light of this, Tymoigne provides his latest contribution to the construction of a measure of systemic risk and identifies specific areas in which we need better data.  With the aid of Hyman Minsky’s theoretical framework, Tymoigne has developed an index of financial fragility for housing finance in the US, the UK, and France.  The point is not to attempt to predict when a shock to the system is likely to occur, but to measure the degree to which such a shock would be amplified through a debt deflation.  From the abstract of his latest working paper:

… instead of focusing on credit risk … financial fragility is defined in relation to the means used to service debts, given credit risk and all other sources of shocks. The greater the expected reliance on capital gains and debt refinancing to meet debt commitments, the greater the financial fragility, and so the higher the risk of debt deflation induced by a shock if no government intervention occurs. In the context of housing finance, this implies that the growth of subprime lending was not by itself a source of financial fragility; instead, it was the change in the underwriting methods in all sectors of the mortgage markets that created a financial situation favorable to the emergence of a debt deflation. Stated alternatively, when nonprime and prime mortgage lending moved to asset-based lending instead of income-based lending, the financial fragility of the economy grew rapidly.

Tymoigne also distinguishes between measuring financial fragility in this way and detecting bubbles: continue reading…

Matthew Goldstein and Jennifer Ablan report on the latest US investment craze:  buying up large bundles of foreclosed homes from Fannie Mae and renting them out to take advantage of the hot rental market.  Randall Wray is among the critics quoted in the article who contend that, as Goldstein and Ablan put it, “the federal government is fostering a transfer of wealth of sorts by selling big pools of foreclosed homes to big fund investors and high-net-worth individuals. There’s also concern that some of the players who helped create the housing crisis will now benefit by buying foreclosed homes at a steep discount.”

Wall Street benefited from the ballooning indebtedness of American households on the way up, and now on the way down they’re taking advantage of the flipside of that indebtedness, as families’ assets are seized, transferred, and rented out … likely to some of the same people who just lost their homes.  That feedback loop is galling enough.  But as Wray has pointed out, it’s also a cycle that’s been greased by foreclosure fraud.

Felix Salmon is surprised at the continued success of the financial industry in pushing legislation (in this case, he’s talking about the proposed “JOBS Act,” a key provision of which involves a nice dose of financial deregulation):  “a bill which was essentially drafted by a small group of bankers and financiers has managed to get itself widespread bipartisan support, even as it rolls back decades of investor protections.”

At this point, it’s very difficult to imagine what could possibly change these dynamics.  Clearly, triggering a global economic collapse hasn’t made a dent in the sway the industry holds.  There was a lot of enthusiasm surrounding the Occupy movements, but it’s hard to see it amounting to a countervailing political force (even if it intended to be one, which isn’t clear).  Dodd-Frank, for all its faults (and they are legion:  see this new Levy Institute working paper by Bernard Shull, and Chapter 1 of this analysis) appears to be the only game in town.  If it’s able to shrink the sector a little that may change the political economy—but only at the margins.  And that’s likely the best case scenario.

(cross posted at EconoMonitor)

Yves Smith at Naked Capitalism has long been skeptical of the negotiations by the State Attorneys General and the banksters over the foreclosure frauds (see here). And while I had held out some hope that California and New York would either refuse to join, or would insist on good terms, today’s announcement of the settlement makes it clear that the banksters had their way. I expect that the US Attorney General, Eric Holder and HUD Secretary Shaun Donovan played important roles in making sure the bank frauds would only get little slaps on the wrist.

Some of the details are not clear, but apparently the 750,000 people who had their homes stolen from them will get a mere $2000 a piece in compensation. That is how this Administration values homeownership. Yep, a bankster can take your home and you might get two thousand bucks–and with that you can pay first and last month’s rent on a cheap, run-down apartment if you are willing to live in a low rent city.

It also gives you some idea of the cost of buying out 49 states: $2.75 billion. Yep, that is all that the states get out of this settlement. They’ll look the other way and let you move in, completely destroy property records and proceed to steal the homes of your citizens while destroying your economy and tax revenues–and for under 3 billion measly dollars you can buy off their chief prosecutors.

What about underwater borrowers? Well after crashing the real estate markets, the worst of the banksters have agreed to provide $3 billion for relief. How far underwater are homeowners? $700 billion. So far. continue reading…

The clock is ticking and right now first-time buyers have to close the deal in six days. The incentive is sweet: up to $8,000 from Uncle Sam. The Internal Revenue Service reported that $12.6 billion was credited to 1.8 million home buyers (the final toll will be higher as transactions in 2010 have not been filed yet, not to mention the inevitable fraud).

Calculated Risk, a highly regarded blog that tracks these matters, suggests that six months of inventory is normal in the housing market. For new homes, in May, the level rose to 8.5 months from 5.8 in April as sales plunged. Things are little better in the market for pre-existing homes; there we find 8.3 months of supply, in part due to the non-stop flow of foreclosures and short sales.

From the data, it seems that the tax credit program has stimulated the market, at least a little, and for awhile. My question to you is, should our uncle in Washington keep the program going?

Pros:

• Propping up shaky home prices may encourage private spending and support aggregate demand.
• Aiding the real estate market in lowering inventories may keep prices from falling further and generate some construction jobs.
• Reaching a “normal” level of inventories may improve everyone’s expectations and thus create a virtuous cycle of self-fulfilling recovery.

Cons:

• The tax credit program may condition potential buyers to wait for another round of subsidies, thus delaying the very purchases we most want to accelerate..
• The temporary subsidy may not be enough to sustain a high volume of transactions, and inventories may rebound (unless higher demand fueled by economic recovery takes place miraculously). Multiplier effects of the subsidy may not be enough to get us to a self-sustaining market.
• The program delivers benefits to people who can afford to buy home, and therefore is regressive. This regressivity implies high opportunity costs.