In 2008, when our nation's housing finance system imploded, the Federal Reserve was forced to step in as "lender of last resort" to America's homeowners. Five years later, the Fed remains the principal source of funding for home mortgages, buying mortgage-backed bonds issued by Fannie Mae and Freddie Mac (both now in conservatorship) and in the process adding trillions of dollars in mortgage securities to the central bank's balance sheet.
As a result, the Fed's balance sheet has taken on some of the characteristics of an old-time savings and loan association. Looking back, it will be recalled that when inflation ticked up, having borrowed short and lent long, the S&Ls got caught in an interest rate bind that led to the demise of their industry over time. The Fed does not appear to be implementing a strategy to hedge the interest rate risks associated with its mortgage-backed securities portfolio. It may not need to, because it is not subject to the same accounting rules that the S&Ls were. However, whether the Fed will be insulated from the risks associated with lending long in a low interest rate environment is yet to be determined. We are in uncharted territory.
In its role in setting monetary policy, the Fed has adopted a hyperlow interest rate strategy designed, at least in part, to put a support under house prices. While this policy has helped to cushion the decline in house prices, it presents significant challenges to individuals and businesses, in particular retirees with investments in interest-bearing accounts, community banks seeking to earn a decent spread on their loans, and insurance companies and pension funds seeking to balance risky stock market investments with investments in long-term bonds. Not surprisingly, these constituencies are starting to make their views known to Congress, and they may become more vocal when the president nominates a new Fed chairman next year subject to confirmation by the Senate.
A significant side effect of the Fed's hyperlow rate policy is that it makes the emergence of any private sector housing finance system almost impossible. Who can compete with the central bank? What private sector player can take the interest rate risks that the Fed is taking?
If the mortgage credit binge of the mid-2000s was a form of financial drug addiction, the Fed's current policies seek to stabilize the situation by putting the mortgage market on methadone. But methadone has some nasty side effects, and the question now is how long it will take to kick the financial methadone dependency and return to normal market conditions. This is not an easy problem to solve, and in making the methadone analogy, I intend no criticism of the Fed. Rather, I sympathize with a tough situation in which our central bank finds itself.
Over the last five years, the only governmental nod in the direction of reconstituting a private mortgage market is a white paper issued by the administration which suggested some alternatives to be considered, but these suggestions have languished. More recently, the Bipartisan Policy Center has made some helpful preliminary proposals on how to rebuild the private secondary mortgage market as part of its overall report on America's housing future. However, Congress and the administration have not committed the time and effort to find a way to provide stable funding for home mortgages from any source other than the Fed.
