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Time for the Fed to start manipulating mortgage rates?

November 24, 2008 |  6:00 am

If you could refinance your mortgage at a 4% fixed rate, you could probably save a bundle, right?

Veteran Wall Street economist Ed Yardeni says it's time for the Federal Reserve to engage in direct market manipulation of long-term interest rates, pulling them down in order to get conventional home loan rates down.

Yardeni, who heads Yardeni Research in Great Neck, N.Y., says that with the housing market still falling fast and the rest of the economy going along for the ride, a global depression is a real risk.

The Fed has slashed its benchmark short-term interest rate to 1% over the last year, he notes, with little or no effect on most long-term interest rates.

Yardeni is calling for the central bank to launch a program that Chairman Ben S. Bernanke discussed publicly in 2002, before he took the Fed's helm. If the economy ever faced a serious deflation threat, and the Fed had already cut short-term rates to zero, policymakers could turn their focus to directly influencing long-term rates, Bernanke said at the time.

This was the famous "Helicopter Ben" speech, for the imagery of a helicopter drop of money into the economy.

Under Bernanke's plan, the Fed would try to manipulate long-term rates by buying long-term Treasury securities for its own account. That's what Yardeni proposed in an email he sent to clients late last week.

I'm not quite convinced this would work as Yardeni sketches it out; for one thing, I wonder who, other than the government itself, would be willing to make and hold 30-year mortgages at 4%. Plus, there inevitably are unintended consequences in attempts to manipulate markets.

In any case, I wanted to share the highlights of his proposal, for discussion's sake.

Here are some excerpts:

The Fed can end the credit crisis today. Chairman Bernanke and his colleagues simply need to announce that the Fed will peg the 10-year Treasury bond yield at 2.0% [down from a market yield of 3.17% on Friday]. This should pull down the 30-year fixed-rate mortgage yield from about 6% now to 4%, possibly lower. That would revive housing sales, home prices, and mortgage refinancing.

The Fed can buy 10-year Treasury bonds with the announced goal of lowering the yield on these securities and pushing down the fixed-rate mortgage rate, which tends to trade off the 10-year Treasury. That's because the average maturity of 30-year mortgages tends to be between 5-10 years as people move and prepay.

How will the Fed pay for the bonds? The Treasury will continue to borrow the funds in the Treasury bill market at rates currently near zero and deposit the proceeds at the Fed. It has been doing so since mid-September to fund the expansion of all the new liquidity facilities established by the Fed to unfreeze interbank lending and money markets. Unfortunately, none of these have done much to open up the mortgage market, which remains in a deep freeze.

The Fed would most likely need to purchase a very small fraction of [outstanding bonds] to peg the 10-year yield. It is very likely that the Fed's purchases would produce capital gains in all sorts of bonds, including mortgage-backed securities, as well as corporate and municipal bonds.

Lower mortgage rates would allow many homeowners to refinance their mortgages. That's what happened after the last recession, with the monthly windfalls helping to boost consumer spending. There is probably enough pent-up demand to significantly reduce the inventory of new and existing unsold homes, which is currently around 4.5 million units, as would-be home buyers respond to the incentive of lower and more affordable mortgage rates.

What if lower mortgage rates don't revive housing activity because lenders are less willing to lend because unemployment is rising? To get out of this "liquidity trap," the Treasury could borrow $1 trillion in the T-bill market and fund a first-come-first-served 4% mortgage sale implemented by Fannie Mae and Freddie Mac with their huge national network of mortgage originators. That should finance up to 5 million home purchases. Americans always respond well to sales. It can be called the Home Recovery Program (HRP).

The best way to remove troubled mortgage assets from complex fixed-income securities and derivatives is to have the borrowers refinance their mortgages. The fairest and most efficient way to do this is with the HRP approach.

There are those who say that housing is going through a necessary "correction." That might explain why the Fed hasn't done more to revive the housing and mortgage markets. It is obvious by now that Mr. Bernanke and his colleagues must act immediately before the housing correction turns into a global depression.

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