The FOMC Nominees on Housing and Mortgage Markets

By Aaron Terrazas on 28 Apr 2014

The Senate is scheduled to vote tomorrow to confirm Stanley Fischer, Lael Brainard and Jerome Powell (re-nomination) as Governors of the Federal Reserve, with Mr. Fischer set to become the vice-chair of the central bank’s policy committee. The Fed has undeniably played an outsized role in housing and mortgage markets in recent years, a role that is likely to continue in the near-term as the exit from unconventional monetary policies continues and as Congress (possibly) forges a new housing finance system. The three new Fed governors will be important voices shaping these issues.

Zillow Research scoured the public record to gain insight into the nominees’ views on housing and mortgage markets. In the cases of Mr. Fischer and Mr. Powell, both of whom have long records in working on monetary policy, there is an extensive public record. In the case of Ms. Brainard, who most recently served as the Treasury Department’s senior diplomat, the record on these particular issues is less abundant as her career has focused overwhelmingly on international trade, finance and development.

It is, of course, impossible to succinctly summarize the nuanced opinions of experts with such long careers. The public record offers just a glimpse into their thinking, and their views will invariably evolve with new evidence and in response to unexpected challenges. However, to the extent that the public record fully captures the complexity of their views, we examine their words and actions on two sets of issues that are central to housing and mortgage markets.

The issues

Beyond the translation of the interest rate set by the Federal Reserve Board’s Open Market Committee (FOMC) into mortgage markets, two sets of interconnected issues are at the core of how the Fed interacts with housing and mortgage markets:

• Asset price bubbles, and the role of central banks in proactively limiting bubbles, responding retroactively to their effects, or inadvertently creating them; and
• The moral hazard associated with insurance or government guarantees, particularly as they relate to private losses against mortgage loans.

There is a longstanding debate among monetary policymakers about the appropriate role of central banks in responding to perceived asset price bubbles. Should monetary authorities proactively address these bubbles (sometimes referred to as “leaning against the wind” or “pricking” bubbles) or should they respond only retroactively to the macroeconomic consequences of bubbles (often referred to as “mopping up” after crises)? The latter view held sway from the 1980s through the early 2000s and was most prominently articulated by former Fed Chair Alan Greenspan. However, the former view has gained traction since the 2008 Financial Crisis and is embraced by the current generation of Fed leadership, including by current Chair Janet Yellen.[1]

Home prices have recovered strongly, if unevenly, since the recession. Markets on the West Coast, some urban centers, and higher price tiers have shown double-digit price appreciation, while growth has been slower elsewhere. There were persistent concerns about limited supply in 2013, as many potential sellers presumably withheld inventory from the market with the expectation of future price gains. Although housing remains historically affordable, there is growing concern that recent gains might not be sustainable, particularly when interest rates eventually rise.

A separate set of debates revolve around the potential of central bank policies to create asset price bubbles. Some observers believe that central bank policies to hold interest rates low for a protracted period, through both the policy interest rate and large scale asset purchases (LSAPs), can push markets toward risky or concentrated investments leading to price bubbles and, ultimately, to financial crises. In the current policy context, the concerns typically focus on how the Fed’s policies may have contributed to overvaluation in emerging market equities and advanced economy housing.

Finally, the Financial Crisis raised difficult questions about the appropriate role of governments in guaranteeing the liquidity and solvency of large, interconnected or systemically important financial institutions. As occurred during the crisis, the failure of one of these groups can cause macroeconomic turmoil. However, guaranteeing their solvency raises the likelihood that a private actor will benefit from a government subsidy, potentially leading to riskier behavior and, eventually, large taxpayer liabilities.

These competing concerns mirror much of the divide within Congress about the appropriate direction for housing finance reform. (In March a bill that would limit the government’s role in purchasing mortgage loans and insuring mortgage-backed securities, the Housing Finance Reform and Taxpayer Protection Act, was introduced in Congress.) Although the Federal Reserve will not play a role in shaping the law, and Fed governors are likely to avoid commenting on pending legislation, they will play a role in monitoring and analyzing the housing finance system that could emerge.

Prior to the Financial Crisis, Freddie Mac and Fannie Mae—the two corporations that hold special charters from the U.S. government and are mandated, among other responsibilities, with ensuring liquidity in housing markets—benefited from the perception of a government guarantee against losses. When mortgage losses mounted, these perceptions proved accurate, and the U.S. government assumed control over the two companies. Taxpayers became liable for potential losses in their portfolio of mortgages. Many lawmakers are concerned about this potentially large liability and hope to limit potential loss to taxpayers in the future without eliminating the essential maturity transformation service (i.e., converting short-term loans from investors into long-term loans for home buyers) that the two companies provide.

A consensus has emerged that some government guarantee is necessary, but there is debate over the extent of that guarantee and whether or not reducing the level of the guarantee will fundamentally shift the behavior of the two corporations. Some policymakers believe that if private investors are forced to assume responsibility for substantial first losses, they will be more prudent in their lending standards; others argue that the moral hazard to maximize risk beyond the private liability will continue as before the crisis, just at a different price-quantity equilibrium.

The nominees

Stanley Fischer

Mr. Fischer previously served as the Governor of the Bank of Israel, in senior positions at the International Monetary Fund (IMF) and as an academic. His research has shaped many of the issues (and individuals) currently responsible for monetary policy around the world.

As Governor of the Bank of Israel, Mr. Fischer took proactive steps to cool an overheating Israeli housing market. Although the macroeconomic and institutional environments were very different from the United States, his actions provide insight into his thinking on asset bubbles. (Unlike its counterpart in the United States, the Bank of Israel is the primary banking regulator and has the sole authority to make such decisions. Also unlike the United States, banks are the principal source of housing finance in Israel allowing the actions of bank regulators to have a direct and targeted effect on mortgage lending.)

Confronting annual home price increases that peaked near 20 percent year-over-year growth in mid-2010, the Bank increased reserve requirements for high-leverage and floating-rate mortgage loans, and set caps on loan-to-value ratios.[2] “The atmosphere in the housing market was becoming increasingly bubble-like, with discussion of the need to buy before prices rose further,” Mr. Fischer said in a 2011 speech.[3]  This logic does not necessarily apply to other asset classes since, as he notes, housing is a unique asset in that it is a widely held and has broad implications for both household finances and aggregate output. Other assets are of interest to central banks only to the extent to which they threaten price, output or financial stability.

A critical nuance is that the Bank of Israel did not estimate that home values were, at the time of its actions, above their equilibrium levels. Rather, the Bank estimated that, given the recent rate of home price appreciation, home prices would in time exceed their equilibrium level. The Bank of Israel’s anticipatory actions in the face of rapidly rising home prices were designed to moderate housing demand and reduce the risk lenders would face if loan defaults were to increase. However, Mr. Fischer noted that it would have been preferable to undertake measures to increase supply—responsibilities that typically lie with fiscal authorities.

With respect to the potential for moral hazard inherent in government guarantees and insurance, Mr. Fischer takes a pragmatic stance, recognizing the need to balance the risks and benefits. “The mere existence of a lender of last resort raises moral hazard issues. That is true,” he writes. “But there is nothing that says that the optimal reaction to moral hazard is to stop selling insurance.” Rather than aiming to avoid moral hazard entirely, he seems to be in favor of proactive, preemptive monitoring of potential conflicts or behavior that could lead to abuse of insurance or guarantees:

“After having had to decide how to deal with moral hazard issues in a variety of financial crises, I have arrived at the following guide to conduct: If you find yourself on the verge of imposing massive costs on an economy—that is on the people of a country or countries—by precipitating a crises in order to prevent moral hazard, it is too late. You should not take the action that imposes those costs. Rather in thinking through how a system will operation in a crisis, you need to take into account the likelihood of facing such choices, and you need to do everything you can in designing the system to keep that likelihood very small.”

Jerome “Jay” Powell

A centrist voice on the FOMC with a background as a lawyer and investment banker, Mr. Powell previously served as a senior Treasury Department official in the administration of George H.W. Bush and has served as a Fed governor since May 2012. His views are generally thought to be guided by experience and intuition more than formal economic theory.

In a series of speeches in 2013, Mr. Powell addressed the issue of how Fed policies might contribute to bubbles in a wide range of asset classes, including emerging market equities, U.S. domestic equities, fixed-income securities (bonds), and housing. While acknowledging the possibility that a protracted period of low interest rates can lead to price bubbles, for the most part, he appears to believe that fundamentals have played a more important role in driving investors to emerging market equities, domestic equities, and housing. (He has also downplayed the effect of LSAPs on interest rates, saying that he believes that the Fed’s main econometric model slightly overestimates their effect.) However, the same comments suggest that he is more concerned about declining spreads and increased leverage in the market for high-yield fixed-income securities (as of June 2013).[4]

With respect to home values, Mr. Powell said in a June 2013 speech that he did not believe housing was anywhere near the bubble conditions that prevailed prior to the crisis. “At the peak of the bubble, house prices were more than 40 percent above their usual relationship to rents, according to one model that the Fed staff follows,” he said. “At their trough, house prices had fallen about 10 percent below fair valuation. Given the price increases over the past year, they are—by the lights of this one model—moving back into the approximate neighborhood of fair valuation.”[5] In general, his remarks signal a confidence in the capacity of markets to recognize and correct course when assets are overvalued while remaining cognizant of the importance of “careful monitoring” by regulators (including the Fed).

Although Mr. Powell has not spoken in depth about housing and mortgage markets recently, he has extensive experience and familiarity with the strengths and weaknesses of the U.S. housing finance system. As an assistant secretary at the Treasury Department responsible for financial issues during the George H.W. Bush Administration in the early 1990s, he spearheaded efforts to increase supervision of Freddie Mac and Fannie Mae in the wake of the Savings and Loan Crisis.[6] At the time, he was in favor of strong regulatory standards and capital requirements for the two government sponsored enterprises, recognizing the risks that their implicit government guarantees posed to the federal budget, and also warned of the possibility that the two companies would attempt to inappropriately influence the regulatory agencies.

Lael Brainard

Of the three nominees, the least is known about Ms. Brainard’s views on housing and mortgage markets. Having previously served in the Obama Administration as the Treasury Department’s Under Secretary for International Affairs, and earlier as an economic advisor to President Clinton, her career has focused mainly on trade, development and international financial questions. These experiences on the frontlines of policymaking during the Asian Financial Crisis in the late 1990s, and during the most recent Financial Crisis, suggest that she is confident in the capacity of regulatory agencies to identify and manage market risks while simultaneously being cognizant of the limits of any regulatory efforts.

Reflecting on the Asian Financial crisis, in 2002 she wrote, “New recruits at the IMF should focus less on the niceties of accounting and lecturing foreign financial authorizes and more on preparing to handle the next crisis. That approach means discerning troubling linkages in the minds and portfolios of international investors, unearthing hidden sources of danger such as unfunded liabilities on central-bank balance sheets, and examining the soundness of financial systems with a view to macroeconomic vulnerability.”[7] Her prediction that the world would sooner or later confront another financial crisis of “potentially worldwide proportions” proved prescient. Of course, operationalizing these general objectives has been particularly difficult where attempted. Nevertheless, a decade later in the wake of the latest financial crisis, her advice to IMF recruits seems equally relevant for central bank nominees.