US Follows UK Approach To Quantitative Easing

In response to interest rates approaching zero both the UK and the US have embarked on a process of quantitative easing, the modern equivalent of printing money to try and drive economic growth. In most circumstances increasing the money supply in this way needs to be done very carefully, as it can lead to inflation and a decrease in the value of a country’s currency. In this situation however, with deflation a much more realistic threat and interest rate reductions failing to drive needed growth, this approach has been deemed worth the risk for the time being.

The approach being taken is to generate money that the central bank, in the case of the US the Federal Reserve, and in the case of UK the Bank of England, use to purchase various forms of debt. As of today the US Fed has decided to follow the approach taken by the Bank of England and start purchasing government issued bonds. The goal of this exercise is to drive down interest rates on this government debt, due to the price of these bonds rising based on increased demand. Hopefully we will then see a similar effect happen in other areas of debt issuance. Up until today the US Fed had chosen not to go down this route. Instead it had chosen to invest in multiple types of commercial debt, the goal being to kick start the flow of lending in this area more directly. This path will continue and will now be complimented with government debt purchases. There will also be an expansion of planned purchases of mortgage backed securities.

Interestingly the US benefits greatly from being a safe haven reserve currency, especially in these troubled times. Despite the huge amount of debt the US plans to issue, the safety of US bonds continues to allow the US government to gain financing at relatively low rates. The dollar has gained considerably in value because of this status. It seems however that the Fed feels we have reached the time to pull out all the stops, so has opened up another front in the battle to revive growth.

The UK is similarly hoping that money flowing into the system through the purchase of UK government debt, will translate into additional lending and generally lower interest rates. It has not embarked on purchasing commercial debt directly as in the US, but could do so in the future. You also have to wonder if the decision by the US to purchase its own debt will put some pressure on the effectiveness of the UK scheme.

At the end of the day we will need to wait and see how effective this all is. Quantitative easing was used by Japan during the period of their “Lost Decade” and there is debate as to the effectiveness of this. Only time will tell how effective it will be for the US and UK.

Will The Housing Bailout Work?

It seems that the new housing bailout being proposed by the administration may not go to the core of the issue, namely helping to stabilize the markets in parts of California and Florida where some of the biggest hits to housing have happened and many problem mortgages exists.

The first approach being proposed, a loan modification, may help some people, especially those whose interest rates have risen considerably or who have suffered a drop in income. The loan servicer can be approached to see if the terms can be adjusted, either by rate reduction or loan term extension. Federal government support provides principle reductions extending up to five years if the borrower stays current. This can amount to $1000 a year. The adjustment lasts for five years after which rates can adjust back up to conforming rates at the time of the adjustment and at most increase by 1% a year. This means there is already an assumption that house prices will have had time to recover or the borrower’s situation improved by that time. We may just be deferring a problem five years out at considerable cost. Another issue is that homeowners may have a second mortgage, which they may have taken to get into the home in the first place or they later added which may complicate things.

The refinance approach may hit a hurdle on a chunk of the California and Florida mortgages as well. To be eligible the mortgage needs to be held by Fannie Mae or Freddie Mac. In this situation if the borrower can pay the new loan amount a refinance may be offered via these institutions. They must have less than 20% equity in their home and loans worth up to 105% of a home’s value may be eligible. Those people with more that 20% equity in their home can refinance though the standard market. The issue is some of the loans in these states were jumbo loans and so won’t qualify, or had low deposits so may not have been Fannie or Freddie loans. Many people who could get Fannie or Freddie loans in these states may have had large equity amounts, down payments, or got into the market long enough ago to still have adequate equity. In addition some people in these states are far more than 5% underwater with their mortgage, which means a modification if viable is the only option.

The one thing not noted is the case of the person with more than 20% equity. If they resisted the temptation to over borrow or refinance money out of the home and have saved money for a rainy day, there is nothing for them if they suffer a drop in income. If the income drop because of the recession is too great to get a regular refinance they have to wait until their finances are depleted for a modification.

A lot of government money is going to go into these programs. If they can’t break the cycle of foreclosures in California and Florida, or stabilize house prices in these states, then they may not do much to put a floor under the issues in the financial markets, or restore house price statistics at the national level appropriately.