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4 Factors and 3 C's: Mortgage Markets Past the Elections

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4 Factors and 3 C's: Mortgage Markets Past the Elections

With only a short while to go before the mid-term elections, we may soon begin to get more clarity about the direction of fiscal and monetary policy and their ultimate effects on the economy. The election comes in the midst of a changing regulatory environment, and one where there is uncertainty about the potential for significant tax increases come January 2011. The elections also occur at a time when the Fed is set to employ relatively untested monetary policy. Depending upon the amount of change to the composition of the Congress, the political winds may speed up, slow down or even arrest this process of change.

Before economic and housing recovery can occur, there are at least four areas in various states of flux which need to solidify, so that a platform of confidence and clarity can begin to form. While there are no guarantees that a sharper picture will come into view after the elections, we should at least be able to get a better sense of where we are headed, which would produce a welcome bit of certainty.

Factor One: New Regulatory Environment

Looking past the elections, the regulatory environment remains a murky one. The forthcoming Consumer Financial Protection Bureau (CFPB) is in its formative stages, and it appears to have mortgage documentation reform as its initial primary agenda. There was a significant study done on improving mortgage disclosures just a few short years ago, and it is reasonable to think that some form of streamlined documentation process will come in fairly short order. However beneficial they might ultimately be, changing regulations and documentation requirements aren't without cost or disruption to the mortgage lending process. Pro-consumer regulations don't necessarily need to be anti-business, but it is a reasonable guesstimation that a Democratic win in November would provide a greater tailwind for faster change. On the other hand, a Republican victory might slow this process somewhat, as business interests might find more ears for their concerns.

There's nothing wrong with making changes to mortgage disclosures, provided greater clarity can actually be achieved. Given prior attempts at document reform, this has proven to be an elusive outcome. One way or another, reform is likely to come no matter whom the victor in November. As such, we think the elections will simply determine the speed of the changes.

Aside from the formation of the CFPB, the Dodd-Frank Act also made considerable changes to the risk/reward calculation for mortgage lending. While the "old" mortgage system may have broken badly, it's worth noting that it did function well for many years, and more importantly, was well understood. What is not clear is whether the writers of the new regulations fully understood the causes of the breakdown, and if the new regulations they wrote properly address them. Until this new lending landscape is again well understood it is hard to expect that borrowing mortgage money will become cheaper or easier for consumers.

Factor Two: The GSEs

Fannie Mae and Freddie Mac are destined to change, as well. But how, and how soon? Despite a number of opportunities for consideration, even the Dodd-Frank Act failed to address the Fannie/Freddie situation. There is no doubt that the quasi-public GSE structure collapsed, but as far as reform goes, one side believes the private sector incapable or trustworthy enough to take over these functions; the other, that the government is largely incompetent and lacks the market skills to do it successfully.

While there is no doubt that the GSEs need to be reformed, the open question of how best to proceed without further disruption to the mortgage finance system remains unanswered. While there is no doubt that the public-private system here has broken, we think it's interesting that there has been far more caution taken in the consideration of changing Fannie and Freddie than that which was afforded to the private sector of the mortgage market. To be sure, both the private market and the GSEs share in the responsibility for the mortgage mess, but only one has had any form of "reform" foisted upon it.

So, will the pace of GSE reform speed up or slow down, depending upon the results of November 2? Our guess is neither; even then, once they do, our suspicion is that only minor reforms will come, with substantial reform possibly kicked past the 2012 presidential election. Preserving the status quo does have risks, but it's not inconceivable that by that time that billions of dollars in losses now picked up by taxpayers will have begun to diminish or even reverse, lessening the need for full-blown overhaul.

Factor Three: Federal Reserve

The Federal Reserve seems likely to embark on a bit of an unknown monetary journey. Having exhausted the value of its primary policy tools (manipulating the Federal Funds and Discount Rates), the Fed is expected to turn to Quantitative Easing (QE), a process where they purchase Treasury obligations; in turn, this drives down the yields on these instruments, pulling interest rates downward. Investors have been snapping up these guaranteed investments for several years, preferring safety over the ability to garner more sizable returns. By driving their prices up (and their yields down) the Fed hopes to make these investments return so little that investors will be forced to consider other opportunities, including mortgage, corporate and municipal bonds markets and such. However, there are no guarantees that this will work or produce the desired effect, or that doing so will produce no effect on future inflation trends.

It has been reported that there is already perhaps a trillion dollars being held by firms waiting for viable opportunities to be placed into the economy. It's also true that there are billions of dollars being held by the Fed for banks in "excess reserve" accounts which are earning perhaps a quarter percent in interest, money which remains parked instead of being pushed out into the economy.

Lowering interest rates may or may not have much effect on final economic growth, since they are at or near record lows already. The price of money could be zero percent, but if there continues to be little reason to borrow to expand capacity or invest in additional productivity -- even when individuals and firms can overcome today's underwriting requirements -- there will be little net beneficial effect.

Factor Four: Tax and Fiscal Policy

Overhanging all these concerns is the expiry of the Bush-era tax cuts. Slated to end in January, discussion of extending, modifying or eliminating them has been postponed until after the elections, which by itself has contributed to the uncertain environment in which the economy stands. An increase in taxes will likely further delay economic recovery and that alone is a strong argument for extending the expiration for a couple of years. However, some in Congress have expressed a preference to retain some brackets and let others expire, and discussion along these lines muddies the water to an even greater degree. It would have been far more beneficial to simply have a decision one way or the other a couple of months ago, but instead, a lack of consensus about what to do leaves us hanging for longer.

It is a reasonable bet that if the Democrats should hold sway come November 2 that tax bills will rise for a fair portion of people and businesses. Conversely, if Republicans are swept in, the Bush-era tax cuts may remain for a while. From a business, economic and planning perspective, it would be good just to know what the tax picture would be, and without it, many plans remain in a state of limbo. This lack of clarity -- this uncertainty -- is said to be holding back economic growth.

Given the extraordinary efforts of the Federal Reserve and other central banks to keep the recession from becoming a depression, there is little more they can conventionally do to spur the economy. For all the money spent on stimulus, it has not had the desired effect; we think this is because the money was concentrated into too few and too narrow economic expressions to do much good, and those effects are starting to wane. A payroll tax cut is probably off the table at this point, but seems to us to be perhaps the only way to spread dollars around the economy in hopes of producing widespread recovery. Failing that, we'd favor at least a straight-up extension of the old tax policies for a while.

The Three C's: Clarity, Certainty and Confidence

We are hopeful that the coming elections will bring clarity to some or even all of these issues. With a little luck, that would lessen the need for unconventional moves which have uncertain benefits and risks. It's our opinion that the economy might benefit most from a kind of stasis, an environment where the rate of regulatory, monetary and fiscal change comes to a pause, at least for a while. We recall a time not all that long ago where we did have political gridlock, and the economic results were quite satisfactory; without these constantly shifting sands, we might foment a sense of certainty, a place where confidence about near and long-term prospects can form, and planning for recovery -- rather than dealing with crisis -- can become the focus.

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