A Sticky Cycle
Back when the housing bust was still in full swing, we frequently mentioned that the incessant bottom calling may be premature, especially from a longer term perspective. Experience showed that housing cycles can be very ‘sticky’, both on the way up and on the way down.
While a real estate bubble expands, ‘wealth’ is seemingly created ex nihilo. Credit expansion and rising home prices egg each other on, an effect amplified by financial innovations such as mortgage refinancing and home equity credit lines. What really expands is not wealth however, but the money supply. It should be obvious that the ‘wealth effect’ this produces is a fiction, but due to the persistence of the cycle, there is a tendency for people to begin to regard the gains as real and permanent.
With respect to the ‘stickiness’ aspect, consider that e.g. Doug Noland (the credit analyst of the Prudent Bear fund) already started looking askance at the balance sheets of GSEs like Fannie Mae and Freddie Mac as far back as 1998. Noland presented a thought experiment at the time: what if the value of Fannie’s portfolio were to decline by just 3% or 4%? He pointed out that its equity would be completely wiped out and rightly noted that this extremely overleveraged entity represented a danger to US tax payers.
Noland drew attention to the fact that the GSEs tended to swing into action whenever a confidence crisis hit the stock market, such as in 1998 when the Russian and LTCM crisis struck. The GSEs would help with system reliquification by stepping up their purchases of mortgages from commercial banks. In essence, they used their nimbus of invulnerability, provided by the well-known fact that they would definitely be bailed out if push ever came to shove, to rescue the still evolving asset bubble on such occasions. Around the same time when Noland began to talk about these activities and the associated risks, the Fed started to accept GSE debt in its open market operations, introducing outright monetization of mortgage debt. This method has a long tradition – it is essentially a modern day version of what the French revolutionaries did with the assignat.
