Why does monetary policy pay so much attention to housing? The easy answer over the last twelve years is the bubble. It was hard not to, though for a very long time policymakers did attempt a systemic disavowal. But beyond the middle 2000’s housing mania, central banks have had a very keen interest in real estate from the beginning.

The shorthand for monetary policy, meaning interest rate targeting, goes something like this: reduce the cost of funding, short end; steepen the yield curve which therefore makes it more profitable for banks to engage in lending. This is called a carry trade, or maturity transformation. The vast majority of bank lending is, surprise, mortgages.

But mortgage lending isn’t so simple and easy, and hasn’t been since securitization went into mass production (about the same time the mortgage-fueled housing bubble appeared in the latter half of the nineties). The shorthand therefore doesn’t really apply. And in mortgages, that’s really the case as I described several years ago in 2014:

First, you have to realize that the Fed through FRBNY’s Open Market desk doesn’t just buy some mortgage bonds as if they were like US treasuries. QE actually operates deep within the bowels of mortgage bond trading in a place called TBA. The entire purpose of the TBA market is to provide liquidity to something that is, at its core, completely and totally illiquid. A mortgage loan is about as static as it gets in banking.

 

What the Fed is buying through the Open Market Desk are largely “production coupons.” The TBA market is a highly standardized operation allowing millions of individual mortgage loans to be packaged into MBS securities in such a fashion that these otherwise immovable loans can be turned to cash in a moment’s notice. But mortgage originators need to “buy” GSE guarantees and factor that cost into the setting of MBS prices (along with a set aside for servicing costs). So whatever the net yield on the mortgage pool, say for argument’s sake it is 5%, the originator will pay 50 bps to the GSE for its guarantee, set aside 25 bps for servicing costs and then subtract its own spread. If that profit spread is 25 bps, the “production coupon” that is left is 4% to the market.

 

The Open Market Desk’s purchase of production coupons amounts to a retail purchase out of what is really a wholesale product. The generic ideal is that by purchasing more production coupons than might have otherwise been bought it will allow more room for originators to pocket a spread. In other words, if the Fed purchases bump up demand to the point that the “market” is competing for production coupons at 3.75% instead of 4%, the originator can gain some additional bps in profit spread and even pass some of those savings to new mortgage loans in the form of lower interest rates. The increased spread should, theoretically, entice more participation and increase production of mortgage loans to add to the TBA pool (because there is more profit to be had).

This complexity matters, even though it’s intended to work out in roughly the same way. It’s not a simple carry trade by any means, though it continues to be described that way. In the real-world model only briefly described above, balance sheet capacity is paramount meaning a whole other set of factors to consider. In the shorthand, there are just two variables, short and long rates.

Turning monetary policy toward economic policy, as the modern central bank has done for itself, the focus on housing is equally fortuitous. Not only are mortgages a bank’s biggest product arena real estate has proven time and again to be one of the more potent pro-cyclical aspects of any developed economy. We can thus extend the shorthand into Economics: steepen the yield curve; encourage mortgage lending; shorten, or reduce entirely, recessions.

This is, essentially, the critique of monetary policy in blaming the Federal Reserve for the housing bubble. Convention says these central bankers did just that in response to the dot-com bust and the recession following it, and therefore in bringing the short end down as far as they did (1% FFT by 2003) they ignited the mortgage fury.

Not so. The Fed bears responsibility for the housing bubble just not in that way. In the same way “rate hikes” produced only conundrums in the bond market, and little tightening, rate cuts amounted to a lot of the same irrelevant flailing. If we are to blame the central bank for anything it’s for not following up with their monetary blindness (“proliferation of products” as Greenspan correctly recognized as his central bank’s impossibility for defining modern money).

In GDP economic accounting, the real estate segment’s direct contribution is counted under fixed investment. The pro-cyclical nature of it is obvious. What’s not is the far right side of the chart above; the housing market crashed, and still twelve years on has yet to really recover (you should also note how there was very little negative contribution from housing leading up to and during the 2001 recession).

Coming at it from the reverse, the answers are quite simple. There isn’t more of a GDP contribution from new real estate construction because there aren’t more homes being sold. The separate statistics for New Home Sales, with the latest update released today, are very much in line with the GDP version of real estate construction from the demand/supply angle.

Sales did spike in the aftermath of Harvey and Irma, but have since declined back into the same trend as before. In other words, that few months of higher sales was not, as many had been hoping under inflation hysteria, the signal for the long-awaited recovery. If there was going to be an economic breakout, it would have been logical to look for it in this part of the housing sector.

It’s just not there, leaving us to try and figure out what it is that’s missing. It can’t be slowing population, as the charts above show. When adjusted for demographics (Civilian Non-institutional Population), builders are still constructing and selling far fewer new homes than they had at any other times except recession.

The thing about balance sheet capacity especially in the later eurodollar era was that it had ignored risk almost by purpose. Ignored is probably too strong a word, as growth and volume were all that mattered. Instead, even the dodgiest of toxic subprime waste was readily produced and marketed because eurodollar liquidity meant a steady flow of derivatives, too; the full range of balance sheet capacity. This led to the belief that hedging and dark leverage were more than sufficient to control even the riskiest of risky pieces.

The Fed via several QE’s can’t create the shorthand monetary policy version, and therefore they failed in their economic quest for positive (recovery) procyclicality via real estate. You can cut funding rates even in TBA (fatter profits spreads from production) and bank balance sheet capacity is what matters instead.

In other words, before the housing bust there were a prevalence of NINJA loans (no income, no job, no assets) among all sorts of other looser standards. These were acceptable because of balance sheet capacity. You could at one time buy subprime and then lay off risk with JPM via IRS and control capital efficiency with CDS written by AIG. JPM doesn’t want to do that anymore, and AIG isn’t at all the same company it was before 2008 (that’s a good thing, by the way).

You want to write a mortgage today, the borrower better have at least a decent job.

Mainstream convention credits post-crisis regulations with making the mortgage process more honest and prudent. That’s true to some degree. What’s missing by focusing exclusively on that part of the picture is everything that really matters for more than just housing and mortgages.

It’s a monetary problem first and foremost – what was it that happened in August 2007 to begin with? By mainstream explanations we are supposed to believe August 9 was the day nearly eleven years ago the Baby Boomers all got together and decided they had had enough of working, or the moment when fentanyl was invented and shipped for the first time in quantity into the United States.

Housing is very much pro-cyclical, and what that means in this context is a continuous drag on the economy despite so much QE effort. This doesn’t mean we should go looking to make the next housing bubble. We don’t need a bubble, but something closer to normal would assist the economy greatly. Rather, it does mean expecting success from the shorthand version of monetary policy grounds those expectations in a world that just doesn’t exist, and hasn’t for a very long time.