PIMCO’s Bill Gross: Lowering Cost of Mortgage Credit Best Path To Normalcy

In his August 2008 Investment Outlook bond king Bill Gross points out that despite Fed Funds being lowered by 3.25% since last September, yields on agency mortgage backed securities are actually higher (see chart). We’ve discussed this repeatedly on this site, noting that after each of the cuts that was made since September, mortgage rates actually rose because mortgages are tied to mortgage backed securities rather than Fed rates (or 10-year treasuries). Mortgage backed securities have been trading on increased inflation expectations since the Fed reached the end of its cut cycle in April when they finally paused (and paused again after the FOMC meeting yesterday).

Gross says that one of his close advisers suggested that the government buy 1 million homes and blow them up, then proposes the following solution:

Up until this point, the joint efforts of the Fed and the Treasury have been directed towards maintaining the stability of our major financial institutions, recapitalizing their balance sheets in “current form,” and lowering the cost of mortgage credit. All are crucial to any solution, but it is this third and last point where markets have failed to cooperate (see chart of rising agency MBS during Fed cut cycle). Add to [rising rates] the increased fees, points, and total spread that an actual homebuyer pays to finance his purchase now as opposed to then, and it is obvious that homes are not the bargains that starving realtors claim they might be. Financial asset prices, as well as those for homes, are really the discounted present value of what investors believe those assets will be worth far into the future. When the discount rate – in this case a 30-year mortgage – rises faster than the expectations for home prices themselves – then the price of a home falls. 7% + “all in” yields for current home financing, in contrast to prior periods of monetary easing, are lowering, not raising the discounted present value of an existing home. Blow them up? Well, yes, I suppose if we could. But absent that, lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy.

Definitely easier said than done, especially when FNMA/FHLMC are still facing major issues. So perhaps it’s all on Morgan Stanley now, as they advise Treasury on FNMA/FHLMC strategy.