A Stitch in Haste

In macroeconomics classes, we usually teach that the Federal Reserve has several tools with which to control monetary policy:

--Change the reserve requirement (i.e., the fraction of a bank's total deposits that must be held in cash on on reserve at the Fed). This is rarely invoked.

--Change the fed funds rate and/or the discount rate. This is what is meant when you hear, as you have eight times in the past year, that "the Fed raised interest rates."

--Use open market operations to add or remove money directly, through buying or selling treasury securities to banks.

--Invoke moral suasion to "suggest," rather than require, that banks adjust their policies.

Well, the Fed quietly invoked moral suasion over the home lending market, probably due to concerns regarding the (potential) housing bubble.

"Financial institutions may not be fully recognizing the risk embedded in these portfolios," the Fed, the Comptroller of the Currency and three other regulators warned in a May 16 letter on home-equity loans to lenders and bank examiners.
...
"The new development is the volume of these interest-only first mortgages we're seeing," acting Comptroller Julie Williams said in an interview. "Banks should be evaluating the risks of these types of loans, not just based on the initial loan terms, but based on the loan terms that may roll into effect over the life of the loan."
...
So-called "guidance letters" such as the one issued May 16 are aimed at improving lending standards without interfering with markets. Another letter, this one dealing with first mortgages, is under discussion, Kevin Mukri, a spokesman for the Comptroller, said.
...
Interest-only mortgages accounted for only 6 percent of adjustable-rate mortgages in 2002. By the end of 2004 they accounted for 23 percent nationwide, according to LoanPerformance, a mortgage-data provider based in San Francisco.

Real estate buyers generally don't use interest-only loans because they want to — they use them because they have to. And since by definition an interest-only loan means that no equity is accumulating in the property, any shock to the buyer (e.g., unemployment) or to the market (i.e., a decline in housing prices) spells trouble for both the buyer and the lender. And these mortgages are adjustible-rate debt, so as interest rates continue to rise (and sooner or later mortgage rates will follow short-term rates up), the sustainability of these lending trends may end. And without these risky "creative" financing arrangement, the stratospheric rise in real estate prices cannot continue. Some markets are already showing signs of faltering.

I'm still willing to refer to the "(potential) housing bubble." But with each new data point the need for the parenthetical seems to diminish.

Hat tip to Housing Bubble blog, which is now the definitive source on the subject. Eclectic Econoclast also has a good post. And keep in mind that Fed Chairman Greenspan is testifying before Congress today; expect the housing market to be on the agenda.

For a primer on how the Fed controls monetary policy via the four methods listed above, see here.