One of the policies that the Fed has been pursuing is extend and pretend. By not requiring the banks the Fed supervises to write-down the value of their real estate loans, the Fed is artificially propping up house prices.
As this blog has mentioned previously, the cost of this extend and pretend policy is that banks have a hard time making loans to small businesses. Banks are senior secured lenders and it is difficult for the banks to assess the true value of the real estate these businesses have to pledge as collateral given that extend and pretend policies might end.
As William Dudley, President of the NY Fed said,
Bolstering the housing market is “particularly important” because it’s a key factor in household wealth ...
“Continued house price declines could lead to even more defaults, foreclosures and distress sales, undermining wealth, confidence and spending,” Dudley said in his speech. “Breaking this vicious cycle is one of the most pressing issues facing policy makers.”...
“If prospective homeowners no longer fear that prices could decline further, they will be more willing to enter the market to take advantage of reduced prices and low financing costs, and existing homeowners will feel more confident about spending,” Dudley said.
“A vicious cycle could be replaced by a virtuous circle, in which stabilization in house prices supports spending, growth and jobs.”Is this a case where the Fed's policies are self-defeating?
So long as the Fed is pursuing policies to artificially support the housing market, isn't that a sure sign that prices on houses are too high?
Perhaps the economy would be better off if the Fed abandon all of its policies designed to help the housing market?
I realize that abandoning these policies would require banks to realize their losses and to wipe out the accounting construct known as book equity. However, in a financial system with deposit guarantees and where banks are required to make detailed disclosure of their assets and liabilities, this would not necessarily be a bad thing.