WSJ's David Reilly confirms Fed sees banks taking losses on mortgages as beneficial to real economy [update]

In his Wall Street Journal Heard on the Street column, David Reilly confirms that the Fed sees banks taking losses on financial excesses, in this case mortgages, as helping the real economy.

This is very important.

We are talking about the most important bank regulator in the US, not just your humble blogger, saying that banks need to start recognizing the losses on their mortgages to help the housing market and the real economy recover.

For an institution that jealously guards its independence, the Federal Reserve is wading into treacherous political waters. 

With the economic rebound still mediocre at best, the Fed is charging into the housing debate. 

But in doing so, it runs the risk of politicizing itself, while also sending mixed signals to banks still trying to find their postcrisis feet. 

The latest effort was a housing "white paper" sent this week to Congress, along with a series of comments from Fed officials about the importance of housing to the economic recovery. In this, the Fed may be laying the groundwork for further quantitative easing, this time purchasing mortgage securities. But its paper went beyond even the Fed's already unconventional policies. This included ideas that might require more taxpayer funding through Fannie Mae and Freddie Mac.... 

The Fed's paper suggested it may be worth pursuing more aggressive actions in terms of loan modifications, mortgage refinancing and sales of foreclosed properties even if they cause greater short-term losses at Fannie and Freddie, and so by extension to taxpayers....  

Beyond Fannie and Freddie, the Fed's paper also took it into other politically charged areas, such as principal forgiveness for underwater mortgage holders. While it didn't specifically endorse such a move, the Fed said that "policy experiments in this area would be useful." 

Meanwhile on mortgage modifications, the Fed noted certain types of loan changes "may be socially beneficial, even if not in the best interest of the lender."... 

The paper also signaled that the Fed, ostensibly the most important bank regulator, will try to involve banks more directly in housing-revival approaches, even as it imposes new, more stringent regulatory constraints. 

One area involves efforts to turn foreclosed homes into rental properties. While this primarily pertains to Fannie and Freddie, the Fed noted that commercial banks as of last September had $10 billion in foreclosed homes on their books. 

Banking regulations typically direct banks to sell foreclosed homes quickly, although the rules do recognize this isn't always practical and so these properties can be held up to five years. 

The Fed said it is now "contemplating issuing guidance" to banks and regulators that would possibly allow banks to turn some of these foreclosed homes into rental properties....

Update

According to the Wall Street Journal's Real Time Economics blog, NY Fed President Dudley gave a speech in which he confirmed that the Fed is calling on banks to recognize their losses to benefit housing and the real economy.

Much of Dudley’s speech was devoted to laying out ways the government and financial institutions can come together to help turn around the still highly problematic state of the housing market. 

“The ongoing weakness in housing has made it more difficult to achieve a vigorous economic recovery,” the official said. “Persistent weakness in housing is particularly problematic because it acts as a drag on spending and job creation in an environment in which such weakness cannot be easily offset by other policy adjustments,” he explained. 

Dudley also said “housing no longer appears overvalued.” 

“With additional housing policy interventions, we could achieve a better set of economic outcomes than with just monetary policy alone,” he explained.

i.e., there is a limit to what can be achieved with monetary policy alone.

Dudley’s prescription to help housing was broad-based. “I believe this should include measures to improve access to mortgage credit, reduce obstacles to refinancing, lessen the flow of homes into foreclosure through bridge financing and accelerated principal reduction, and to facilitate the absorption of [lender owned housing] back into use as owner- or renter-housing,” he said.

With the Fed officially adopting the position that banks can act as a safety valve between the excesses of the financial markets and the real economy, a sizable portion of my blueprint for saving the global financial system is moving from theory into practice.