Quantitative Easing, Cyprus and Housing

"Hope is a wonderful thing. But we also need to remember that changes in the stock market, the housing market and the overall economy have relatively little to do with one another over years or decades. (We economists would say that they are only slightly correlated.) Furthermore, all three are subject to sharp turns. The economy is a complicated system, with many moving parts." 

Robert Shiller

“Yes, We’re Confident, but Who Knows Why”

The New York Times


A safe and happy holiday to all.

Watching the events in Cyprus, one is reminded of the definition of systemic risk coined by the “Counterparty Risk Management Group” spawned by former Fed of New York chief E. Gerald Corrigan.  When the markets are surprised, so the thinking went in August of 2008, a systemic event may occur.


The retail depositors of Europe were certainly surprised when that long convenient offshore banking haven known as Cyprus almost became a test ground for fiscal stringency.  Until now, most of the worst losses in banks have been quietly papered over to spare Europeans the distress of having to admit that their economies are largely de-capitalized.  Cyprus was especially offensive because its wealth – or, at least, liquidity – came from Russia, Europe’s energy provider.  But now it seems that the Russians may have already moved most of their money out of Cyprus, making the bank closures moot. 


With the fiasco in Cyprus, the Europeans have confirmed that they have not the slightest idea how to deal with a real banking crisis – especially on the periphery of what is now considered Europe.  Did EU banking officials really believe that haircutting depositors would be sufficient to restore confidence in Cypriot banks?  The infantile quality of the actions of EU officialdom is mind boggling. Compare the purposeful, serious approach that the FDIC and other regulators in the US have taken to selling hundreds of failed banks with the tomfoolery in the EU.  

But more than anything else, events in Cyprus should remind us all that the supposed economic stability in the US and EU is about an inch deep.  Since every policy aspiration at the Fed is about confidence and virtually all of the major economic relationships we pretended to understand have shifted, the only tangible basis for policy is hope, as per Bob Shiller above.    

This past couple weeks, in fact, we could discern a subtle shift in the Matrix, a change in the narrative coming from some of the more savvy observers on Wall Street.  There is no connection between the real economy and the upward movement of certain asset markets, so goes the thread, markets such as residential real estate.  As a result, goes the narrative, the Fed will continue to buy securities indefinitely via QE, raising the possibility of a further rally in bonds.

The fact that BB rated corporates have rallied more than three quarters of a point in yield over the past several years should not daunt the true believers at the Fed.  Even those members of the Sanhedrin who admit that there is no longer a causal link between home price appreciation (HPA) and the US jobs sector adamantly believe in the power of Quantitative Easing to restore economic prosperity.  It is a matter of faith, you understand, not empirical scientific proofs.  

Fed of New York President William Dudley, a former Goldman Sachs economist, is out saying that the US economy could be galloping by the end of 2013, perhaps 50% above current consensus estimates.  Dallas Fed President Richard Fisher has likewise called a 3% GDP growth rate by the end of the year.  What is the driver of optimism at the Fed?  A rebound in residential real estate prices. No matter that this housing rally is driven by short supply and a growing pile of cash from Wall Street.  The wealth effect, Fed officials and members of the Big media call it.  

But wait.  To convert higher home prices into cash consumption, consumers will need to either sell their homes or borrow.  Q: Is this why all of the larger banks are focused on growing credit card volumes?  Hmmm.  

But of course it would be wrong to blame “institutional capital” for the expanding prices in the US residential housing sector.  Truth to tell, the well-springs of irrational exuberance in, say, Phoenix and the giddy gyrations of Nicosia are identical.  For example, Mom and Pop and smaller players drove the AZ and NV markets higher three years ago. If you were buying homes at or near retail in Pheonix in 2012, you were two years too late. 

What will investors say, the Fed really should wonder, when those nine-ish gross yields promised by late arrivals to the rent trade get cut in half a couple quarters from now.  Reading IPO filings for the REITs that have come to market over the past six months, a sense of wonder results regarding the operating efficiency of some of the newer players in the rent trade.  Truly amazing. 

And as noted earlier, there is virtually no net US bank lending to 1-4 family real estate, this despite the almost 10% rise in HPA over the past year.  Yet so powerful is the word of Bernanke that the mere mention of further policy moves by the central bank sends private equity funds into paroxysms of ecstasy.  Jeff Pintar was quoted in the WSJ this week to the effect that nearly every home listed for less than $400K in Orange County, CA "is being pursued by institutional investor capital." But rents in many communities are now well above what it would cost to buy the home.  Yet another success for Chairman Bernanke and the Federal Open Market Committee.

Next month at American Enterprise Institute, I will be talking about the impact of the Fed’s quantitative easing on the US real estate market.  But the events in Cyprus stem from precisely the same source as the surge in US home prices, namely monetary expansion by the Fed.  


The excessive monetary emissions of the US have covered the world in greenback paper dollars.  This sea of paper money has grown much faster than the underlying economy, putting great pressure on asset returns.  Financial repression predates Chairman Bernanke.  Our allies have been forced to allow their own money fiat supplies to expand as well.  The Fed celebrates the end-effect of its pro-inflationary policy as a “success,” but never admits to being the source of the problem.  And you can forget about selling the Fed’s portfolio.  This is a permanent liquidity “add.”  Bubbles made of fiat paper dollars must inevitably create new asset bubbles.  Just remember that when Abraham Lincoln created the greenback to finance the Civil War, the dollar bore interest like a T-bond. Americans understood that paper money was really a form of debt. 

Net, net, there is far too much bad paper money chasing too few real economic opportunities, forcing “leakage” via offshore havens such as Cyprus.  Russian cash found a ready entry point into the EU and far higher rates of interest than are available in the US.  As Andrew Ross Sorkin noted last week in the New York Times:

“If you had 100,000 euros in a Cypriot bank account over the last five years, where the interest rate has averaged about 5 percent, you would have about 127,600 euros today. Even after the bailout, which would require you to give up 10 percent of your deposit — 12,760 euros — you would be left with 114,840 euros. The American bank? The $100,000 you deposited at Bank of America five years ago is about $105,100, at the going rate of about 1 percent interest a year.”

So let’s not cry for the people of Cyprus or even Europe for being upset over the clumsy handling of this debacle.  At least the Europeans still have a sense of indignation and, more important, a positive real interest rate. Cry more for the Americans, a nation of sheep who live like socialists, but talk about democracy and free market capitalism as the national creed.     

We may take comfort from the fact that we are all united by the fact of drowning in a bitter sea of fiat paper dollars.  Like professions of faith or hope, paper money is cheap and makes everything it touches cheaper as well.  The difference between Cyprus and America is that the Cypriots are angry and offended by the idea of taking a loss, but Americans are mute because they expect to be bailed out by the Fed.  As and when economic reality rears its ugly head in the US and, like the people of Cyprus and the EU, Americans start to doubt the inevitable bailout, look out.