Bernanke: Raise Conforming Limit to $1Million

November 27, 2007 10:16 PM by Robert Blumen (Archive)

In the Q-and-A after his testimony to congress, CNBC reports that Bernanke suggested raising the conforming loan limit to $1 million.

The conforming limit is the maximum size of individual mortgage that can be pooled into a mortgage-backed security to be eligible for purchase by one of the housing GSEs (Fannie and Freddie). The GSEs were originally chartered to create a more liquid secondary market in mortgages for lower-to-middle-income home buyers. See Econbrowser on how the GSEs work. See also, The Economist on the unfolding crisis.

As the CNBC reporter points out, we haven't yet had quite enough inflation for a million-dollars to be in the price range of lower to middle class buyers (though I have read stories about people with very little income being given mortgages of almost this amount during the peak of the lending bubble).

As happens predictably in a government-generated crisis, original intentions are ignored and organizations are used for whatever purpose appears to provide a solution to the crisis at the time, setting up another crisis when the unseen future consequences of the first "solution" start to come into play.

If this were to happen, this and the super-SIV conform to my general belief that we are headed toward a hyperinflationary collapse of the dollar.

The transmission mechanism for this crisis will be the monetization of assets by the central bank. As financial institutions threaten to become insolvent when their mal-investments are marked to market (which may well be zero for many of them), the central bank faces a serious dilemma: let the institutions fail, which would surely lead to a cascading debt-defaulting-deflationary domino chain as debt defaults shrink the balance sheets of banks -- and therefore the quantity of money -- putting further pressure on asset markets; or, implement a stopgap solution of monetizing the assets. The central bank instead would purchase the assets, writing a check out of nothing to fund them.

This solution has the virtue of preventing the imminent deflationary meltdown, but does nothing to change the fact that, retroactively the underlying investments were not economically rational and are not worth the sale price that would required to keep the institution solvent. Eventually with enough money created, the nominal prices of the assets will match their market values, but at a much lower level for the purchasing power of each monetary unit.

Raising the conforming limit enables the GSEs to accumulate more of the otherwise worthless paper assets containing ever larger defaulted mortgages. The larger the GSEs become, the more credible becomes the inevitable realization that they are "too big to fail". Since these institutions are already quasi-underwritten by the Fed, the proposal for a government bailout will be more obvious than a direct bailout of the large Wall Street banks.