Fed Chief Warns on Mortgages

Federal Reserve Chairman Alan Greenspan warned Thursday that new, more liberal kinds of mortgages were helping to drive up home prices and fueling the danger of a sharp price decline, but said the economy overall was on “reasonably firm footing.”

Greenspan said interest-only mortgages in particular were contributing to what he termed “froth in some local markets.” He said he continued to be bewildered by the decline in mortgage rates and other long-term interest rates even as the Fed was beginning the second year of its campaign to raise short-term rates.

But on the whole, Greenspan said, the economy is humming along.

“You can’t get around the fact that this is the most extraordinarily successful economy in history,” he told Congress’ Joint Economic Committee.

Nothing that Greenspan told lawmakers Thursday led analysts to believe that the Fed would soon abandon its course of raising short-term interest rates. The Fed’s policymaking Federal Open Market Committee next meets June 29-30.

In fact, Greenspan quoted from the Open Market Committee’s statement after its May meeting, in which it said it believed it could raise rates at a “measured” pace without upsetting the rebound from the 2001 recession.

The federal funds rate -- the rate governing overnight loans between banks -- is now at 3%. When the Fed began raising the rate last June, it was at 1%, a historically low rate aimed at boosting economic growth.

“We’re still in the middle innings of the Fed tightening,” said Mark Zandi, chief economist at consulting firm Economy.com. “He’s sticking to the script that he laid out.” Zandi predicted that the Fed would not pause before pushing short-term rates up an additional percentage point, to 4%.

Some committee Democrats took issue with Greenspan’s upbeat tone.

“I am concerned about what continues to be a disappointing economic recovery for the typical American worker,” Sen. Jack Reed (D-R.I.) said. Wages are stagnant even as corporate profits are soaring, Reed said, and with energy and health costs rising, that is “squeezing the take-home pay of workers.”

Greenspan responded that “there is no question that this standard of living is unmatched, and it’s unmatched for everybody. Everybody has got a car, and the cars that people have today are so superior to what they were 50 years ago it’s unimaginable.”

Greenspan acknowledged some concern about the housing sector, which he said was overheating in some local markets. The National Assn. of Realtors estimated Wednesday that sales of existing homes would approach 7 million this year, topping last year’s record of 6.78 million.

Second homes bought for investment or vacation purposes can be sold quickly because the owners do not live in them, and they account for much of the acceleration in home sales, Greenspan said.

“The apparent froth in housing markets may have spilled over into the mortgage markets,” he added. “The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other relatively exotic forms of adjustable-rate mortgages, are developments of particular concern.” In interest-only loans, the borrower does not begin paying off any of the principal for several years.

Although these types of mortgages have “appropriate uses,” Greenspan said, the fact that some people may be using them to buy homes that they otherwise could not afford is “beginning to add to the pressures in the marketplace.”

The Fed chairman called the decline in mortgage and other long-term interest rates “among the biggest surprises of the past year.”

While short-term rates have risen by 2 percentage points in 12 months, he said, the rate on 10-year Treasury notes has declined by 0.8 percentage point.

“It’s the fastest decline that we have seen ... in many decades,” he said. “So something unusual is clearly at play here.”

One factor, Greenspan suggested, is the entry into the global labor market of “educated, low-cost employment pools in China, India and the former Soviet Union.” These workers may be taking jobs away from Americans, but Greenspan said they also were exerting downward pressure on prices -- including interest rates -- around the world.

Greenspan was emphatic that the unusual behavior of long-term interest rates did not presage what it often has in the past: an economic slowdown, caused partly as banks got squeezed by falling income from their long-term loans and rising costs from their short-term borrowings.

In the global marketplace, he said, domestic banks are not the only source of the funds that keep the economy greased. Foreign central banks, for example, are now financing much of the huge U.S. budget deficit by buying U.S. Treasury bonds.

As he often does, Greenspan decried the federal deficit and said he supported President Bush’s tax cuts only if they were accompanied by spending cuts or other tax increases that offset their effect on the deficit. The administration opposes such a “pay-as-you-go” approach.

“I think that we’ve got to find a way to construct the system which enforces the issue of choosing between A and B,” Greenspan told Rep. Loretta Sanchez (D-Anaheim). “Right now everybody wants A and B, and unless you repeal the laws of arithmetic it won’t work.”