September 01, 2007
Bernanke and Gramlich on the subprime issue
Also featured yesterday at the Federal Reserve conference in Jackson Hole were speeches by Fed Chair Ben Bernanke and former Fed Governor Edward Gramlich.
Bernanke expressed concerns that the housing situation is going to get worse before it gets better, in part because
Despite the slowdown in construction, the stock of unsold new homes remains quite elevated relative to sales, suggesting that further declines in homebuilding are likely.
In addition, the Fed Chair observed,
recent market developments have resulted in additional tightening of rates and terms for nonprime borrowers as well as for potential borrowers through "jumbo" mortgages. Obviously, if current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy.
Bernanke also reiterated what I think is exactly the correct Fed attitude about all this:
It is not the responsibility of the Federal Reserve--nor would it be appropriate--to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.
Bernanke does not intend to "bail out" anybody, but has no desire to see the rest of us go down with the subprime ship.
Some analysts, as always, wanted to read between the lines and interpret this as code for the Fed positioning itself for a rate cut. I continue to advocate interpreting Bernanke as a straight shooter who is openly sharing his understanding and concerns. His statement-- which I highly recommend in its entirety-- is I believe as accurate an analysis of the current problems as you will find anywhere. But an accurate analysis does I think lead one to tend toward a rate cut, and I continue to expect that we'll see one.
I was also very interested in Bernanke's current views on how well the financial innovations in mortgage lending have been fairing:
I suggested earlier that the mortgage market has become more like the frictionless financial market of the textbook, with fewer institutional or regulatory barriers to efficient operation. In one important respect, however, that characterization is not entirely accurate. A key function of efficient capital markets is to overcome problems of information and incentives in the extension of credit. The traditional model of mortgage markets, based on portfolio lending, solved these problems in a straightforward way: Because banks and thrifts kept the loans they made on their own books, they had strong incentives to underwrite carefully and to invest in gathering information about borrowers and communities. In contrast, when most loans are securitized and originators have little financial or reputational capital at risk, the danger exists that the originators of loans will be less diligent. In securitization markets, therefore, monitoring the originators and ensuring that they have incentives to make good loans is critical. I have argued elsewhere that, in some cases, the failure of investors to provide adequate oversight of originators and to ensure that originators' incentives were properly aligned was a major cause of the problems that we see today in the subprime mortgage market.
But Bernanke again seemed to express the view that these problems will prove to be self-correcting:
In recent months we have seen a reassessment of the problems of maintaining adequate monitoring and incentives in the lending process, with investors insisting on tighter underwriting standards and some large lenders pulling back from the use of brokers and other agents. We will not return to the days in which all mortgage lending was portfolio lending, but clearly the originate-to-distribute model will be modified--is already being modified--to provide stronger protection for investors and better incentives for originators to underwrite prudently.
Edward Gramlich was unable to attend the conference due to very grave illness, but his comments were presented by his (and my) long-time friend David Wilcox, one of the Fed's star research economists. Gramlich drew an analogy between the subprime situation and previous boom-bust cycles arising from previous technological innovations:
In the nineteenth century the United States benefited from the canal boom, the railroad boom, the minerals boom, and a financial boom, a postwar boom, and a dotcom boom.
The details differ, but each of these cases feature initial discoveries or breakthroughs, widespread adoption, widespread investment, and then a collapse where prices cannot keep up and many investors lose a lot of money. When the dust clears there is financial carnage, many investors learning to be more careful next time, but there are often the fruits of the boom still around to benefit productivity. The canals and railroads are still there and functional, the minerals are discovered and in use, the financial innovations stay, and we still have the internet and all its capabilities.
Gramlich wants the see substantial promise still in the expansion of mortgage debt to a class of borrowers for whom it was previously unavailable. He attributes the good parts of the boom to elimination of usury laws, automation and securitization of loans, and the Community Reinvestment Act, which encouraged banks to issue moderate-income mortgages, which they then discovered to be good business.
He acknowledges that, as in his other technological booms, there were excesses here, and suggests a combination of Fed loosening of interest rates and regulatory reforms to help correct some of these problems, among these being supervision of all loan originators, expansion of predatory lending statutes, and greater funding for community resource groups to help troubled borrowers work out their problems, or, at worst, buy the foreclosed properties and convert to rental units.
It's nice to hear from someone with such constructive optimism about our current situation. But I think we need a little more hard-nosed analysis of exactly what went wrong before we get further into the details of what needs to be done to fix things.
Posted by James Hamilton at September 1, 2007 05:44 AMdigg this | reddit
Gramlich seems to be echoing the thesis of Daniel Gross's recent book, Pop! Why Bubbles are Great for the Economy.
However, I beg to differ in that I don't see any redeeming features in this latest round of subprime "innovation." Just a few years ago, Bush was touting high home ownership rates for minorities as an "achievement" of his administration. It's too bad that we now know how that came about. There are strong parallels to Katrina here, which now include a much-publicized rescue attempt. But, we know how things played out before. Wake of hurricane, wake of subprime, same old, same old.
Posted by: Emmanuel at September 1, 2007 06:49 AM
The Fed ignored the impact of "actions of lenders and investors" on "many outside the markets" during the period of accumulation of excessive leverage. Instead it argued, repeatedly, that leverage was within acceptable bounds.
Now the Fed is admitting it has to cut rates to defend "many outside the markets" from the effects of de-levering.
Which was a more appropriate policy response? Arguably raising rates to stem leverage would have resulted in a much lower dead weight loss to the economy, and in far less moral hazard. Its a pity the Fed didn't take this into consideration at the time.
Posted by: David Pearson at September 1, 2007 06:55 AM
As a layman, I've been following boom/bust- mania/panic writings for 2-3 decades. Clearly, boom/bust episodes are mainly psychologically driven events (optimism/pessimism).
These are human nature derived and over the whole cycle balance out(reversion to the mean).
The problem we have today is the apparent encouragement of this behaviour by US govt through their CB. This is nothing less than "citizens abuse"
The current finance system encourages citizens to participate in the wonderful new era of_________; then pulls the rug from under their feet but bails out the financial/banking system.
I have not read the European policy makers Jackson Hole speeches, yet. But I have have an inkling that their main point will be "we told you so"
Posted by: groucho at September 1, 2007 08:53 AM
This "constructive optimism" that you find so nice to hear, James, may be a tad thin on analysis and thick on apology.
He acknowledges that, as in his other technological booms...
So this housing boom was a technological boom?
Laser-powered nail guns maybe? [Ok, alien-powered nail guns, maybe.] Like the rail-road boom?
Now, I'm severely deficient in constructive optimism but readily admit that IT did make a contribution, (that investment did result in better products and services)[possibly higher productivity and certainly greater wealth disparity...'Was it worth it?' is still a question I can mull over.]
Was this a glorified tulip boom with no tangible improvements benefiting the general population or a constructive advance?
Posted by: calmo at September 1, 2007 10:50 AM
With respect to the first two comments hereinabove, "good on you."
The purpose of this perpetual central bank manipulation is, of course, to "keep the people on their economic treadmills" and to continuously reset upward the run speed.
If a person can be induced to ask the wrong questions, it really does not matter what answers he comes up with.
The correct question is, "why has the purchasing power of my currency fallen in half over the last quarter century?" As I noted in a thread on another site, "in three such steps, a dollar becomes a dime."
For the majority of a population, inflation at that level is not "your friend," whether reported accurately or not.
Posted by: esb at September 1, 2007 11:03 AM
I'm not a mortgage expert, but it seems that Bernanke, Gramley and others are painting the situation with too broad a brush.
The first "traditional model", in which S&L's took in deposits, issued short-to-intermediate term CD's and then made 30 year fixed rate mortgages which they kept on their books was badly flawed and eventually failed (a quick sidenote to avoid the broad brush flaw myself - the spectacular S&L debacle came AFTER the first traditional model failed when the Garn-St. Germain Act of 1982 tried to correct the problem by essentially allowing S&Ls free reign to make non-mortgage investments).
Anyway, to my mind the SECOND "traditional model" wherein S&L's and mortgage companies underwrote fixed and variable mortgages which were then packaged into fairly standard conforming and nonconforming RMBS and sold to investors was an excellent model that has enough transparency to put reputational capital at risk.
What has failed miserably and wretchedly is the current model of securitizing (and occasionally resecuritizing and re-resecuritizing) RMBS (which are of course pools of mortgages already securitized ONCE). The idea that you could opaquely pool RMBS, CMBS, corporate bonds and commercial loans into CDOs that were worth more than the additive worth of the component parts is probably the single nuttiest thing I've seen in 25 years as an investment professional. It's as if the purveyors of ETFs were trying to package and resell common equities for a premium because they'd created a senior tranche of the ETF that was AAA-rated.
I'm very glad that Chairman Bernanke is not going to protect the people who invested in these strange creatures of financial alchemy; unfortunately, because of the broad extent to which CDOs were sold and the leveraged fashion in which many European Banks chose to play the game with conduits, SIV-lites and SIVs, this debacle has such broadly-based implications for the system that the discount window just isn't going to be enough.
And I'm going on the record here and now - the odds of a recession beginning sometime in 2008 are now 90%, IMO, because you need an aggressive Fed easing RIGHT NOW to have a meaningful impact on the real economy in 1Q 2008 and we're not going to get it (and 25 bp in mid-September does NOT qualify as aggressive easing in my book).
Posted by: Anarchus at September 1, 2007 11:12 AM
"'Real money' (U.S. insurance companies, pension funds, etc.) accounts had stopped purchasing mezzanine tranches of U.S. Subprime debt in late 2003 and [Wall Street] needed a mechanism that could enable them to 'mark up' these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!!"
Posted by: Anonymous at September 1, 2007 02:24 PM
Perhaps another example of a boom and bust cycle following innovation was the electric holding companies of the 1920s.
Electric utilities were growing rapidly and consolidated first into "natural monopolies" based on economics of scale. They further gained gained formal monopoly status with state public utility regulation.
With that cosy arrangement, smart operators used the holding company financial innovations to bypass state regulation and lever the whole enterprise so that a huge empire could be controlled with 51% of the top tier holding company stock. When they sold minority shares to customers of the ground level companies, they were essentially fleecing their own customers.
With the Great Depression, the lever worked in reverse and the Feds wrote the Public Utility Holding Company Act (PUHCA) that formalized a tightly regulated industry under close fed and state regulation. This has only recently seen legislative relief and change in what was for decades a very stogy business.
Moral? Crooks are always out their looking for a mark but sometimes the governmental cure is worst than the bite.
Posted by: Joseph Somsel at September 1, 2007 04:23 PM
Bernanke has lost some of his credibility by saying 'subprime is contained' and 'there is no housing bubble.' It is obvious to anyone attentive enough that he and the FED were wrong on both counts. Your continued confidence in his comments and 'analysis' is not justified. At this point, even a FED rate cut doesn't seem likely to affect longer-term mortgage rates.
Gramlich's comments remind me of the comments of a journalist (I think from the Slate magazine) who said something like "bubbles are good."
However, one has to keep in mind that housing is to a large extent an 'unproductive' asset and a loose lending boom for housing activity can never be compared to the impact of the internet on productivity.
I agree with Emmanuel's comments and in particular reading Gramlich's comments instantly reminded me of the book by Daniel Gross.
Professor, I think adequate attention has not been paid to the similarities between 'vendor financing' during the internet bubble and the 'builder-financing' during the housing bubble.
(Maybe someone can talk to D.R Horton, Beazer, Hovnanian, N.V. Homes, etc. to get precise data on this)
Posted by: TedK at September 2, 2007 10:20 AM
Fannie Mae has been buying Mortgages since 1938 so it seems like the shift away from portfolio based banking significantly predates the current troubles.
Posted by: Don at September 2, 2007 03:17 PM
Edward Gramlich wrote:
When the dust clears there is financial carnage, many investors learning to be more careful next time, but there are often the fruits of the boom still around to benefit productivity. The canals and railroads are still there and functional, the minerals are discovered and in use, the financial innovations stay, and we still have the internet and all its capabilities.
Is it naiveté that blinds one to the common sense of the broken window fallacy? Perhaps it is a lack of understanding of the boom-bust cycle. Whatever, I am shocked that such an idea would be given a place at an event as important as the Jackson Hole Conference.
The boom phase of the business cycle comes from the illusion that more can be produced than can actually be produced. When projects have run their course and it becomes obvious that there is not enough actual capital to complete the projects the result is bankruptcy and business failure. But this malinvestment is not without cost. The Capital that has been consumed in the failed projects is capital that was not and never will be available to actual projects that could hve been completed to help society. Bricks and windows are broken and so because of the bubbles caused by the boom useful capital is destroyed.
In his paper Gramlich makes an elementary mistake that was pointed out by Bastiat in 1850. Gramlich can only see what is, not what could have been. He believes that the broken window puts people to work rather than seeing that it destroys capital and wastes resources.
No, "Bubbles are not great for the economy!" Bubbles destroy capital and destroy wealth.
Posted by: Anonymous at September 4, 2007 06:09 AM
I find it ironic that so many smart people can look at data that is really has quite obvious meaning and yet fail to see it for what it is(not the fine folks at this site; the Einsteins at this conference, think tanks, colleges and business all over the country.) If you don't like (or agree with) what the facts are telling me change the theory. It could be that there's too many smart people paid to creat theories I suppose. As Anonymous says, bubbles are bad and for a lot of reasons not the least of which is opportunity cost. But it doesn't take a bubble to misallocate capital.
What if I described a business to you that has 70% of it's company resources dedicated to HR, marketing, debt management and administration with 30% creating and selling products? Not much of future do you think? That's what the data describes about the US. We have allocated an enormous amount of resources (and most of that from money borrowed from somewhere) to non-productive (tradeable goods) activities. For example, I'm in healthcare. Roughly 10% of GDP (and most of that not really going to providing actual healthcare). Home building- what another 7-10%? Retail, easily 10%. Fed, state and local government, something north of 20%. And how about this: 1980-1$ of debt to $2 GDP (productive use of money); today, $6 debt to $1 GDP (not so much). I could go on and on but you are all smart people.
I had instructor in AF survival training who once said, "if it looks like a banana, smells like a banana and tastes like a banana - it's effing banana!" It might just be time to see the banana for what it is.
Posted by: Footwedge at September 4, 2007 02:48 PM