August 21, 2009
The Road Ahead for the Fed
Tom Keene has been doing a series for Bloomberg Radio this week on the new book, The Road Ahead for the Fed. You can listen to Tom's interviews with me or three of the other authors who contributed to the book by clicking on a link below.
Posted by James Hamilton at August 21, 2009 07:21 PMdigg this | reddit
There is a little-discussed threat to Fed independence, and signs are that it will appear soon.
Data released yesterday show one in three foreclosures are prime fixed rate. These are conforming mortgages, not option arms. Deutsche Bank estimates that almost half of borrowers will be underwater by next year, and using Freddie Mac data, close to a third already have that status. So we have a budding crisis in prime conforming foreclosures. Sure, some will be driven by unemployment. The majority, however, will be WALK-AWAYS by underwater borrowers.
The Fed's independence is threatened by the government's response to a walk-away crisis. Let's say the response is "right to rent" legislation. What would that do to conforming MBS spreads? Blow them out. And who is the biggest buyer, by far, of MBS? The Fed. The interests of the Fed and the Administration/government would be directly at odds, and the pressure would be for the Fed to continue to purchase MBS despite the deterioration in collateral rights.
We could see this dynamic play out over the next six months. Exit plan for the Fed's balance sheet? It is more likely that they will buy another trillion in MBS next year.
Posted by: David Pearson at August 22, 2009 06:47 AM
The road ahead for the Fed may be politically rocky. To counteract the biggest financial crisis since the great depression, the Fed has rolled out many new programs and committed trillions of dollars in aid to financial institutions. The intervention has distorted market prices. The massive expenditures have ignited fears of inflation down the road, bailouts have increased the problem of moral hazard.
The response to the Fed's actions are not unexpected. Wall Street and financial institutions have applauded the Fed's efforts. A WSJ poll of economists overwhelmingly supported the Fed's actions, and some have referred to the Fed as the "savior" of the nation.
The support from Wall Street contrasts with that of Main Street and some politicians. Only 30 percent of the public rated the Fed's performance as either excellent or good, in this July 2009 Gallup Poll. This rating was the lowest among the nine Federal agencies surveyed.
Criticism of the Fed includes the taxpayer bailouts of financial institutions, politicising of the Fed, lack of transparency, and the failure of the Fed to adopt counter cyclical policies that might have prevented the greatest financial meltdown since the great depression.
Congressman Ron Paul, with more than 200 co-sponsors, introduced a bill to provide greater oversight and transparency. One of the harshest critics of the Fed is Senator Richard Shelby, a member of the Senate Committee on Banking, Housing and Urban Affairs. In a July 23, 2009 hearing he said :" It was the Fed that failed to adequately supervise Citigroup and Bank of America, setting the stage for bailouts in excess of $400 billion. It was the Fed that failed to adopt mortgage underwriting guidelines until well after the crisis was underway. It was the Fed that said that there was no need to regulate derivatives . It was also the Fed that lobbied to become the regulator of financial holding companies as part of Gramm-Leach-Bliley. The Fed won that fight and got the additional authority It sought. Ten years later, however, it's clear that the Fed has proven that it is incapable of handling that responsibility".
Bernanke's reappointment will provide an early test of the Fed's political standing. The outcome may have little to do with the Fed's deficiencies and inaction prior to the financial crisis, but rather may hinge on the balance between the administration's desire to reaffirm it's message of change and the fact that Bernanke is a team player in the middle of a financial crisis.
Posted by: fwm at August 23, 2009 03:14 PM
Two facts argue against your premise that walk-aways will become the larger component of mortgage defaults. One is that unemployment and under-water mortgages are overlapping sets. Since unemployment is more immediate, some part of potential walk-aways will be sliced away through job loss. The other fact is that underwater-ness is not a magic switch that forces default. There are a number of reasons that people continue to pay mortgages on underwater homes. Many who bought their homes at a given price did so because they thought the monthly payment was a good deal for what they were getting. Moving is a pain, and when you default, you move. Default impairs credit, and can hurt employment prospects, as well. The list goes on.
So while it is possible that walk-aways will become a far larger problem, it isn't a given. Your argument about Fed independence relies on something like a walk-away surge. So what is the argument to support the inevitability of that surge?
Posted by: kharris at August 24, 2009 05:25 AM
Great interviews Professor.
I think many agree with Allan Meltzer that the failure of Lehman Brothers was the precipitation of the decline. I think I would agree that it was a part but not necessarily the worst decision the FED has made in its existence, as Meltzer says. But I take a little different twist on why the markets were so shocked.
Generally the "too big to fail" players were all being bailed out, before and after Lehman. What Lehman demonstrated is that competetors to Goldman Sachs would be destroyed. If you played ball with Goldman like AIG you would be propped up, but without the blessing of Goldman you were dead. The markets froze because the government was picking winners and losers and the passage of the TARP gave them to mega bucks to do what ever they wanted.
Market forces were no longer valid. Only the forces of government largess ruled. But market forces had the last word and the economy crashed. The same will be true of current government manipulation. The market will rule thought government actions can postpone and intensify the destruction.
Posted by: DickF at August 24, 2009 06:38 AM
One can model the influence of unemployment on mortgage defaults. Take the historical correlation between unemployment and defaults, and use it to predict defaults at a 10% rate of unemployment. Logic tells me that based on Fannie and Freddie's maximum default experience in the 90's recession, that number is much smaller than what we are seeing today. Therefore, something else -- negative equity -- is at work. I admit to not having specific numbers, but I believe total delinquencies maxed out below 5% in the 90's compared to about 13% currently. If you know differently, let me know.
Also, I would point to the cure rate for prime conforming mortgages, which is dramatically lower (at around 6%) than the recent peak of about 40%. Again, I don't have numbers for the previous trough, but I would guess the number is far above 6% based on the low flow-through to foreclosure at that time. If prime conforming defaults were primarily unemployment driven, one would expect higher cure rates as unemployment is in many cases a temporary condition, even during a recession, and because the foreclosure process is a lengthy one.
Finally, there is the degree of negative equity. At greater than 20%, there is little hope of regaining lost equity in the home. That prompts borrowers to look at the cost of ownership -- at an inflated loan value -- based on the cost of renting. In many geographies, particularly California, the cost of renting is far lower than the borrowing cost AT PREVIOUS LOAN VALUES (not at current market values). It is a prudent family decision, at that point, to walk away from one's home.
Posted by: David Pearson at August 24, 2009 05:55 PM
many do "agree with Allan Meltzer that the failure of Lehman Brothers was the precipitation of the decline". They are mostly wall st types perpetrating this self interested myth. Also check out Rogoffs rebuttal of this in the FT.
Proofs Lehmans Sept. 14 bankruptcy was not prime cause of the late 2008 great recession.
1.OTHER DRIVERS FULLY EXPLAIN THE 4Q DOWNTURN IN THE REAL US ECONOMY
a.Housing collapse: prices, starts and foreclosures and lagged effect.
b.Energy shock through July with $100+ bbl oil prices.
c.State and Local govt shrinkage related to tax revenue loss and March 2008 shutdown of auction rate market for project finance.
d.Securitization credit collapse: unguaranteed market was shrinking since March.
e.Global export collapse. US exports down a real -3.6% and -19.5% in 3Q 4Q, far larger than the real GDP Decline. Trade finance dries up.
f.Stimulus unwound: Stimulus package #1 was small and temporary: It worked 2Q: then unwound in the third and fourth quarter.
2.OTHER PROBLEMS BESIDES LEHMAN PRESSURED THE FINANCIAL MARKETS IN SEPTEMBER.
a.WAMU bonds also default in Sept.
b. Fannie and Freddie faced default risk threatening $5.2 trillion of paper and guarantees.
c.Mortgage insurers and pool insurers faced insolvency threat.
3. LEHMAN BANKRUPCY FURTHER DISRUPTED THE FINANCIAL MARKETS, BUT BANKING HAD IN MANY RESPECTS STOPPED SUPPLYING CREDIT ALREADY.
a.Lets stipulate that commercial paper, money market mutual funds, bank funding and CDS markets showed further stress in September, partly Lehman related.
b.Only the first two directly supply credit
c.The Treasury formally announced blanket money market guarantees Sept 19, printed regs Sep 28.
d.The treasury also ramped up the CP guarantee program to $130 bio in Sept/Oct. Nonfinancial CP outstandings rose over $1 trillion in 4Q.
e.Securitization, already in major decline, slowed its rate of decline after Lehman.
4. THE REAL ECONOMY ALREADY SHOWED AN ACCELERATING RATE OF DECLINE IN AUG-SEPT.
a. A Lehman caused credit crunch would take at least 1-2 months to noteably affect real activity.
b. Initial unemployment claims breached 400 thousand in early august.
c. Commodity prices, after spiking to a peak in late July, had collapsed by Sep 14.
d. US industrial production (measured mid-month) fell a disastrous 4.0% in Sept, far worse than any other month.
e. Real consumer spending fell -0.5% in September, the recession�s largest monthly decline.
No statistical proof has been offered by anyone that further credit withdrawals beginning late September FURTHER drove down activity in credit starved sectors. There was clearly credit starving going on. That had commenced a year earlier and progressively gotten worse. The only �proofs� of this largely mythic Tale of Lehman are thousands of self serving Wall St types intoning it to each other.
Posted by: AWH at August 25, 2009 11:25 AM
The Road Ahead For The Fed: Back To 1913
Although the Fed is better known for its monetary policy role, the Fed's lender-of-last-resort function was founded "..in 1913 largely in response to the periodic episodes of banking panics..."(Bernanke speech January 5,2007).
Historically, the Fed used monetary policy to moderate the inevitable froth and excesses that develop during the up phase of a business cycle. This policy of taking away the punchbowl when markets become frothy is known as "leaning against the wind". The policy appears to have peaked in the year 1999. From the FOMC transcript of September 24, 1999 then Fed Governor Lindsay commenting on the elevated level of stock prices said "..while it is not so large to exert undue pressure on the real side of the U.S. economy, this emerging bubble is nevertheless real...I can attest that everyone enjoys an economic party. But the long-term costs to the economy and society are potentially great....The case for a central bank ultimately to burst that bubble becomes overwhelming. I think it is far better that we do so while the bubble still resembles surface froth and before the bubble carries the economy to stratospheric height." At that same meeting Greenspan said: "I recognise that there is a stock market bubble at this point." Shortly thereafter on December 5, 1999 Greenspan made his famous "irrational exuberance" speech. The stock market reacted negatively , and that was the peak of the "leaning against the wind" policy.
Over time, the Fed developed justifications for not intervening in markets: markets self correct;
bubbles are hard to identify definitively; intervention might do more harm than good; the certainty of inaction boosts market confidence; major economic downturns are rare events; the downside economic damage from a bursting bubble can be limited by prompt Fed action. This policy of less intervention coincided with a political climate emphasising deregulation and free markets.
Of course, it doesn't hurt that this policy of noninterference allowed the Fed to avoid the "heat" associated with being a "party spoiler". Moreover the Fed's lender-of-last-resort function allows the Fed to demonstrate its considerable technical skills in mopping up the mess of a burst bubble. Nobel Prize winner Paul Krugman said: "It is slightly shameful but true observation that economists interested in policy find themselves pleasantly stimulated by economic crisis, just as professional military men are somewhat cheered by the prospect of war. This is particularly true when the events are dramatic without being too threatening in a personal sense. I have never seen as many happy people at the National Bureau of Economic Research as I did during the first few days after the 1987 stock market crash . There is extra satisfaction when the crisis is one that you and your friends think you understand and to be around when a crisis you have predicted actually comes to pass is truly heaven." (Essays in International Finance No 190 July 1993)
The Fed's lender-of-last-resort function has succeeded in stabilising financial markets, at least for now. Bernanke has been reappointed (subject to congress) and heralded as a "savior". These actions would appear to reinforce the Fed's proclivity for "non-intervention" and rely instead on its lender-of-last -resort function to clean -up bubbles when they burst.
Posted by: fwm at August 26, 2009 12:04 PM