Comments on Housing and the Monetary Transmission Mechanism

Here are the comments that I delivered this morning at the Fed Jackson Hole conference.

Governor Mishkin has done a nice job of categorizing the various channels by which the consequences of monetary policy might be transmitted to the economy. I’d like to take a step back and reflect on what are the instruments of monetary policy, the transmission of whose effects we’re discussing.

The instrument of monetary policy that we tend to think of first is the time path of short-term interest rates. It’s natural to start there, because it’s easy to quantify exactly what the Fed is doing.

But another instrument of monetary policy that I think needs to be discussed involves regulation and supervision of the financial system. This is inherently a messier question. It’s harder to quantify the effects, and many of the issues I’m going to be raising today may be outside the current regulatory authority of the Federal Reserve itself. Indeed, one way you can view the history of our financial system is that a certain type of problem becomes recognized, we develop regulations to deal with it, and then new parallel institutions evolve, outside that regulatory framework, where the same kind of problem arises in a new setting.

Although the regulatory question is messier to address, I think we’d all agree there have been periods historically where it played a key role in determining the course of events. The most recent experience might be the 1980s, for which you all know the story.1 As a result of a series of bad luck and bad decisions, a significant number of U.S. banks and savings and loans at the time ended up with a position of negative net equity. But that did not prevent them from being able to borrow large sums at favorable rates, thanks to deposit insurance. The decision problem for an entity in that situation has a clear solution– with the lower part of the distribution truncated, you want to maximize the variance of the investments you fund with that borrowing. That recklessness in lending was a factor aggravating both the boom and the subsequent bust of that episode. Fortunately, through a combination of good luck and good policies, we were able to correct the resulting mess in a way that avoided the more severe problems that some of us were anticipating at the time.

Why do I suggest that there might be something similar going on in the current environment? I’m basically very puzzled by the terms of some of the mortgage loans that we’ve seen offered over the last few years– for example, mortgages with no downpayment, negative amortization, no investigation or documentation of the borrowers’ ability to repay, and loans to households who had demonstrated problems managing simple credit card debt.

The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run, and potentially applies to any institution whose assets have a longer maturity than its liabilities. The problem arises when the losses on the institution’s assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent.

In the traditional story, the institution we were talking about was a bank, its long term assets were loans, and its short term liabilities were deposits. In the current situation, the institution could be a bank or investment fund, the assets could be mortgage-backed securities or their derivatives, and the short-term credit could be commercial paper. The names and the players may have changed, but the economic principles are exactly the same. How much of a worry this might be depends on the size of specific potential losses for Institution X relative to its net equity, and the volume of short-term loans that could potentially be disrupted as a result.

This is not just a theoretical possibility. My understanding is that this is exactly what happened to Germany’s IKB Deutsche Industriebank on August 9 to set off the tumult in global short-term capital markets.2

Governor Mishkin discusses the potential role of real estate prices in the monetary transmission mechanism. I am seeing that not as an issue in its own right, but instead as a symptom and a propagation mechanism of the broader problem. It is a symptom in the sense that, if loans were extended to people who shouldn’t have received them, real estate prices would have been bid up higher than they should have been. And it is a propagation mechanism in the sense that, as long as house prices continued to rise, all sins were forgiven. Even a completely fraudulent loan would not go into default when there’s sufficient price appreciation, since the perpetrator is better off repaying the loan in order to enjoy the capital gain.

The problem is that, as this process gets undone, both effects operate in reverse. A credit crunch means that some people who should get loans don’t receive them, depressing real estate prices, and as prices fall, some loans will become delinquent that otherwise might not. If such fundamentals are indeed contributing factors on the way up and the way down, the magnitude of the resulting decline in real estate prices, and their implications for default rates, could be much bigger than the reassuring numbers Mishkin invites us to remember based on the historical variability of these series. What worries me in particular is, if we see this much in the way of delinquencies and short-term credit concerns in the current economic environment, in which GDP has still been growing and house price declines are quite modest, what can we expect with a full-blown recession and, say, a 20% decline in average real estate values?

Now, the question that all this leads me to ask is why– why did all this happen? Why were loans offered at such terms? I’m not sure that I have all the answers, but I am sure that this is the right question. And if you reject my answers, I hope it’s because you have even better answers, and not because you dismiss the question.

It seems the basic facts highlighted in Green and Wachter’s paper yesterday might be a good place to begin. Since 1990, U.S. nominal GDP has increased about 80% (logarithmically). Outstanding mortgage debt grew 50% more than this, raising the debt/GDP ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed by Fannie and Freddie grew 75% faster than GDP, while mortgages held outright by the two GSEs increased 150% more than GDP. The share of all mortgages held outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% in 2006, which includes $170 billion in subprime AAA-rated private label securities. The fraction had been as high as 20.5% in 2002.3. It is hard to escape the inference that expansion of the role of the GSEs may have had something to do with the expansion of mortgage debt.

Source: Green and Wachter (2007).

This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises– about $70 billion last year– represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we’d have at least part of the answer to the puzzle.

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I’m thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, “the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default.” And the Fed says, “oh yes we would.” And the market says, “oh no you wouldn’t.”

It’s a game of chicken. And one thing that’s very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do. That would be an event with significant macroeconomic externalities that the Fed is very much committed to avoid.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks. So here’s my key recommendation– any insitution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.

While I think the answer to our question may begin here, it certainly doesn’t end, as indeed, thanks to Lockhart, the growth of mortgages held outright by the GSEs in 2006 was held in balance, and we simply saw privately-issued mortgage-backed securities jump in to take their place, with their share of U.S. mortgages spiking from 8.6% in 2003 to 17.4% in 2005. One might argue that the buyers of these private securities may have made a similar calculation, insofar as the same aggregate conditions that keep Fannie and Freddie afloat would perhaps also be enough to keep their noses above water. Or perhaps Professor Shiller is right, that psychologically each investor deluded himself into thinking it must be OK because he saw everybody else doing the same thing. Or maybe they were more rationally thinking, “the Fed wouldn’t let us all go down, would it?” And the Fed says, “oh yes we would.” And once again, regulation, not selecting an optimal value for the fed funds target, has to be the way you want to play that game.

If these bad loans were all a big miscalculation, perhaps that is something the Fed might consider addressing as a regulatory problem as well. The flow of accurate information is absolutely vital for properly functioning capital markets. I have found myself frustrated, in looking through the annual reports of some of the corporations and funds involved in this phenomena, at just how difficult it is to get a clear picture of exactly where the exposures are. I think the accounting profession has let us down here, which you might describe as a kind of networking equilibrium problem. But if the Federal Reserve were to develop and insist on certain standards of accounting transparency for its member institutions, that might help to be a stimulus to get much more useful public documentation for everybody.

It also might be useful to revisit whether Fed regulations themselves may be contributing to this misinformation. Frame and Scott (2007) report that U.S. depository institutions face a 4% capital-to-assets requirement for mortgages held outright but only a 1.6% requirement for AA-rated mortgage-backed securities, which seems to me to reflect the (in my opinion mistaken) assumption that cross-sectional heterogeneity is currently the principal source of risk for mortgage repayment. Perhaps it’s also awkward for the Fed to declare that agency debt is riskier than Treasury debt and yet treat the two as equivalent for so many purposes.

Of course I grant the traditional argument that regulation necessarily involves some loss of efficiency. But to that my answer is, it’s worth a bit of inefficiency if it enables us to avoid a full-fledged financial crisis. I’d also point out that, if our problems do indeed materially worsen, the political calls for regulation will become impossible to resist, and much of the cures recommended by the politicians would create dreadful new problems of their own– that too is part of the historical pattern we’ve seen repeated many times. For this reason, I think it would be wise for the Federal Reserve to be clear on exactly what changes in regulatory authority could help prevent a replay of these developments, and preposition itself as an advocate to get these implemented now. Such steps will also be necessary, I think, to restore confidence in the system, if the situation indeed worsens from here.

Now, I should also emphasize that understanding how we got into this situation is a different question from how we get out. Tighter capital controls by themselves right now would surely make the matter worse, and allowing an expansion of the GSE liabilities may be as good a short-term fix as anybody has. But I do not think we should do so without seeing clearly the nature of the underlying problem, and certainly cannot think that by itself expansion of GSE liabilities represents any kind of long-run solution.

Finally, in closing, suppose that I’m wrong about all of this. Suppose that the developments I’ve been talking about– the appearence of loan originators in every strip mall, anxious to lend to anyone, and other parties just as anxious to buy those loans up– suppose that it is all a response to the traditional monetary instrument, the manipulation of the short-term interest rate. After all, a 1% short-term rate, 6% 30-year mortgage rate, and 13% house price appreciation, such as we saw in 2004, is plenty of incentive to borrow and repay. I used to believe that this was sufficient to account for all that we were seeing, and many of you perhaps still think that way. But if it were the case that all these institutional changes are just a response to interest rates, it means that the lags in the monetary transmission process are substantially longer than many of us had supposed. If people were still buying houses in 2006 as a result of institutions that sprung up from the conditions in 2004,it means that, if we thought in 2004 that overstimulation could easily be corrected by bringing rates back up, then we would have been wrong. And likewise, suppose you believe that the pain we’re seeing now, and may continue to see for a matter of years, until the new loan originators all go out of business, and recent buyers are forced out of their homes, is simply a response to a monetary tightening that ended a year ago. If so, then if we think today that, if things get really bad, we can always fix things by rapidly bringing interest rates back down– well, then, once again, we’d be wrong.


1. See for example Kane (1989) and Keeley (1990).
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Wall Street Journal, August 10, 2007, p. A1.
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Sources: Office of Federal Housing Enterprise Oversight, Enterprise Share of Residential Mortgage Debt Outstanding: 1990 – 2007Q1, and Lockhart (2007).
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Frame, W. Scott, and Lawrence J. White. 2007. “Charter Value, Risk-Taking Incentives,
and Emerging Competition for Fannie Mae and Freddie Mac,” Journal of Money, Credit, and Banking, 39, pp. 83-103.

Green, Richard K., and Susan M. Wachter. 2007. “The Housing Finance Revolution.”

Kane, Edward J. 1989. The S&L Insurance Mess: How Did It Happen? (Washington: Urban Institute Press).

Keeley, Michael C. 1990. “Deposit INsurance, Risk, and Market Power in Banking,” American Economic Review, 80, pp. 1183-1200.

Lockhart, James A. III. 2007. Housing, Subprime, and GSE Reform: Where Are We Headed?

Shiller, Robert J. 2007. “Recent Trends in House Prices and Home Ownership.”

40 thoughts on “Comments on Housing and the Monetary Transmission Mechanism

  1. spencer

    I’ve been worried about your last points for several years. As the US financial system has become more and more integrated in a world wide financial system the Fed’s ability to influence the economy has been significantly reduced.
    Tt should be obvious that the traditional policy levers are not what they use to be.
    We have been seeing signs of this for about 20 years as the old relationship between long yields and short yields has broken down.
    The Fed has been tightening for 5 years and essentially the only impact on the economy is in housing.
    We should be spending much more time discussing why the old policy levers no longer work.

  2. Venkat

    Seems such a comprehensive analysis given the constraints of a speech. The professor does a great job of addressing the origins of this mess as well as highlighting the limitations of the solutions, namely expanding role of GSEs and levering of short-term rates, in coming to the financial system’s rescue. It is almost a beauty to read this! I have read upwards of 100 articles on this and have to say this one is the top of the heap in terms of analyzing the immediate implications of various patch-work solutions being proposed.
    It is almost too dishonest that we want to keep the prices up no matter what. A simple minded question: Is the government/fed’s mandate only to prevent corrections but not monitor asynhronous appreciations and take neutralizing steps. I would suspect that incomplete and skewed inflation calculation is one of the root causes of loose monetary policy not just in the U.S but almost everywhere in the world, save Switzerland and few other conservative or undeveloped economies.
    Money is fast losing value. Mis-allocation of resources towards non-productive things has gone on for too long. That’s just my opinion.
    Inevitably we will all be saved from this bubble too and “global” economy or helicopters with money will surely save us!

  3. James I. Hymas

    Well, I like it!

    I would much rather have the GSEs regulated as banks than have them continue in the current twilight zone. The recent debates regarding portfolio limits & jumbo loan definitions are politicized, not something that gives me a lot of comfort.

    Are there estimates of that the GSEs Tier 1 ratios would be if they were subject to banking rules? What are your views on the social purpose of the the GSEs – would you regulate them strictly as banks? Would you restrict their charter to Mortgage & money market investments? If you accept a government interest in the encouraging the enterprises, how would you effect this encouragement? Via reduced capital ratio requirements? Via reduced margin rates on specific types of investments? Via Federal investment in the capital of the GSEs? Via Federal guarantee of some portion of their holdings?

  4. David Pearson

    Great speech.
    On the transmission lag, perhaps a narrative is in order.
    By 2003 low rates caused a boom in mortgage originations — $2.8tr, far in excess of previous records. After the Fed rate hike campaign began, the boom also tailed off. Mortgage lenders were faced with too much capital and too much capacity; and investors with too little supply to meet their demand for yield.
    Enter exotic products, which were hatched by a handful of niche Orange County-based lenders. Investors loved the yield, which was scarce in the low-volatility world created by the Fed put. Mainstream lenders hesitated at first, and then rushed in to Alt-A and subprime to defend share and achieve volume growth. The volumes would never return to 2003 levels, but the exotic loans made up for it in margin.
    Each successive wave of low-payment products further lowered the minimum payment, mitigating or delaying the effect of monetary transmission (i.e. of rate hikes).
    To an option arm borrower, the rate hikes never happened: in fact, their payment in 2006 was below that of a level-pay ARM in 2003.

  5. Lord

    It does seem apparent the agencies displaced the s&ls becoming too large to fail, and attempts at regulating them merely pushed the issue to the unregulated asset based securities issuers. This may have worsened things by eliminating any lending standards. While borrowers may have taken advantage of this, lenders were desperate for what they felt were safe investments with a good yield and didn’t want to look too closely beyond the rating. They may have be priced low for the risk assumed, but higher than they should have been had they been safe. A lot of this comes directly and indirectly out of the account imbalances, whether saving for rapidly aging populations like the developed world, converting natural resources into financial assets, or providing employment growth through undervalued currencies. Naturally, the Fed has little control over these and can only react to them. It may well have to push harder on the levers in the future as its audience may not be a domestic one.

  6. HZ

    As I commented on earlier in your “Solutions to the mortgage problem” thread, this GSE/Fed conflict of interest could be solved by mandating that first lien mortgage amount be tied to replacement cost or rent, instead of appraised value (often from comparable sales). Since a somewhat positive CPI is a policy goal for the Fed, of which rent is a significant component, the interests of the two are then much more in alignment. No capital control is then needed, with the added advantage that GSE loans can be extended to households of all credit risk spectrum (if the loan can be covered by rent after foreclosure there would have been little need to foreclose in the first place and there is little credit risk). Further it anchors the housing value to rent and does not subsidize speculation on intangibles.

  7. Lorne

    Participation of the GSO’s in a mortgage bailout depends upon investor confidence, since such entities borrow short and lend long, and narrow spreads are essential to success of such an endeavor. (Sounds like the root cause of the S&L crisis). Or if you prefer, the Fed can provide
    1 1/2 trillion in funding.
    This would be a good time to review Bill Poole’s thoughts on the GSO subject:

  8. Anon

    “any insitution that is deemed to be “too big to fail” should be subject to capital controls that assure an adequate net equity cushion.”
    Absolutely. But doesn’t the Fed officially take the position that no institution is too big too fail. You run into a problem of definitions here.
    I propose: Any institution that regularly accesses the commercial paper market to finance on going activity should be subject to capital controls that assure an adequate net equity cushion.
    Re: why did some of this nutty mortgages get written? The calculated risk blog raises the possibility that the need for high-yield (and therefore high risk) mortgages led CDO packagers to pay a premium for non-traditional loans. The possibility that financial innovation created incentives that weakened underwriting standards needs to be investigated.

  9. Anarchus

    Nice essay (and a wonderful view, btw).
    I was a little surprised by the suggestion that Federal Reserve policy would be the mechanism by which Fannie and/or Freddie wouldn’t be allowed to fail. While it’s very clear that most fixed income investors assume that the U.S. Government wouldn’t allow the GSE’s to fail, I’ve always guessed that in a worst case scenario it would be the Treasury and a legislative fix rather than a Fed policy fix. Not to mention but that in the present world where the Government is sometimes viewed as the problem rather than the solution, IF the capital markets decided that the Fed was going to lower rates and gush liquidity to save Fannie and Freddie, I suspect that long-term interest rates would spike up into the teens as they eventually did in the late 1970s/early 1980s and to the extent long rates rose faster than inflation I’m not sure the Fed policy bailout process would work — of course, I’m not sure that long rates would go up faster than inflation, either, but they might.

  10. craig tindale

    Its the damn HELICOPTERS!
    Seriously when Bernanke suggested in 1999 that valid monetary policy might be , lower interest rates, money supply funded tax cuts, monetrary rains on consumers via the RE asset channel, nincreased consumption through the wealth effect of RE asset appreciation etc etc the writing was on the wall.
    To pretend this was anything else than a purposeful stimulation of the economy by the Fed using monetary transmission methods is intellectually dishonest.
    To be surprised that monetary policy stimulation in the RE asset channel has 2-3 year time lag is astounding. DOH !
    Of course it takes this amount of time to filter through and yes it will take 3 years to filter, it questions the entire fed intervention methodology, Bernanke and the rest of the Milton zealots have blown up the lab, how are they going to explain what they were doing was really and experiment and they werent sure of the outcome?.

  11. Hal

    I think the one comment you made that pointed to the crux of the problem was that, just as when housing prices were appreciating many bad loans turned out good, so if we get into a state of housing price deflation then many good loans will turn bad. If this kind of positive feedback effect really exists, it calls for institutional mechanisms that can put on the brakes.
    I don’t know what institutions those would be, but many forms of regulation can be seen as attempts to quell and moderate positive feedbacks in the markets. In principle, providing more and timelier information and transparency can system responsiveness and provide negative feedback to fix the problem.

  12. Rick

    One simple question:
    why has Fannie still not published a balance sheet since 2003? (Level 3 accounting, anyone?)

  13. dug

    ” Why were loans offered at such terms? ”
    It really is the key question –
    Another take on the same question: ” Why were loans offered at such terms in the United States and nowhere else?”
    Other countries also had low interest rates, encouraging new mortgage lenders and products in this period. None of them saw it go as far as in the US. Why did subprime get so big? Why could low-doc borrowers do so with nothing down? This didn’t happen in other countries like Canada or the UK, or anywhere in Europe. Their subprime sectors stayed small, and low-doc borrowers had to pay bigger downpayments, not smaller.

  14. fredw

    Questions : Why are FNM and FRE being proposed as possible “solutions” to the mortgage crisis when FNM can’t even provide quarterly or annual reports and FRE recent results demonstrate they’ll have work on their hands just keeping themselves solvent ? Why did regulators allow in the first place neg amort , stated income – no or low doc loans , option ARMs , 2/28 or 3/27 mortgage products – the latter products being basically a form of bridge financing ? If we actually are a capitalist and not socialist system , why are any businesses considered “too big to fail ” in the first place ? Why hasn’t anyone considered that all derivatives should be bought and sold transparently through regulated exchanges ( like options are ) with bid and ask prices established , thereby avoiding mark to fantasy issues ? Finally , apart from completely blowing up CDO and CDO – squared or cubed products , why not let home prices fall.. how else will the present situation resolve itself without rationale pricing being allowed to come back so that intelligent buyers will return to the housing market ?

  15. bullb

    quote ———————

    “….But let’s consider the implications of Hamitlon’s “too big to fail” recommendation. Who else do we need to worry about?
    The Bank of England, in its latest Financial Stability report identifies the concentration of activity in sixteen of what it calls “large complex financial institutions” as a source of systemic risk. Those firms are: ABN Amro, Bank of America, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman, HSBC, JP Morgan Chase, Lehman, Merrill, Morgan Stanley, RBS, Societe Generale, and UBS. The report notes:

    Given their scale and their pivotal position in most markets, distress at an LCFI could have a large, unanticipated, impact on other financial market participants. This could arise from losses on direct exposures to an LCFI that failed or from the wider market implications of actions taken by an LCFI to manage problems.


    —————–end quote

    Also, your thoughts along the lines of
    “….I’m basically very puzzled by the terms of some of the mortgage loans that we’ve seen offered over the last few years– for example, mortgages with no downpayment, negative amortization, no investigation or documentation of the borrowers’ ability to repay, and loans to households who had demonstrated problems managing simple credit card debt…”
    seems very disingenuous.

    These things have been going on for a long time – remember you were actively trying to deny a bubble, and pretend that these things had nothing to do with housing prices. All the time living in ground zero of real estate – San Diego. I still see you trying to wiggle out in your last post “Report from Jackson Hole” pretending that all this were a surprise, and people who were warning of this were clueless.

    I think you are a just carrying water for Republicans – you denied the bubble and the lax lending, because you wanted to believe in the Bush economy. The same motivation holds for your picking on the GSEs, while keeping mum about the 16 LCFIs that BoE mentions.

  16. James I. Hymas

    Why hasn’t anyone considered that all derivatives should be bought and sold transparently through regulated exchanges ( like options are ) with bid and ask prices established , thereby avoiding mark to fantasy issues ?

    Because that would destroy the market. On my own blog, for instance, I looked at the Bear Stearns 2005-1 ABS: seven tranches were offered in the prospectus with issue sizes of (millions): $314, $38, $19, $4, $4, $3, $4. Not only would the smaller tranches have their returns (such as they may be!) eaten up by listing fees, they would almost never trade and, I suspect, would rarely attract even a somewhat realistic bid and offer.

    I suspect that you could spend an entire career as the biggest ABS trader on the street and never once be asked to quote on the smaller tranches.

    I will also note that while some options are exchange-traded, not all of them are.

    I also suspect that bigger mark-to-fantasy issues will surface with private equity funds, but we will see about that.

    If we actually are a capitalist and not socialist system and you are so eager to promote the former, why are you proposing so much new regulation?

  17. JDH

    Burb, you delude yourself quite profoundly by pretending that you have any insight whatever into my motives and intentions. I call it as I see it, always have, always will. And I have limited patience for someone who feels a need to frame the issues as you have here.

  18. donna

    Maybe the problem is we shouldn’t have institutions that are “too big to fail”.
    But then my view is colored by trying to get JP Morgan to settle my mom’s estate for the past four years, instead of dealing with a small local bank that was bought by a larger local bank that was bought by a national bank that was bought by JP Morgan.
    Maybe what we really need is not to have these big institutions that are allowed to buy up everything and then not give a damn about how things are actually run.
    At to the Fed, maybe they ought to stop supporting this crap, and let the “too big to fail” institutions fail and be broken up – just as the S&Ls were.

  19. Lord

    Such is the irony of regulation. Letting smaller institutions fail only increases the size of larger ones making them too large to fail. Letting larger ones fail won’t create a thousand smaller institutions immune to failure, only that many more subject to failure. Regulation drives activity from the regulated to the unregulated. Asset based investment securities issuers transfer the risk to numerous investors who presumably aren’t too big to fail but borrowing may just transfer this risk back on lenders. Regulation decried as anticapitalistic when it is capitalism itself that produces the need for it and calls for letting capitalism run like that isn’t what brought us to this point in the first place.

  20. andiron

    “”””If so, then if we think today that, if things get really bad, we can always fix things by rapidly bringing interest rates back down– well, then, once again, we’d be wrong.”””
    i see it that you recommend no FED cuts (and i agree w/ that position) but why such tormenting presentatio?

  21. Joseph

    Very nice presentation. It certainly seems like a game of chicken and the market is pricing risk as if they believe the Fed will blink first. The Fed only has two choices. Let the whole country go down with the ship in order to teach a few people a lesson or act to mitigate the problems. But if they decide to own the problem, they better as well decide to take on the responsibility of new regulations to prevent the problem.

  22. Anon

    “If we actually are a capitalist and not socialist system and you are so eager to promote the former, why are you proposing so much new regulation?”
    I thought that the Great Depression definitively established that reasonably stable capitalist economies require careful regulation of financial institutions/markets. I would say that the false dichotomy quoted above is one of the sources of the current crisis.
    Another idea for regulation: All financial institutions that issue credit that is directly or indirectly (e.g. through increases in margin requirements) callable report the borrower, the amount borrowed and any collateral to the Fed.

  23. knzn

    I think Donna has something with the idea that institutions shouldn’t be allowed to get so big that they are “too big to fail.” The reason that sufficiently large institutions are too big to fail is that their existence makes the monetary policy transmission mechanism lumpy and uncertain. The Fed can thus get into a situation where it has to choose between a very high risk of depression and a very high risk of inflation. If Some Huge Mortgage Lender (SHML) is allowed to fail, it could be an economic disaster; on the other hand, preventing it from failing could be inflationary. If all institutions are sufficiently small, the the transmission mechanism gets smoother, and, for example, if all institutions were the same size, there would be some optimal number of failures that gets the economy to the optimal point on the Phillips curve.

  24. Anarchus

    At the risk of going off topic, I’m uncertain as to whether or not their are any financial institutions considered too big to fail.
    Fannie and Freddie are special cases – while they are big, it’s their unique status as GSEs that’s behind their perceived government protection and resulting near-treasury borrowing rates.
    Continental Illinois in 1984 was the 7th largest bank in the US and was allowed to fail. The Bank of New England in January 2001 was approx. the 25th largest bank in the country. IF the #7 bank was allowed to fail, I don’t think (and don’t ever invest assuming) that any bank or financial institution is too big to fail.
    What the Fed is very sensitive to, rightly or wrongly, is the broad form of Herstatt Risk – in which a large financial institution with a complex book of business fails so quickly that settlement and counterparty problems pull otherwise healthy institutions into an ugly black hole of finance.

  25. John F. Wilson

    The “Green and Wachter” mortgage holdings data cited in this piece are actually from the Federal Reserve’s Flow of Funds accounts. The FOF source of many such US macrofinancial data is all too frequently lost or ignored in subsequent citations. I hope Green and Wachter attributed them as such in their piece.

  26. Anarchus

    Btw, there’s a great summary of Professor Leamer’s (of UCLA) Jackson Hole essay posted over at Calculated Risk:
    Leamer has the best explanation of the unusual interaction between housing and employment in this cycle that I’ve seen, and provides a decent explanation of how the housing recession/near depression could end up having a milder economic impact than some perma-bears expect.
    That said, I still expect a recession in 2008, but if China, SE Asia and Eastern Europe remain strong then the US might well escape with an unusually mild “growth recession” instead of a garden variety downturn.

  27. James I. Hymas

    Anon 4:03: I don’t think anybody yet has argued in favour of a roll-back in regulation; I, for instance, commented above that I would prefer some kind of bank-like regulation for the GSEs to the politicized twilight zone that currently exists; I would also like to hear a good vigorous debate regarding appropriate capital requirements for banks and brokerages over the next few years, as the fall-out from the current situation becomes clear.

    No, I was just curious about the overall thrust of fredw’s seemingly rhetorical questions: some advocate laissez-faire capitalism – let ’em fail! – and others advocate regulatory micro-management – exchange traded derivatives only! I don’t know how he reconciles these positions, or whether he has considered their practical effects.

  28. Ray Stone

    JDH, Thanks for sharing your comments with those of us not in attendance. I was hoping to hear your take on Mishkin’s talk. I basically agree with you, although I am not unsympathetic to the view that the Fed in buying insurance against deflation in 2003, took rates too low, and as one of the tools to insure against deflation, and promised to keep rates low for a long time, the so-called “considerable period”. This envirnoment in combination with all the factors that you noted provided the backdrop for the mess we are in now. You mention the “lags” story as one a factor that diminsishes the 1% funds rate as a contributing factor. To this, I would note that ARM’s with initial rates tied to other stort term rates, have “substantial lags” in the resetting of these rates, perhaps this is why what happened in 2003 still matters for 2007.

  29. Anarchus

    Ray S – I’ve thought for a while that the Fed’s purchase of “insurance against deflation in 2003” was probably its least insightful move of the last 20 years.
    The reason I think the move was so wrong-headed is that it was based at least in part on this study:
    Preventing Deflation: Lessons From Japans Experience in the 1990s
    Intl Finance Discussion Paper, Fed Reserve Board of Governors
    June 2002
    The study suggests that policy makers should try to anticipate potential deflations because once deflations have started monetary policy is not so useful.
    I was surprised that the Fed could publish a 60+ page study of Deflation in Japan and not mention demographics a SINGLE TIME!
    Well, it surprised me, anyway, since IMO you cant begin to analyze or understand whats happened in Japan without examining the demographic shrinkage in their labor force since 1998 in light of the straightforward identity:
    GDP=(GDP/Totl hours)*(Totl hours/Employed)*(Employed/Labor Force)*(Labor Force/Population)*Population
    So, GDP growth is a direct mathematical function of changes in the labor force, and Japans labor force peaked (probably permanently) in 1998. Not to mention but as Japans population increases turned negative in 2005 the likely impact on aggregate demand seems obvious.
    So to my mind, demographics were and are a key driver of Japans problems and the U.S. at least does not face THAT problem.
    Its also kind of interesting that the Fed study above provided some of the basis for one of then-Governor Bernankes more famous speeches on November 21, 2002, where he addressed the issue of Deflation: Making Sure It doesnt Happen Here by citing Milton Friedmans helicopter drop of money.

  30. tim straus

    Brilliant and concise…some of the post essay bloggers are correct however; the core problem lies with a systemic bias of monetary and governmental authorities to keep the natural processes of a dynamic complex capitalist economy from self-correcting excesses, despite the painful results. A dynamic economy by definition lives in a state of flux, the goal of stability for political reasons or even falsely presumed assumptions concerning equilibrium processes results in an organizational bias that is consistently reflationary, from one bubble to the next. Yes the uncontrolled creativity of financial engineers and the institutions that paid massive rewards for their innovations have their hands in this, as do all of the architectures of this period of “finance capitalism” that were incented with the perception of virtual invincibilitybut the real culprit is the Fed and the government support for its policiesas it was in the S&L crises when the laws were changed to allow savings institutions in the early 80s and monetary policy post Volker became one based on contained bubble inflations. The moral purpose of capitalism is to create the greatest number of goods and services for the greatest number of people, not a system designed as a Mobius strip of wealth creation for the stewards of capitalit is also a emergent system, its has become supreme because of its inherent adaptabilityits ability to change as global circumstances requireit evolves. To stop this process, to assume a superior knowledge than the marketplace is arrogance and hubris, and when it is institutionalized it leads to the form and depth of the financial and ultimately economic disruptions that we are and will continue to face as a result of past policiespolicies whose biases have been ingrained in the American socioeconomic system and have infected the worlds. Here is a quote from former Fed Chairman Greenspan on the tools of the subprime to inflate a wealth effect to keep the US economy humming ( the tax and monetary incentivized consumption of a non-wealth producing asset from borrowed capital from overseas sources is another travesty that deserves considerably more attention) :
    Alan Greenspan, at Federal Reserve Systems Fourth Annual Community Affairs Research Conference, Washington, D.C. April 8, 2005
    “Innovation has brought about a multitude of new products, such as subprime loans…With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers….
    Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.
    These improvements have led to rapid growth in subprime mortgage lending… fostering constructive innovation that is both responsive to market demand and beneficial to consumers.”
    The housing bubble was a conscious policy tool for economic purposesthe laws of unintended consequences be damned.
    Innovation in financial creativity fed demandthe demand was there already as new, less fiducially responsible financial intermediaries took over from banks, mutual funds and pension funds as we entered a return and actuarially starved world. Build it and they will come is an expensive game Wall Street rarely plays, the system was already voraciously seeking to buy the paper produced and the rationalizations for the presumed safety by buyers and rating agencies alike were well entrenched in concepts of MPT and the CAPM.
    The atomization of risk smeared broadly all over the world has only connected the world more rapidly to the contagion. Like matter, risk cannot be destroyed
    The monster is loose, any economist that truly believes they know the future of how this all plays out should become a weathermanno matter how sophisticated and powerful the computer models are that drive their forecasts the intermediate and longer term forecasts remain as dismal today as they did 25 years ago.
    The global economic system can and will adjust, it is a process I term economic homeostasisbut dynamic systems live near the edge of chaos, unfortunately we have come mighty close to tipping over the boundariesdue more to false presumptions of monetary and governmental. The Fed and government must act, but they must do so in a way that does not prevent the system from cleansing itselfbelieve me the blood on all Street is just startingthe pain is no longer simply relegated to Main Street and over aggressive mortage brokerage houses.

  31. Anon

    James Hymas 8:50
    I would argue that the inconsistency lies in current policy. It doesn’t make sense to say that hedge fund industry does not need to be regulated and then as soon as multiple large fund failures are on the horizon claim that their failure is a systemic problem.

  32. James I. Hymas

    Anon 1:38 – It’s very difficult to comment on your proposed regulation without knowing the specifics!

    So far the system is working as it should – the financial sector’s top tier is well capitalized and nothing too spectacular has happened.

    And, quite frankly, I have a lot more faith in the ability of, say, Citigroup’s credit risk department to ensure that threats to Citigroup’s capital are both profitable and contained than I have for any sort of regulatory body.

    Citigroup itself is regulated with a high capital requirement that forms a significant barrier to entry. If that barrier to entry is pushed down the line to hedge funds – or just guys who like to trade on margin – we risk losing an important source of liquidity and innovation.

    So – be more specific! I may have my biases, but I’m listening!

    To get a little closer to the original topic, though, a lot of what I’m getting from Prof. Hamilton’s comments and from Prof. Taylor’s is that hedge funds have simply been exploiting unforseen consequences to Fed Policy – and I will claim that in doing so they have been providing a public service for which they should be thanked!

    There has been a huge economic impact from US housing related investment over the past few years. In amplifying and accellerating this impact, hedge funds have helped prevent these unforseen consequences from becoming too ingrained in the real – as opposed to the financial – economy. The current correction may have large financial and social costs, but I claim that the damage is largely limited to the financial sector as opposed to the broader economy and that this is a good thing.

  33. GWF

    I share your sense that something other than optimistic beliefs about home prices and interest rates is required to explain the origination of so many high-risk loans, and that the other key factor was some form of moral hazard or market failure. But it is not clear that the primary source of this market failure were the GSEs and the belief that they are too big to fail. My sense is that private securitization is also to blame and that the relevant market failure relates to structural flaws with securitization. (Indeed, the growth of the GSEs may simply reflect the continued trend towards disintermediation in the mortgage market, and their role may have actually shrunk relative to the private MBS segment of the market.)
    At this early stage, it is hard to be very precise about what has gone wrong in the securitization market. Clearly there has been over-reliance on ratings that proved to be wrong. But I think investors, like the rating agencies, came to believe that senior tranches of securitizations would never fail regardless of the underlying collateral or securitization structure. Given those beliefs, I think that certain sponsors began to behave opportunistically. Ethan Penner alludes to such behavior in his August 27th WSJ op-ed piece (“many CDO issuers bought all sorts of assets and combined them into proverbial ‘witches brews’ that they foisted onto the bond market, sucking out profits and fees at issuance in a game that was ongoing as long as the deals held up.”) Such sponsors, in turn, had the incentive to package almost anything, including uneconomic subprime mortgage loans. I think that this phenomena is at least part of the picture.

  34. DickF

    Spencer wrote:
    (I)t should be obvious that the traditional policy levers are not what they use to be.
    We have been seeing signs of this for about 20 years as the old relationship between long yields and short yields has broken down.
    The Fed has been tightening for 5 years and essentially the only impact on the economy is in housing.
    We should be spending much more time discussing why the old policy levers no longer work.
    Sorry I am so late to the party.
    I don’t think we should be discussing why the old policy levers no longer work, we should be discussing why they never have worked yet we keep pretending that they have.
    I am concerned with relaxing requirements on GSE’s to solve another problem. The GSE’s were created to deal with a perceived problem. They were given special allowances because there was a perception that they were dealing with a perceived problem, and now many are being cited as part of the problem.
    The GSE’s will always have a moral hazard problem because they are a creation of goverment and government never wants to admit it is wrong. They are in trouble right now because the government removed them from competition with other institutions and the lack of market discipline has allowed them to walk the edge of failure. Unless they are subjected to market discipline they will never succeed and it is doubtful that even then they can survive.
    If we relax regulation on the GSEs the regulations will stay relaxed because the GSEs will be unable to function without them.
    I was disappointed with your recommendations. It seems to be just more of the same with an implied intention that we will fix things with different policy just as soon as the crisis is over. So went the American Continental, so went the French assignant.
    The problem is government intervention and that will not be solved by more government intervention.

  35. James I. Hymas

    I think that certain sponsors began to behave opportunistically.

    Of course. That is the sponsors’ purpose in life.

    There is an unfortunate misperception in the market place – shared by some professionals – that we’re all one big happy family, earnestly doing our best to help one another out. This is a very dangerous misperception.

    Sponsors exist to fleece the unwary. A dealer’s greatest joy in life is to leave his counterparties naked and hungry. A portfolio manager who does not have these precepts front and centre when trading client money should not be in the business.

    The aspect of the current debate I find most disturbing is not simply the rush to judgement on the credit rating agencies, but the assumption that they have any responsibility at all for portfolio losses. All they’ve done is offer advice to portfolio managers, that’s all.

    It’s portfolio managers who push the button, it’s portfolio managers who make the big bucks and it’s portfolio managers who are very quick to claim credit for wild gambles that work out all right.

    Why do I see such little discussion of their role in the affair?

  36. direlink

    It is funny to see the elephant in the room being talked around. This was the result of a politicized fed who pulled out all the intervening measures to get a second term for BUSH. (Greenspan’s weekly Whitehouse meetings tell alot) Al owed the GOP for his stature and he paid his final dues – held the rate down too long, said ARMS were good, OK’ed tax cuts for rich. November 2001 “heli” speech by Bernanke was added fuel for the fire and path to the chair. They even threw in a useless war to use the full Keynesian stimulus playbook to win.
    We are now seeing the 180 degree turn of Fed intervention that worked in the short-run (Bush 2nd term) yet now huge long-run deficits, negative ratings for Bush, and the credit crisis.
    They manipulated a lot of econ talking heads and still are. Sucker born every minute!

  37. Mike Laird

    JDH, good speech.
    What do you think the odds are that the Federal Reserve will determine clearly the changes in regulatory authority needed to help prevent a replay of the recent mortgage turmoil, and preposition itself as an advocate to get these changes implemented? Have they taken similar actions in the past?

  38. James I. Hymas

    Looks to me like there’s another problem beyond the GSEs, Professor! There was a Bloomberg Report today:

    Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

    As far as I can make out, the FHLBs don’t even bother preparing books to BIS standards and reporting their Tier 1 Capital Ratios.

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