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links for 2007-09-02

I Am Not at the Jackson Lake Lodge This Labor Day Weekend

But lots of people are. And to me at least the most interesting things are not taking place outside the Jackson Lake Lodge:

But rather in the windowless meeting room and the nearly-windowless basement function rooms of the Lodge itself.

First, Jim Hamilton shows a graph that tells us the magnitude of the rapid recent growth in structured-finance mortgage products ("asset-backed securities issuers"):

And

Econbrowser: Comments on Housing and the Monetary Transmission Mechanism: 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... 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... 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.... Short-term creditors... have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent... otherwise sound institutions... liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent....

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....

[W]hy 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....

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.... [I]nvestors 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... a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default....

[Thanks to] OFHEO Director James Lockhart... the growth of mortgages held outright by the GSEs [stopped]... 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....

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....

[U]nderstanding 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... allowing an expansion of the GSE liabilities may be as good a short-term fix as anybody has...

Ben Bernanke talks about Housing, Housing Finance, and Monetary Policy. Paul Kedrosky sums up what he said:

Paul Kedrosky: Ben Bernanke's Money Sentences: Here are the two "money" sentences from Fed chair Ben Bernanke's Jackson Hole speech today on housing:

  1. The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets.
  2. 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.

You can use 'em both to make whatever case you want, and while I think they are appropriately counterbalances, Fed critics are going to seize on the two lines as being entirely in conflict. They aren't...

Ben Bernanke is saying that he is not going to let the subprime crisis spill over and cause rising unemployment and falling prices if he can possibly help it by lowering interest rates if necessary, but that he is not going to lower interest rates if it isn't necessary in order to give a present to lenders and investors who made bad bets. He is not saying interest rates will fall this month or next month. He is saying that interest rates will fall if he and the rest of the FOMC determine that spillovers from the subprime crisis to aggregate spending, production, and employment are on the way.

As if scripted--it wasn't--Rick Mishkin says that Ben Bernanke's task is not that hard hard to do, because by the time Bernanke sees whether or not the subprime crisis has or has not caused steep falls in housing prices in Orange and Riverside counties there is still plenty of time to avoid substantial rises in unemployment:

Krishna Guha in the FT: Central bankers should ease monetary policy quickly and aggressively in response to a big fall in house prices, Federal Reserve governor Frederic Mishkin said on Saturday.... [T]he optimal policy response was both quicker and more aggressive than that suggested by a standard policy rule, in which policymakers respond only to deviations in output and inflation. He said simulations show that this approach “can be very successful at counteracting the real effects” of even a large house price slump, because of the long lags from changes in housing wealth to changes in consumer spending. That time lag gives the central bank “plenty of time to respond” to the house price decline....

Mishkin said he was not suggesting that getting the right response to a house price slump is easy, but that “monetary authorities have the tools to limit the negative effects on the economy from a house price decline.” The Fed governor said housing and mortgage markets have not been “close to the epicenter of previous cases of financial instability.” But he added “I would note that the current situation in the US could prove to be different.” He said the recent experience with subprime loans fitted a boom-bust pattern of financial innovation....

Mishkin said... it seemed reasonable to work on the basis that it was similar to the wealth effect from financial assets - about 3.75 cents of extra spending per dollar of housing gains.... Mishkin poured cold water on Alan Greenspan’s theory that mortgage equity withdrawal plays an independent role in driving spending. “We do not think that ATM withdrawals drive consumer spending, so one must doubt whether mortgage equity withdrawals do so,” he said.... Mishkin said that a central bank could “mitigate” the concern that easing monetary policy following the collapse of an asset bubble would make future bubbles more likely if it “publically emphasises that its monetary policy is not directed at stabilising any particular asset price but is rather focused on achieving price stability and maximum sustainable employment.” In the increasingly likely – if not yet certain - event that the Fed decides to cut interest rates in response to the current financial market turmoil, this is likely to be the way in which it presents its decision.

And, not in Jackson Hole but in London, Mark Gilbert of Bloomberg writes about bonds rerated from AAA to CCC overnight:

Unsafe at Any Rating: Watching the rating cuts trickle out of the derivatives forest is akin to searching for elephant dung on a path to try and work out how many pachyderms are in the jungle. There's clearly a herd in there. And it's probably much bigger than the ordure you have seen so far would suggest. Last week, Standard & Poor's butchered the ratings on $3.2 billion of debt from structured investment vehicles spawned by Solent Capital Partners LLP in London and Avendis Group in Geneva. About $254 million was slashed from the top AAA grade to CCC+ and CCC -- slides of 16 and 17 levels, triggered by their investments in mortgage-backed bonds.

Think about that for a second. You left the office Tuesday owning a AAA rated security. By the time you got back to your desk on Wednesday morning, it was eight steps below investment grade in a category S&P defines as "currently vulnerable to nonpayment." Try explaining that to your pension-fund trustees.... DBS Group Holdings Ltd., Singapore's biggest bank, said on Aug. 7 it had S$1.4 billion ($921 million) at stake in collateralized-debt obligations. This week, it boosted that total to S$2.4 billion... the bank had overlooked its commitment to a unit called Red Orchid Secured Assets.... A rare moment of comedy arises from what Moody's Investors Service had to say about the oversight. "I don't think DBS will be the only one who has missed something the first time," said Deborah Schuler, a senior Moody's analyst in Singapore. Could this be the same Moody's that called structured investment vehicles "an oasis of calm in the subprime maelstrom" in a July 23 report?...

It will be hard enough for central bankers in the U.S. and Europe to set monetary policy at next month's meetings when they have no way of knowing how bad the financial storm might get and how much it might hurt economic growth. The more things that go boom in financial markets in the coming weeks, the harder the task facing the rate setters will get.

While before he flew to Jackson Hole Jim Hamilton concludes that the mortgage security crisis appears more contained than last week:

Econbrowser: Update on the fed funds market: As noted by Calculated Risk and William Polley, the last few days we've seen the return of slightly more normal behavior in the overnight market for fed funds.... On both Monday and Tuesday, the effective fed funds rate actually ended up above the Fed's nominal 5.25% target. This is the first time this happened since the tumult in short-term credit markets began August 10. We also saw a much more normal spread between the high and low trades of the day than we'd seen at any time since August 10.

The Fed continued to be in a position of adding reserves on Monday and Tuesday, implementing $9.5 billion in 10-day repurchase agreements on Monday and $2 billion in overnight repurchase agreements on Tuesday. In other words, insofar as the Fed intervened in markets on Monday and Tuesday, the net effect was to keep rates lower than they otherwise would have been.

I had described last week's data as suggesting a two-tier fed funds market in which the Fed had basically abandoned its target for the effective fed funds rate in order to keep the highest rates being charged from spiking excessively. This week's data look like a much more integrated market in which the Fed's actions would once again be consistent with an effective rate in the neighborhood of 5.25%. Even so, it is a market in which there is a remarkable demand for excess reserves.... [B]anks remain unusually averse to the prospect of ending the period short of their reserve requirements...

FT.com / Columnists / Martin Wolf - Central banks should not rescue fools: Sometimes a picture is worth a thousand words. The one last Wednesday showing Christopher Dodd, chairman of the US senate’s banking committee, flanked by Hank Paulson, Treasury secretary, and Ben Bernanke, governor of the Federal Reserve, was such a picture. This showed Mr Bernanke as a performer in a political circus. Mr Dodd even announced Mr Bernanke’s policies: the latter had, said Mr Dodd, told him he would use “all the tools” at his disposal to contain market turmoil and prevent it from damaging the economy. The Fed has its orders: save Main Street and rescue Wall Street.

Such panic-driven politicisation is almost certain to lead to both overreaction and the creation of bad precedents.... Policymakers must distinguish two objectives: the first is macroeconomic stability; the second is a sound financial system. These are not the same thing. Policymakers must not only distinguish these objectives, but be seen to do so. The Federal Reserve failed to do this when it issued statements, on prospects for the economy and on emergency lending, on August 17. This unavoidably – and undesirably – confused the two goals.

The statement on the economy was also premature. Everybody knows that the Fed’s job is to stabilise the economy and prevent deflation. Everybody knows, too, that the Fed will investigate the economic implications of the crisis in the credit markets at the next meeting of the open market committee. If prospects seem significantly worse, the Fed will, presumably, cut rates. But now a cut looks pre-announced. Monetary policy should not be made “on the hoof” in this way, except in the direst of circumstances.

This brings one to the second objective: ensuring the functioning of the financial system. The question is how to help the system without encouraging even more bad behaviour. This is such an important question because the system has been so crisis-prone.... [T]he underlying game as “seek the sucker”: sucker number one is persuaded to borrow too much; sucker number two is sold the debt created by lending to sucker number one; sucker number three is the taxpayer who rescues the players who became rich from lending to sucker number one and selling to sucker number two....

The crisis is focused in markets in structured credits and associated derivatives. The cause seems to be rampant uncertainty. Investors have learnt from what happened to US subprime mortgages that these securities may be “weapons of financial mass destruction”, as Warren Buffett warned. With the suckers fled, the markets have frozen. The people who created this kind of stuff distrust both the instruments and their counterparties. This, in turn, has led to the panic purchases of US Treasury bills shown in the chart.

Yet the difficulty is not a lack of general liquidity. Central banks have provided it freely. Some would argue that, in the case of the Fed, with its half a percentage point cut in the discount rate, provision has been too cheap and, in the case of the European Central Bank, provision has been too free....

This then is a crisis in the market for financial lemons. So what should the authorities do about that? My answer is “nothing”. They should, of course, stand ready to provide liquidity to the market, at a penal rate (since insurance should never be free), and also to adjust interest rates to overall macroeconomic conditions....

[S]uppose central banks... refuse[d] to intervene in the afflicted markets. What would happen? Sellers... must demonstrate the precise properties of what they are trying to offload. Where they cannot do this, they may have to hold securities to maturity. Meanwhile, vulture funds would invest in obtaining requisite knowledge. Losses will also have to be written off. How much of the market in securitised lending would survive this shake-out, I have no idea. But I do not care either. That is for the players to decide, after they realise the consequences of getting it wrong.

Burned children fear the fire. If some of the biggest and most powerful institutions in the world have been playing with fire, they need to feel the burns. It is not the central banks’ job to rescue them by creating a market in the incomprehensible. It is their job to preserve the banking system and the health of the economy. Neither seems now to be in grave danger.

Decisions made in panic are almost always bad ones. Stick to principles and let the masters of the financial system sort themselves out. They are paid enough to do so, after all.

Let me state, contra Martin Wolf, that I believe that Ben Bernanke has done a pretty good job. He doesn't want to get himself into the situation that Alan Greenspan got himself in after 1987 and that he feared he had gotten himself in after 1998--that interest rate cuts in response to a financial-sector liquidity panic had led to an economy in which inflation was rising and expectations of inflation looked in danger of losing their anchor. That was a bad situation for the Federal Reserve to be in in 1990. It feared it was back there in 2000. Ben Bernanke does not want to repeat this scenario: he doesn't want to cut interest rates unless he forecasts that the macroeconomic situation requires it--that predictions of falling spending, falling production, and rising unemployment require interest rate cuts. It is appropriate for a central bank to cut interest rates to maintain near-full employment. But further steps, or advance steps not needed for macroeconomic stability would not be.

Martin Wolf says that Bernanke should have kept quiet because everybody already "knows that the Fed’s job is to stabilise the economy and prevent deflation... [and] that the Fed will investigate the economic implications of the crisis in the credit markets at the next meeting of the open market committee. If prospects seem significantly worse, the Fed will, presumably, cut rates," and that Bernanke's saying what everybody knows means that "a[n interest rate] cut looks pre-announced." First, everybody doesn't know what the Fed's job is--and many who do or did know need to be reminded. Second, an interest rate cut looks preannounced only if people like Martin Wolf and his peers say that it looks preannounced.

As Jim Hamilton wrote:

Econbrowser: Bernanke and Gramlich on the subprime issue: Some analysts, as always, wanted to read between the lines and interpret [Bernanke's statement] 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...

The FOMC may cut interest rates (I think it should). And it may not. Interpret Bernanke as meaning what he said.

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