Larry White on How the Fed Contributed to the Housing Boom

I have made the case here many times that the Fed's monetary policy in the early-to-mid 2000s was inordinately loose, and as a result, helped create the housing boom. Two channels through which this accommodative monetary policy affected the housing sector is that it (1) encouraged households to take on excessive leverage and (2) created a "search for yield" environment where investors looked at investment options they normally would ignore (e.g. subprime MBS). Larry H. White in this new paper adds another channel:

The Fed’s policy of lowering short-term interest rates not only fueled growth in the dollar volume of mortgage lending, but had unintended consequences for the type of mortgages written. By pushing very-short-term interest rates down so dramatically between 2001 and 2004, the Fed lowered short-term rates relative to 30-year rates. Adjustable-rate mortgages (ARMs), typically based on a one year interest rate, became increasingly cheap relative to 30-year fixed-rate mortgages. Back in 2001, non teaser ARM rates on average were 1.13 percent cheaper than 10-year fixed-mortgages (5.84 percent vs. 6.97 percent). By 2004, as a result of the ultra-low federal funds rate, the gap had grown to 1.94 percent (3.90 percent vs. 5.84 percent). Not surprisingly, increasing numbers of new mortgage borrowers were drawn away from mortgages with 30-year rates into ARMs. The share of new mortgages with adjustable rates, only one-fifth in 2001, had more than doubled by 2004. An adjustable-rate mortgage shifts the risk of refinancing at higher rates from the lender to the borrower. Many borrowers who took out ARMs implicitly (and imprudently) counted on the Fed to keep short-term rates low indefinitely. They have faced problems as their monthly payments have adjusted upward. The shift toward ARMs thus compounded the mortgage-quality problems arising from regulatory mandates and subsidies.

Read the whole paper here.

Another Economic Prophet: Peter Schiff

I have labeled Nouriel Roubini and Andy Xie as certified economic prophets for calling the financial crisis ahead of time. Let me add Peter Shiff to the list. He too warned of the looming financial crisis. What is really remarkable is that he made this call many times despite the intense ridicule he received from the naysayers. See him get scorned below:

I admire Peter Schiff's resolve. Thanks to my student Adam Alderman for the pointer.

Did the "Great Moderation" Contribute to the Financial Crisis?

Since the early-to-mid 1980s there has been a pronounced drop in macroeconomic volatility. This development has been called the "Great Moderation" and can be seen in the figure below. This figure shows the rolling 10-year average real GDP growth rate along with one-standard deviation bands. These standard deviation bands provide a sense of how much variation or volatility there has been around the 10-year average real GDP growth rate. The figure shows a marked decline in the real GDP volatility beginning around 1983. (Click on figure to enlarge)

Solid line = 10 year real GDP growth rate rolling average
Dashed line = 1 standard deviation

Something I have been wondering lately is whether this "Great Moderation" contributed to the financial crisis by creating complacency about macroeconomic conditions. Is it possible that policymakers, investors, and others came to believe that improvements in macroeconomic stability were a given and, as a result, let their guard down? Thomas Cooley believes this may be the case:

There is another, deeper possible link between the Great Moderation and the financial crisis that is worth thinking about, because it may help to inform the financial regulation of the future. The idea is simply that the decline in volatility led financial institutions to underestimate the amount of risk they faced and overestimate the amount of leverage they could handle, thus essentially (though unintentionally) reintroducing a large measure of volatility into the market.

Financial institutions typically manage their risk using what they call value at risk or VaR. Without getting into the technicalities of VaR (and there is a very long story to be told about the misuse of these methods), it is highly likely that the Great Moderation led many risk managers to drastically underestimate the aggregate risk in the economy. A 50% decline in aggregate risk is huge, and after 20 years, people come to count on things being the same.

Risk managers are supposed to address these problems with stress testing--computing their value at risk assuming extreme events--but they often don't. The result was that firms vastly overestimated the amount of leverage they could assume, and put themselves at great risk. Of course, the desperate search for yield had something to do with it as well, but I have a hard time believing that the managers of Lehman, Bear Stearns and others knowingly bet the firm on a systematic basis. They thought the world was less risky than it is. And so, the Great Moderation became fuel for the fire.

So as much as the Great Moderation has been praised, it may turn out to be a key contributor to the biggest financial crisis since the Great Depression.

The Challenges Ahead

Nouriel Roubini reminds us of the challenges facing President-elect Obama over the next few years:

Obama will inherit [an] economic and financial mess worse than anything the U.S. has faced in decades: the most severe recession in 50 years; the worst financial and banking crisis since the Great Depression; a ballooning fiscal deficit that may be as high as a trillion dollar in 2009 and 2010; a huge current account deficit; a financial system that is in a severe crisis and where deleveraging is still occurring at a very rapid pace, thus causing a worsening of the credit crunch; a household sector where millions of households are insolvent, into negative equity territory and on the verge of losing their homes; a serious risk of deflation as the slack in goods, labor and commodity markets becomes deeper; the risk that we will end in a deflationary liquidity trap as the Fed is fast approaching the zero-bound constraint for the Fed Funds rate; the risk of a severe debt deflation as the real value of nominal liabilities will rise given price deflation while the value of financial assets is still plunging.

[...]

So let us not delude each other: the U.S. and global recession train has left the station; the financial and banking crisis train has left the station. This will be a long and severe and protracted two year recession regardless of the best intentions and good policies of the new U.S. administration. It will take a lot of hard work and sound policies to clean up this mess and reduce the length and severity of this economic contraction.

Expect a few more gray hairs from out next President.

Will the Euro Survive?

I was a little puzzled last week after reading Wolgang Munchau's column in the FT. He noted that some of the European countries outside the Eurozone--specifically Denmark, Hungary, Iceland--are now wishing they were members and probably will become so in the near future. Based on these developments he argued the global financial crisis should actually lead to an enlargement of the Eurozone. While his argument makes sense in the case of the few countries mentioned above, what about the broader Eurozone? Does not the global financial crisis add more stress to the viability of the Eurozone? In a reply to Munchau, Desmond Lachman says yes:

Sir, Wolfgang Münchau seems to be very wide of the mark in asserting that the present global financial crisis will lead to the early expansion of the eurozone... For, as the marked widening in interest rate spreads on Italian and Spanish government bonds would suggest, the more pressing question raised by the crisis is not so much whether the eurozone will expand but rather whether or not the euro can survive in its present form.

In 1998, when the euro was launched, Milton Friedman famously warned that the euro would be truly tested by the first major global economic recession. He issued this warning in the belief that, lacking labour and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the U.S. economy.

Judging by October's alarming plunge in global equity prices and the virtual freezing up in global credit markets, there can be little doubt that Europe, along with the United States, is at the start of its worst economic recession in the postwar period. And judging by the bursting of Spain's outsized housing market bubble and by the precarious state of Italy's public finances, there can be little doubt that Spain and Italy will be the two major European economies that will be put to the severest of tests as the global recession deepens.

For in order to cope with their respective problems, Spain and Italy will need low interest rates and weak currencies that continued euro membership clearly precludes.

In short, Lachman is questioning whether the Eurozone in its current form is an optimal currency area and, thus, whether it can truly survive. Apparently, so are some investors thinking this way. Over at intrade.come there is a contract on whether "any country using the Euro to announce their intention to drop it on/before December 2010." Here is the latest figure--where price equals probability-- from the contract (click figure to enlarge):


Currently the probablity of say Spain or Italy leaving the Euro is between 30-35%. Although not very high, it is a sizable increase from when the contract was introduced in early 2008. So what is the future of Euro?

Update: Here is a related post from Naked Capitalism. Here are some papers from a conference on the future of the Euro hosted by The Economist magazine and CATO.

An Impressive Recession Indicator

Add this metric to your list of recession indicators: the year-on-year change in civilian unemployed - 15 weeks and over. Whenever this measure exceeds 0% for a sustained period there has been a recession. This pattern can be seen in the figure below, where NBER-dated recessions are in gray bars (click on figure to enlarge):

The consistency of this pattern is remarkable. Thanks to Robin G. Brown, one of my students, for pointing this relationship out to me.

More Excess Reserve Buildup Ahead

Bloomberg reported yesterday that the Federal Reserve is encouraging more hoarding of excess reserves by banks shoring up its efforts to "sterilize" its injections of liquidity to the banking system:

Nov. 5 (Bloomberg) -- The Federal Reserve boosted the interest rate it pays banks for the excess cash they keep on deposit, aiming to prevent its record injection of funds into the financial system from affecting its monetary policy.

``The rate on excess balances will be set equal to the lowest Federal Open Market Committee target rate in effect during the reserve maintenance period,'' the Fed said in a statement. The federal funds target stands at 1 percent.

The WSJ's RTE blog also noted this development and reported the Federal Reserve believes this move "would help foster trading in the funds market at rates closer to the FOMC’s target federal funds rate." In response, a perplexed reader named "confused" left the following comment at the RTE blog:

Why? The entire point to flooding the market with liquidity was to get inter-bank and bank-corporation lending started again. If that leads to a traded fed-fund rate less than the target rate, that just means the excess liquidity still needs time to work. This move seems to completely negate the prior efforts. I ask again: why???

Great question from "confused." Here are my thoughts on this matter.

Update: A reader in the comments section directs us to FT.com/Alphaville where Sam Jones provides further insight on this development. He argues we are in a liquidity trap, the Fed now recognizes it , and as a result it may cut back on sterilizing its liquidity injections. I hope Sam is correct. What do you think?