Monthly Archives: September 2007

Now we know a bit more about the terms on which Northern Rock can access the financial resources of the Bank of England. In a statement dated September 14, Northern Rock says:
“…Northern Rock has agreed with the Bank of England that it can raise such amounts of liquidity as may be necessary by either borrowing on a secured basis from the Bank of England or entering into repurchase facilities with the Bank of England. Such repurchase facilities would include securities that have prime residential mortgage assets as underlying collateral. The collateral that can be used under this “Repo” facility is similar in nature to the collateral currently utilised by many Eurozone banks with the ECB.”

As I suspected, Northern Rock was unable to access the Bank of England’s Standing (collateralised) lending facility or participate in normal liquidity enhancing Repo operations, because these require collateral of a kind Northern Rock was unwilling or unable to offer – sterling and euro-denominated instruments issued by UK and other European Economic Area central governments, central banks and major international institutions rated at least Aa3 and, exceptionally, US Treasury bonds. Instead they are allowed to offer as collateral asset-backed securities, specifically, prime residential mortgage backed securities. Anne Sibert and I have recommended extending the menu of assets eligible for discounting at the Bank’s Standing lending facility and for normal repo operations (see (1), and (2)) and it is good to see that a small step has been taken on the road to the Bank of England functioning as Market Maker of Last Resort. Unfortunately, the widening of the set of eligible collateral is so far only for exceptional and one-off bail outs like the Northern Rock credit line. It is, however, scandalous that so little is known about this facility. It is tax payers’ money that is put at risk. It is also essential that the level playing field among competitors in the financial markets be distorted as little as possible. The following information should therefore be put in the public domain:

  1. The terms and conditions of the credit facility, including the interest rate charged on any use of the credit line, the fee charged for making the credit line available, the amount of the credit line, the period for which it will be available and any other relevant characteristics.
  2. The exact nature of the collateral that can be offered, its valuation and the haircuts imposed.
  3. Equivalent information as regards any repurchase agreements with the Bank of England.
Keeping this information confidential and secret destroys the accountability of the Bank, the FSA and the Treasury for the public resources put at risk. It is a distortion of the competitive level playing field of our financial institutions. It is also completely unnecessary for the effective implementation of the bail out. The same unnecessary secrecy surrounds borrowing at the Standing collateralised lending facility of the Bank of England, the choice of target reserves at the Bank of England by individual banks, and the use of these reserve facilities. Information on the use by individual, named institutions of any of these resources/facilities, and on the terms attached to this use, should be in the public domain. The current lack of transparency is both economically and politically damaging.

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On 12 September 2007 (in a Paper submitted to the Treasury Committee by Mervyn King, Governor of the Bank of England) the Bank told the world the following:

“…the moral hazard inherent in the provision of ex post insurance to institutions that have engaged in risky or reckless lending is no abstract concept”.

On September 13, 2007, we received the announcement that the Bank of England, as part of a joint action by HM Treasury, the Bank of England and the Financial Services Authority (according to the Memorandum of Understanding between these three parties), had bailed out Northern Rock, a specialist mortgage lender, by providing it with a short-term credit line. Without this, Northern Rock, which funds itself mainly in the wholesale markets, would not have been able to meet its financial obligations.

It will be interesting to see how this reported credit line is secured, or how any draw-downs of this credit line are collateralised. If Northern Rock had sufficient collateral eligible for rediscounting at the Bank of England’s Standing (collateralised) Lending Facility, it presumably would have done so, rather than invoking this emergency procedure involving the Bank, the FSA and the Treasury. Collateral eligible for rediscounting at the Standing Lending Facility consists of sterling and euro-denominated instruments issued by UK and other European Economic Area central governments, central banks and major international institutions rated at least Aa3 (and, exceptionally, US Treasury bonds). Such assets are said to be scarce on the balance sheet of Northern Rock. The severity of the penalty rate (relative to the policy rate of 5.75%) charged Northern Rock will also be important in determining the long-term damage to financial stability caused by this operation.

The Bank’s September 12 Paper recognises conditions when this kind of bail out is justified:

“…, central banks, in their traditional lender of last resort (LOLR) role, can lend “Against good collateral at a penalty rate” to any individual bank facing temporary liquidity problems, but that is otherwise regarded as solvent. The rationale would be that the failure of such a bank would lead to serious economic damage, including to the customers of the bank. The moral hazard of an increase in risk-taking resulting from the provision of LOLR lending is reduced by making liquidity available only at a penalty rate. Such operations in this country are covered by the tripartite arrangements set out in the MOU between the Treasury, Financial Services Authority and the Bank of England. Because they are made to individual institutions, they are flexible with respect to type of collateral and term of the facility”.

The MOU states in paragraph 14:

14. In exceptional circumstances, there may be a need for an operation which goes beyond the Bank’s published framework for operations in the money market. Such a support operation is expected to happen very rarely and would normally only be undertaken in the case of a genuine threat to the stability of the financial system to avoid a serious disturbance to the UK economy.”

It is clear that the conditions for a justifiable bail out, as specified in the MOU and reiterated in the Bank’s September 12 Paper, were not satisfied.

First, it is by no means obvious that Northern Rock (total assets £113 bn as of 30 June 2007) suffered just from illiquidity rather than from the threat of insolvency. The organisation has followed an extremely aggressive and high-risk strategy of expansion and increasing market share, funding itself in the expensive wholesale markets for 75% of its total funding needs, and making mortgage loans at low and ultra-competitive effective rates of interest. No matter how efficient you are, or how safe your assets are, if the effective interest rate on your borrowing exceeds that on your investments, you are unlikely to be a long-term viable proposition, no matter how impressive the growth of your turnover. Northern Rock’s share price had been in steep decline since February of this year, well before the financial market turmoil hit.

Second, it is hard to argue that the survival of Northern Rock is necessary to avoid a genuine threat to the stability of the UK financial system, or to avoid a serious disturbance to the economy. The bank is not ‘too large to fail’. As the fifth largest mortgage lender in the UK, it is not systemically significant. When all else fails, the ‘threat of contagion’ argument can be invoked to justify bailing out even intrinsically rather small fish, but irrational contagion, that is, contagion not justified by objective balance sheet and off-balance sheet realities, is extremely rare in practice, and could have been addressed directly had it, against the odds, occurred, following the insolvency of some bank.

No doubt its depositors (of which there are rather too few) are covered by the Financial Services Compensation Scheme to the tune of £31,700 per person (100% of the first £2,000 and 90% of the next £33,000). If most of its mortgage assets are good (albeit unprofitable, given Northern Rock’s funding costs), they will find willing buyers among the remaining viable mortgage lenders. Northern Rock’s shareholders would, of course, lose everything and the remaining creditors (including depositors with balances in excess of the deposit insurance limit) would have to wait to see how much the realisation of the assets generates. Top management would lose its jobs. All this is as it should be. What would happen to staff below the strategic decision-making levels would depend on which parts of the business remain viable after the financial restructuring following the insolvency.

Following the bail out of Northern Rock, I can only conclude that the Bank of England is a paper tiger. It talks the ‘no bail out’ talk, but it does not walk the talk. It does not matter whether the decision to bail out Northern Rock was initiated and/or actively supported by the Bank, or whether the Bank was bullied into it by the Treasury and the FSA. Moral hazard has received a boost in the UK banking sector and in the UK financial system as a whole. We will all pay the price in the years to come, when the next wave of reckless lending washes over us. Let’s hope that the collateral requirements and penalty rate charged on the credit line will be tough enough to limit the damage.

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This post is almost identical to one that appeared on 13 September 2007, in the Financial Times, Martin Wolf’s Economists’ Forum.

There are times when I am quite pleased that Marty Feldstein, whom I admire as a professional economist and consider a friend, is not Chairman of the Federal Reserve Board. This is because his policy recommendations at the end of his Jackson Hole presentation amount to the proposal that the Fed forget about price stability and instead focus solely on cutting interest rates to minimize the likelihood and depth of a serious slowdown/recession in the US. That advice is dangerous. It is also rather surprising for Marty to express so much concern about a significant fall in US consumption demand, when he has called, for decades, for a significant increase in US private and public saving. When, at last, it looks as though he may get at least half of what he has asked for – lower US private consumption – it makes no sense to immediately ask for measures to boost private consumption.

Marty’s analysis of the origins and likely future course of the current financial turmoil in the US, and of its likely implications for the real economy and inflation, is quite convincing, although marred somewhat by the usual parochialism of US-based economists.

Extremely low credit risk spreads (as well as low long-term real interest rates) were a feature of the global economy, not just of the US. The fact that there was a willing demand for extremely large quantities of US sovereign debt from foreign official holders at very low yields no doubt contributed to the low level of US long-term interest rates and to the US housing boom. The willingness of European and Asian financial institutions to invest in securities that, directly or indirectly, exposed them to the US subprime and alt-A mortgage sectors must have been instrumental in the rapid expansion of this form of lending. The failures of regulation and supervision in residential mortgage lending markets and the unbridled growth of off-balance sheet vehicles that had neither capital nor supervision or regulation can be in part accounted for by regulatory arbitrage and by the restraining impact on national regulators and supervisors of competition for business between national financial centres. These pressures no doubt induced national regulators and supervisors in the US and elsewhere to take a hands-off approach and to rely on self-regulation (aka no regulation).

Home building in the US may have fallen by 20 percent over a year, but exports have grown by about 11 percent. Homebuilding is less than 5 percent of GDP while exports are now over 11 percent of GDP (imports are over 16 percent of GDP). Any recent and future decline in US housing construction is likely to be more than offset by the change in the trade balance. That leaves, of course, the wealth effects and liquidity/collateral effects on private consumption of a decline in US house prices.

But is a significant decline in US consumption not exactly what is required (and long overdue) for both internal and external balance reasons? Marty is always telling us that both the US private sector and the US public sector are saving too little. How will the private sector’s contribution to national saving be boosted without a significant fall in private consumption demand?

Given the prevailing nominal rigidities in US wage and price setting, any significant decline in household consumption and aggregate demand will depress economic activity. If liquidity constraints are empirically significant in the US, as they appear to be, the short-run Keynesian multiplier will deepen the economic downturn. One can easily envisage a quite deep recession.

The only mechanism to mitigate this, other than a fiscal expansion which would further weaken the external balance and also not do much for the national saving rate, would be a significant reduction in the US external trade deficit, brought about through an already weak and further weakening US dollar. This scenario would indeed become more likely were the Fed to cut its policy rates.

Marty, however, wants to use lower interest rates to stimulate every component of aggregate demand, with the possible exception of public spending on goods and services: “…lower interest rates now would help by stimulating the demand for housing, autos and other consumer durables, by encouraging a more competitive dollar to increase net exports, by raising share prices that increased both business investment and consumer spending, and by freeing up spendable cash for homeowners with adjustable rate mortgages”

Except for the increase in next exports, this sounds like a recipe for restoring the unsustainable status quo ante. And it is not at all obvious that, given the boost Marty wants to give to private consumption and investment demand, there would be any reduction in the US net external deficit at all.

In my view, given that increasing the US national saving rate is (a) necessary and (b) practically inconceivable without an economic slowdown and a possible recession in the US, it is better to have the slowdown now, while the world economy is still booming, than to wait until the world economy too slows down significantly. It makes no sense to call for higher private saving and then, when you are at last likely to get what you want, to ask for measures to boost private consumption.

Finally, from my perspective, risk-based “decision theory” would lead to the opposite conclusion from the one reached by Marty. He believes that the risk that the economy could suffer a very serious downturn should dominate the risk of higher inflation. I disagree. The Fed’s triple mandate (maximum employment, stable prices and moderate long-term interest rates) does not support any asymmetric treatment of risk to the real economy and risk to inflation (in the UK and in the eurozone, the central bank mandates are lexicographic, with price stability taking precedence over real economy objectives). So the question is: what would be a worse outcome – a deep recession or a loss of inflationary credibility? I would argue that the risks to price stability and to the anti-inflationary credibility of the Fed should take precedence over the risk of a deep recession. Recessions tend to be short. Restoring anti-inflationary credibility is a long-drawn out and costly process.

Clearly, if the current state of the economy is such that interest rate cuts would support the real economy without raising the risk of boosting inflation above the (implicit or explicit target rate), there is no short-run trade-off, no dilemma and no need for risk-based “decision theory”. Unfortunately, I don’t think were are in such a welcoming environment. Gauging the risk to price stability not from the Fed’s will ‘o the wisp indicator of core inflation but rather from the underlying behaviour of headline inflation, US inflation has been above the Fed’s comfort zone for five years. Unit labour cost growth is rising, quite likely a reflection of a decline in productivity growth that is not just cyclical.

To play fast and loose with inflation at this point risks undermining all that has been achieved since Volcker took over as Chairman of the Fed. This is even more pertinent because the Fed has a new Chairman whose first real test this is. Should he choose to act in a way that undermines the credibility of the Fed’s commitment to price stability, and should this lack of credibility get embodied in inflation expectations and long-term contracts, the cost of regaining virtue would be much higher than the cost of having a slowdown or even a recession now.

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Joint post by Willem H. Buiter and Anne C. Sibert. This post appeared first as a Comment in the Financial Times, Thursday, September 6, 2007.

Should the Bank of England do more to calm the money markets? During the current turmoil, it has been more hands-off than the European Central Bank, which has injected liquidity on a massive scale, and the Federal Reserve, which has injected liquidity on a modest scale and cut its discount rate by 50 basis points. The Bank is criticised by the City and some commentators for this “passive” policy stance. Would a more activist stance be appropriate?

Should the Bank have cut its policy rate? Neither the Fed nor the ECB has yet done so. The policy rate is not appropriate for addressing credit and liquidity crises. The Bank should cut Bank rate only if necessary to achieve its inflation target and, subject to that, to support the real economy. While Bank rate may well have peaked, there is no case for a cut now.

Should the Bank have cut its discount rate – the rate on overnight borrowing from its standing (collateralised) lending facility? We think not. It would be a bonus to those already willing and able to borrow at the discount window, but would do nothing to boost banks’ ability and willingness to access that window. The problem is that the Bank’s definition of eligible collateral at the discount window and in open market operations is too restrictive. Also, stigma continues to attach to discount window borrowing.

Should the Bank have injected additional liquidity to keep interbank rates closer to its policy rate, using short-term repos (repurchase agreements) at the policy rate, longer-term repos at market rates or outright purchases? We believe the main problem is that eligible counterparties (banks, building societies and certain securities dealers) do not have eligible assets to offer as collateral or sell outright.

The gap between overnight money market rates and policy rates is not significantly higher in the UK than in the US or the eurozone. On September 4, the overnight gap was 36 basis points in the UK, 26 in the US and 44 in the eurozone. A wider gap opens up at longer horizons: at one month, the UK gap is 93 basis points, compared with 55 for the US (putting the market rate above the discount rate) and 47 for the eurozone. At three months the gap is 105 basis points for the UK (putting the market rate above the discount rate), 45 for the US and 75 for the eurozone.

We believe there are three features of the UK discount window regime and one related feature of the open market regime in need of an urgent fix. First, the Bank should help to de-stigmatise discount window borrowing. Even the quality press calls this the “emergency facility”. It is no such thing. Every party uttering the words “emergency facility” should be corrected by the Bank.

Second, like the Fed, the Bank should extend the term of its discount window loans from overnight to at least 30 days. Third, the Bank accepts as collateral at its discount window or in open-market purchases only instruments issued by European Economic Area central governments, central banks and major international institutions rated at least Aa3 (and, exceptionally, US Treasury bonds). This is too restrictive. The ECB accepts marketable and non-marketable securities rated at least A-, including securities issued or guaranteed by private entities. The Fed has been quite restrictive, but the Federal Reserve Act allows it to lend, in a crisis, to any institution,organisation or individual and against any collateral.

Faced with financial turmoil, the rule of thumb should be: if it can be valued, it is eligible as collateral at the Bank’s standing lending facility. If securities become illiquid in turbulent markets (for example, debt backed by impaired mortgages), the Bank may have to act as market maker of last resort and establish a price itself. To avoid moral hazard, an appropriate “haircut” (discount) should be applied to the instrument’s fair value. Longer term, the Bank should extend its set of eligible discount window counterparties to all institutions subject to a Bank-approved prudential regulatory regime.

What the Bank did on September 5 was mainly ‘mood music’ for the markets. The substance is that the reserve target ceiling has been raised a little. Eligible banks can hold a slightly larger amount of reserves at the Bank without incurring a 100 basis points cost; banks were also given an extra week to choose their reserve targets. This addresses none of our concerns.

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Joint post by Willem H. Buiter and Anne C. Sibert. This post was published earlier in the Daily Telegraph, on September 3, 2007, as “City comment: Put the NHS out of its misery and allow competition”.
Does any reader of this column still believe the once conventional wisdom about UK healthcare? That is, that healthcare in the UK is among the best in the world, first, because provision is fair and good care is accessible to all and, second, because it offers good value for money.
Unfortunately, neither of these assertions is correct. Among the rich industrial countries, only the United States has a healthcare system that is less fair and less accessible, and (at least as judged by admittedly imperfect quantitative health indicators) offers poorer value for money than the UK. The bureaucratic monster that is the NHS has few incentives to encourage efficient use of resources; it is dominated by producer interests and used as a political football by national party politics. Patients have very limited choice of providers and virtually no recourse if they are unhappy with their quality of care.
Healthcare should be available to all, regardless of ability to pay. However, the principles on which the NHS is based, universal healthcare financed entirely out of tax revenues and free provision at the point of delivery, no longer make sense. Research and development has created effective, but expensive, treatments that are not affordable for all – and this makes free universal access at the point of delivery impossible.
Currently, what determines your quality of care in the NHS is your education, intelligence and connections. While the “aristocracy of pull” (in Ayn Rand’s wonderful words) receive their cancer treatment in the Royal Marsden, the inarticulate and less-well-connected may never see an oncologist. We need to find more fair and more efficient ways of allocating healthcare. Rationing by queuing works for taxis – it is fair and efficient. But, when your place in the health queue is determined by unaccountable bureaucrats, luck and pull, it is inefficient and unfair.
The NHS is the sacred cow of UK politics. Being perceived as hostile to its principles is the kiss of death for a politician. Better, therefore, to have unelected academics point out that the emperor has no clothes and to propose alternatives.
The NHS must go. It should be replaced with a system that guarantees good quality healthcare to all, but one which is – at least to a much greater degree – financed through payments for service. A system of mandatory health insurance of the kind found in the Netherlands would provide an attractive alternative, but there are good systems all over the Continent that might serve as examples.
In the spirit of the Dutch system, we propose that a committee of experts should determine the benchmark standard of healthcare. The government should then design a default health insurance plan that meets this benchmark. This plan, as well as plans that offer additional care, can be offered in a competitive market by regulated insurance companies that negotiate fees for services with healthcare providers. Everyone must have a health insurance plan that is at least as good as the default plan. The government should pay the premia for people who cannot afford them; individuals with the income and desire to purchase coverage that exceeds the standards of the benchmark plan may do so. Health insurance should not be tied to employment (through tax or other incentives) – one of the singular weaknesses of the US system.
Insuring people with known pre-existing conditions at a reasonable, affordable rate is often not commercially viable. There are two solutions to this. First, those who would be uninsurable in a purely private insurance market could be guaranteed the default insurance package, with the government providing excess payments to the insurance companies to make this financially viable. Second, those with pre-existing conditions could be put in an “assigned risk pool” at a capped premium, the way bad drivers currently are in many US states for car insurance. Insurance companies could be forced to sell a certain percentage of their plans to people in the assigned risk pool. As this would increase the price of the default plan, in this solution, the less risky subsidise the risky.
It is fair that those who have the means to pay for their healthcare should do so. It is efficient some of the payment should be “at the point of delivery”. The argument that healthcare should be free at the point of delivery because it is essential for life and human dignity is silly. Food is essential for life and human dignity but we do not expect supermarkets to hand it out for free. Thus, in a sensible healthcare system, individuals should pay for their healthcare both through insurance premia and through (co-) payments for services, eg 20pc of the cost of most services up to some maximum amount each year.
A universal mandatory insurance scheme requires competition among insurance providers to produce reasonably efficient outcomes. But, some inefficiency is inevitable when the suppliers of the services (the healthcare providers) know much more about the services than the consumers (the patients). Having a public or not-for-profit health insurance provider alongside the private providers might be useful for cost control. There is also an efficiency argument for preventive health services to be funded publicly and offered free at the point of delivery; this includes inoculations and vaccinations, dental check-ups for children, eye tests for everybody and a range of other services.
During the past five years, just under two additional percentage points of GDP have been spent on improving the NHS. This has been poor value for money, with most of the additional resources going into the pay packets of the incumbent providers and with little apparent improvement in accessibility and care. The provision of medical care need not be done by the public sector. It may be more efficiently done by the for-profit private sector, or by non-profit NGOs and similar organisations with charitable status. Let them all compete on a level playing field and may the best provider gain market share.
Finally, we would depoliticise the oversight and regulation of healthcare. The amount spent on healthcare by the state must remain a political decision. The allocation of public funds could be delegated to a group of non-elected experts, appointed by the Secretary of State for Health and accountable to Parliament. A few months ago, Jim O’Neill proposed the creation of an education policy committee, along the lines of the Monetary Policy Committee of the Bank of England, to minimise the influence of party politics on educational policy. The case for a health policy committee to oversee and set priorities for public spending on health care seems equally convincing.

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The two Bs in the title of this post refer not to bed and breakfast, but to the rather less restful and nutritious contributions made on Friday, August 31 by President Bush in the Rose Garden of the White House and by Chairman Bernanke of the Federal Reserve Board, at the annual Jackson Hole Conference in Wyoming.

Both addressed the crisis in the US subprime mortgage market, falling US house prices, the wider turmoil in credit markets and the liquidity problems encountered by a growing number of diverse financial institutions. Bernanke listed the weapons in the Fed’s armoury and tried to outline the Fed’s contingent reaction function to new developments. Bush outlined a small bailout for financially distressed low and middle-income homeowners.

Bernanke’s ‘wait and you shall see’ Chairman Bernanke first. He succeeded completely in what he said out to do: he said nothing at all new, but said it very well indeed. Ignoring the scholarly/historical bits, what is relevant to future Fed policy can be captured by the following quotes and their translations.

“…. if current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. We are following these developments closely.”

Translation: Even though the Fed is in Washington DC, we are not asleep at the wheel.

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

Translation: We can inject additional liquidity through open market purchases or at the discount window; we can cut the discount rate or the Federal Funds target rate, and we can widen the range of eligible assets we will accept as collateral in repos or at the discount window.

“… the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.”

Translation: An increase in credit risk spreads represents a tightening of monetary conditions, even if the Federal Funds target is unchanged. The Fed is aware of this.

“… in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.”

Translation: Never mind what we said following the August 7 FOMC meeting. That was then. This is now. HOWEVER, financial kerfuffles influence the setting of the Federal Funds target if and only if (and to the extent that) they have a material impact on our fundamental objectives, employment and price stability, going forward.

What does this mean for the likely future path of the Federal Funds rate? Most of the recent real economy data are robust, including the QII GDP growth rate of 4.0 percent (annualised) and robust personal income and personal spending growth in July. However, they extend no later than July 2007, and therefore do not capture any negative effect on consumer and investment demand of the August financial turmoil.

The Core PCE deflator index rose 0.1 percent in July 2007, keeping the 12 month rate of core PCE deflator inflation at 1.9 percent for a second month. Headline CPI also rose by 0.1 percent in July, and fell to 2.1 percent over a 12-month period, down from 2.3 percent in June. While both are north of the centre of the Fed’s assumed comfort zone (which ranges from 1.0 to 2.0 percent), they are low enough not to be a cause for embarrassment were the Fed to decide to cut the Federal Funds target on September 18.

Although if I were a voting member of the FOMC, I would vote to keep the Federal Funds rate constant, barring exceptional developments between now and September 18, I believe that the most likely outcome is a 25 bps ‘insurance cut’ in the Federal Funds rate. We shall see.

Bush’s small bail-out By revealed preference, poverty in the USA is something this Republican Administration and Democratic Congress (like past Republican and Democratic Administrations and Congresses) can live with. The prospect of a couple of million homeowners being foreclosed upon during the year before a presidential election is, however, more that the body politic can stand – these people might well be voters. President Bush gave us the homeowners bailout ‘lite’ in his speech. The Congress will no doubt up the ante and turn this into a homeowners bailout ‘premium’.

Bush first gave a concise statement of the case against bailing out mortgage lenders, speculative investors in real estate and those who unwisely took on excessive mortgages. He then outlined a plan for bailing out the last-mentioned category.

“A federal bailout of lenders would only encourage a recurrence of the problem. Its not the governments job to bail out speculators, or those who made the decision to buy a home they knew they could never afford. Yet there are many American homeowners who could get through this difficult time with a little flexibility from their lenders, or a little help from their government. So I strongly urge lenders to work with homeowners to adjust their mortgages. I believe lenders have a responsibility to help these good people to renegotiate so they can stay in their home. And today Im going to outline a variety of steps at the federal level to help American families keep their homes.”

There are a number of aspects of these proposals that are interesting from an economic point of view.

(1) It represents a cyclically appropriate, albeit small (especially in the President’s version – the only one formally on the table) fiscal stimulus. That’s what is meant by “…a little help from their government”.

(2) The fiscal stimulus proposed by the President will be implement mainly through quasi-fiscal means. That means that they will not come in the form of on-budget tax cuts or increases in subsidies or other public spending. Instead they will be hidden in below-market mortgage interest rates, supported by Federal Guarantees, through subsidized mortgage insurance and other off-budget measures that are functionally equivalent to tax cuts or subsidies. The full budgetary impacts will be obscured and delayed.

That is clear from the central role assigned to the Federal Housing Association (FHA), the cornerstone of socialised housing finance in the USA. The FHA is a government agency that started operations in 1934 and provides mortgage insurance to borrowers through a network of private sector lenders. Bush proposes to expand a proposal he sent to the Congress 16 months ago that enables more homeowners to qualify for this insurance by lowering down-payment requirements, by increasing loan limits and providing more flexibility in pricing. There are obvious elements of subsidy in this proposal.

Already about to come online is a new FHA program (‘FHA-Secure’) that aims to allow American homeowners who have a good credit history but cannot afford their current mortgage payments to refinance into FHA-insured mortgages. Again, the unaffordable can only be made affordable through a Federal subsidy.

The President also proposes to change a feature of the US Federal income system that can hit homeowners who no longer can service their mortgages hard. Debt forgiveness counts as taxable income. Assume you have $100,000.00 worth of mortgage debt you cannot afford to service. Your house is worth $100,000.00 to the bank. If the bank were to forgive you your mortgage debt and take your house n exchange, you would still be left with income tax liability on the $100,000.00 of forgiven debt. That seems a bit rough. Of course, you could instead sell the house to the bank for $100,000.00 and use the proceeds of the sale to pay off the loan. No income tax would be due (there could, under certain conditions, be capital gains tax).

The US Congress is likely to expand on these proposals by letting Fannie May (or Federal National Mortgage Association) and Freddie Mac (or Federal Home Loan Mortgage Corporation), two Government Sponsored Enterprises (GSEs) created by the Congress that are at the heart of the US system of socialised housing finance, expand the scale of their operations, specifically by increasing the upper limit on the size of the mortgages they can extend or guarantee from its current level of $417,000.00.[1]

(3) It represents a redistribution of income towards those low and middle-income Americans that had taken on excessive mortgage debt. The bill is paid mainly by the shareholders of the mortgage lenders (that is what is meant by “… a little flexibility from their lenders,…” and by the American tax payer who will have to foot the bill of the increased subsidies attached to the loan guarantees and subsidised mortgage insurance offered by the FHA. If the Congress manages to get Fannie May and Freddie Mac involved in the game, the cost to the tax payer could turn out to be significantly higher.

(4) By subsidising excessive and imprudent borrowing, it reinforces the moral hazard faced in the future by low and middle income Americans pondering the size of the mortgage they can enforce (if the market-friendly President Bush is willing to bail us out today, would a more market-sceptical President Barack Obama or President Hilary Clinton not do so again tomorrow?)

(5) By leaning on the lenders to show greater leniency towards delinquent mortgage borrowers than would be required by the mortgage contracts and the dictates of the competitive environment, it will discourage future subprime lending and other higher-risk mortgage lending by banks and other mortgage finance institutions. This will further increase the role of the FHA, Fannie, Freddie, and the Federal Home Loan Banks, and will further strengthen the role of socialised housing finance in the USA.

(6) There is a reasonable prospect that Federal legislation and Federal regulation and supervision of the housing finance industry will be changed in such a way as to reduce the likelihood of the excesses, the mis-selling and the misrepresentations that became rampant especially during the past 5 years or so. There has been a serious failure by the regulators to stop the rogue mortgage lending practices that have proliferated, and not just in the subprime market. The Fed, both under Chairman Greenspan and under Chairman Bernanke is one of the institutions that bears responsibility for this regulatory fiasco.

It is, unfortunately, quite likely, that the legislative and regulatory changes we will get will amount to a Sarbanes-Oxley-style regulatory overshoot, that is, regulation of the ‘if it moves, stop it’ variety. This will discourage future lending to low-income or credit-impaired would-be homeowners even when such lending is fundamentally sound.

Parochialism in US economic policy

Both sets of remarks were amazingly parochial. The President clearly believes that, except for oil and Chinese imports, the US is a closed economy.

Chairman Bernanke’s text contains a few rather generic references to global matters, but rather less than the topic deserved. Surely the fact that so much of the subprime exposure ended up in European and Asian financial institutions must have made it easier for the US lending excesses to occur. One also has to recognise the importance of international regulatory arbitrage as a factor limiting the ability of national regulators to impose even mild disclosure restrictions (let alone more serious regulatory constraints, whether for prudential or consumer protection reasons) on internationally mobile financial institutions.

Even in a lecture on ‘Housing, Housing Finance, and Monetary Policy’, it is surprising not to find the word ‘exchange rate’ in a section of the lecture titled The Monetary Transmission Mechanism Since the Mid-1980s’. During the past 20 years, the US economy has become increasingly open, both as regards trade in real goods and services and trade in financial instruments. Transmission of monetary policy through the exchange rate undoubtedly has become more important, both for prices and for aggregate demand, during this period, and US real interest rates are increasingly influenced by global economic developments, as Governor Bernanke himself has pointed out in a lecture on the global saving glut.

When all is said and done, the entire construction sector in the US is 5 percent of GDP. The bit that is hurting badly, residential construction, is somewhere between 3 and 4 percent of GDP. Exports are 12 percent of GDP and growing in volume terms at an annual rate of over 11 percent. Import-competing industries are also doing well. The combination of a sharp nominal and real depreciation of the US dollar and continued rapid growth outside the US accounts for the strength of the externally exposed sectors of the US economy. It goes a long way towards offsetting the weakness of parts of the nontraded sectors, including housing. While increased credit risk spreads represent a tightening of monetary conditions, the weaker dollar represents a loosening of monetary conditions. There is no indication from Chairman Bernanke’s address that the Fed pays any attention to this in its actual policy deliberations. This is especially surprising in view of Chairman Bernanke’s recognition of these issues ‘in the abstract’, in a recent lecture.

Of course, housing troubles are not limited to the construction sector. Housing wealth is an important component of total net household financial wealth; real estate assets can be collateralised and thus are a ready source of consumer spending power. Another Fed Governor, Frederic Mishkin argued at the same Jackson Hole conference that a fall in housing wealth could be a serious drag on consumer spending, assuming that the marginal propensity to spend out of housing wealth was 3.75 percent (a very precise number indeed).

Bottom line A 25 bps cut in the Federal Funds rate on September 18 is unnecessary, likely, but my no means a foregone conclusion. By the time Congress is done augmenting the Bush mini bail-out of financially stressed mortgage holders, there may be a fiscal stimulus worth about 0.5% of GDP. With elections looming, this fiscal stimulus could be enacted rather swiftly. The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions (albeit at spreads closer to long-run historical levels rather than at the anomalously low levels of 2003-mid 2007) and to provide a boost to asset markets. The US housing market is in structural trouble, with excess capacity in most categories that will take years to work off. But that is a small enough part of the US economy not to be a serious drag on overall activity in the years to come.

© Willem H. Buiter 2007



[1]Together, the three mortgage finance GSEs (Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks) have about 4.4 trillion dollars of on-balance sheet assets. Fannie May had about $2.6 trillion, Freddie Mac has about $820bn and the 12 Federal Home Loan Banks just over $ 1.0 trillion. Fannie Mae and Freddie Mac initiated the securitisation of home mortgages.

Labels: , , ,

The two Bs in the title of this post refer not to bed and breakfast, but to the rather less restful and nutritious contributions made on Friday, August 31 by President Bush in the Rose Garden of the White House and by Chairman Bernanke of the Federal Reserve Board, at the annual Jackson Hole Conference in Wyoming.

Both addressed the crisis in the US subprime mortgage market, falling US house prices, the wider turmoil in credit markets and the liquidity problems encountered by a growing number of diverse financial institutions. Bernanke listed the weapons in the Fed’s armoury and tried to outline the Fed’s contingent reaction function to new developments. Bush outlined a small bailout for financially distressed low and middle-income homeowners.

Bernanke’s ‘wait and you shall see’ Chairman Bernanke first. He succeeded completely in what he said out to do: he said nothing at all new, but said it very well indeed. Ignoring the scholarly/historical bits, what is relevant to future Fed policy can be captured by the following quotes and their translations.

“…. if current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. We are following these developments closely.”

Translation: Even though the Fed is in Washington DC, we are not asleep at the wheel.

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

Translation: We can inject additional liquidity through open market purchases or at the discount window; we can cut the discount rate or the Federal Funds target rate, and we can widen the range of eligible assets we will accept as collateral in repos or at the discount window.

“… the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.”

Translation: An increase in credit risk spreads represents a tightening of monetary conditions, even if the Federal Funds target is unchanged. The Fed is aware of this.

“… in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.”

Translation: Never mind what we said following the August 7 FOMC meeting. That was then. This is now. HOWEVER, financial kerfuffles influence the setting of the Federal Funds target if and only if (and to the extent that) they have a material impact on our fundamental objectives, employment and price stability, going forward.

What does this mean for the likely future path of the Federal Funds rate? Most of the recent real economy data are robust, including the QII GDP growth rate of 4.0 percent (annualised) and robust personal income and personal spending growth in July. However, they extend no later than July 2007, and therefore do not capture any negative effect on consumer and investment demand of the August financial turmoil.

The Core PCE deflator index rose 0.1 percent in July 2007, keeping the 12 month rate of core PCE deflator inflation at 1.9 percent for a second month. Headline CPI also rose by 0.1 percent in July, and fell to 2.1 percent over a 12-month period, down from 2.3 percent in June. While both are north of the centre of the Fed’s assumed comfort zone (which ranges from 1.0 to 2.0 percent), they are low enough not to be a cause for embarrassment were the Fed to decide to cut the Federal Funds target on September 18.

Although if I were a voting member of the FOMC, I would vote to keep the Federal Funds rate constant, barring exceptional developments between now and September 18, I believe that the most likely outcome is a 25 bps ‘insurance cut’ in the Federal Funds rate. We shall see.

Bush’s small bail-out By revealed preference, poverty in the USA is something this Republican Administration and Democratic Congress (like past Republican and Democratic Administrations and Congresses) can live with. The prospect of a couple of million homeowners being foreclosed upon during the year before a presidential election is, however, more that the body politic can stand – these people might well be voters. President Bush gave us the homeowners bailout ‘lite’ in his speech. The Congress will no doubt up the ante and turn this into a homeowners bailout ‘premium’.

Bush first gave a concise statement of the case against bailing out mortgage lenders, speculative investors in real estate and those who unwisely took on excessive mortgages. He then outlined a plan for bailing out the last-mentioned category.

“A federal bailout of lenders would only encourage a recurrence of the problem. Its not the governments job to bail out speculators, or those who made the decision to buy a home they knew they could never afford. Yet there are many American homeowners who could get through this difficult time with a little flexibility from their lenders, or a little help from their government. So I strongly urge lenders to work with homeowners to adjust their mortgages. I believe lenders have a responsibility to help these good people to renegotiate so they can stay in their home. And today Im going to outline a variety of steps at the federal level to help American families keep their homes.”

There are a number of aspects of these proposals that are interesting from an economic point of view.

(1) It represents a cyclically appropriate, albeit small (especially in the President’s version – the only one formally on the table) fiscal stimulus. That’s what is meant by “…a little help from their government”.

(2) The fiscal stimulus proposed by the President will be implement mainly through quasi-fiscal means. That means that they will not come in the form of on-budget tax cuts or increases in subsidies or other public spending. Instead they will be hidden in below-market mortgage interest rates, supported by Federal Guarantees, through subsidized mortgage insurance and other off-budget measures that are functionally equivalent to tax cuts or subsidies. The full budgetary impacts will be obscured and delayed.

That is clear from the central role assigned to the Federal Housing Association (FHA), the cornerstone of socialised housing finance in the USA. The FHA is a government agency that started operations in 1934 and provides mortgage insurance to borrowers through a network of private sector lenders. Bush proposes to expand a proposal he sent to the Congress 16 months ago that enables more homeowners to qualify for this insurance by lowering down-payment requirements, by increasing loan limits and providing more flexibility in pricing. There are obvious elements of subsidy in this proposal.

Already about to come online is a new FHA program (‘FHA-Secure’) that aims to allow American homeowners who have a good credit history but cannot afford their current mortgage payments to refinance into FHA-insured mortgages. Again, the unaffordable can only be made affordable through a Federal subsidy.

The President also proposes to change a feature of the US Federal income system that can hit homeowners who no longer can service their mortgages hard. Debt forgiveness counts as taxable income. Assume you have $100,000.00 worth of mortgage debt you cannot afford to service. Your house is worth $100,000.00 to the bank. If the bank were to forgive you your mortgage debt and take your house n exchange, you would still be left with income tax liability on the $100,000.00 of forgiven debt. That seems a bit rough. Of course, you could instead sell the house to the bank for $100,000.00 and use the proceeds of the sale to pay off the loan. No income tax would be due (there could, under certain conditions, be capital gains tax).

The US Congress is likely to expand on these proposals by letting Fannie May (or Federal National Mortgage Association) and Freddie Mac (or Federal Home Loan Mortgage Corporation), two Government Sponsored Enterprises (GSEs) created by the Congress that are at the heart of the US system of socialised housing finance, expand the scale of their operations, specifically by increasing the upper limit on the size of the mortgages they can extend or guarantee from its current level of $417,000.00.[1]

(3) It represents a redistribution of income towards those low and middle-income Americans that had taken on excessive mortgage debt. The bill is paid mainly by the shareholders of the mortgage lenders (that is what is meant by “… a little flexibility from their lenders,…” and by the American tax payer who will have to foot the bill of the increased subsidies attached to the loan guarantees and subsidised mortgage insurance offered by the FHA. If the Congress manages to get Fannie May and Freddie Mac involved in the game, the cost to the tax payer could turn out to be significantly higher.

(4) By subsidising excessive and imprudent borrowing, it reinforces the moral hazard faced in the future by low and middle income Americans pondering the size of the mortgage they can enforce (if the market-friendly President Bush is willing to bail us out today, would a more market-sceptical President Barack Obama or President Hilary Clinton not do so again tomorrow?)

(5) By leaning on the lenders to show greater leniency towards delinquent mortgage borrowers than would be required by the mortgage contracts and the dictates of the competitive environment, it will discourage future subprime lending and other higher-risk mortgage lending by banks and other mortgage finance institutions. This will further increase the role of the FHA, Fannie, Freddie, and the Federal Home Loan Banks, and will further strengthen the role of socialised housing finance in the USA.

(6) There is a reasonable prospect that Federal legislation and Federal regulation and supervision of the housing finance industry will be changed in such a way as to reduce the likelihood of the excesses, the mis-selling and the misrepresentations that became rampant especially during the past 5 years or so. There has been a serious failure by the regulators to stop the rogue mortgage lending practices that have proliferated, and not just in the subprime market. The Fed, both under Chairman Greenspan and under Chairman Bernanke is one of the institutions that bears responsibility for this regulatory fiasco.

It is, unfortunately, quite likely, that the legislative and regulatory changes we will get will amount to a Sarbanes-Oxley-style regulatory overshoot, that is, regulation of the ‘if it moves, stop it’ variety. This will discourage future lending to low-income or credit-impaired would-be homeowners even when such lending is fundamentally sound.

Parochialism in US economic policy

Both sets of remarks were amazingly parochial. The President clearly believes that, except for oil and Chinese imports, the US is a closed economy.

Chairman Bernanke’s text contains a few rather generic references to global matters, but rather less than the topic deserved. Surely the fact that so much of the subprime exposure ended up in European and Asian financial institutions must have made it easier for the US lending excesses to occur. One also has to recognise the importance of international regulatory arbitrage as a factor limiting the ability of national regulators to impose even mild disclosure restrictions (let alone more serious regulatory constraints, whether for prudential or consumer protection reasons) on internationally mobile financial institutions.

Even in a lecture on ‘Housing, Housing Finance, and Monetary Policy’, it is surprising not to find the word ‘exchange rate’ in a section of the lecture titled The Monetary Transmission Mechanism Since the Mid-1980s’. During the past 20 years, the US economy has become increasingly open, both as regards trade in real goods and services and trade in financial instruments. Transmission of monetary policy through the exchange rate undoubtedly has become more important, both for prices and for aggregate demand, during this period, and US real interest rates are increasingly influenced by global economic developments, as Governor Bernanke himself has pointed out in a lecture on the global saving glut.

When all is said and done, the entire construction sector in the US is 5 percent of GDP. The bit that is hurting badly, residential construction, is somewhere between 3 and 4 percent of GDP. Exports are 12 percent of GDP and growing in volume terms at an annual rate of over 11 percent. Import-competing industries are also doing well. The combination of a sharp nominal and real depreciation of the US dollar and continued rapid growth outside the US accounts for the strength of the externally exposed sectors of the US economy. It goes a long way towards offsetting the weakness of parts of the nontraded sectors, including housing. While increased credit risk spreads represent a tightening of monetary conditions, the weaker dollar represents a loosening of monetary conditions. There is no indication from Chairman Bernanke’s address that the Fed pays any attention to this in its actual policy deliberations. This is especially surprising in view of Chairman Bernanke’s recognition of these issues ‘in the abstract’, in a recent lecture.

Of course, housing troubles are not limited to the construction sector. Housing wealth is an important component of total net household financial wealth; real estate assets can be collateralised and thus are a ready source of consumer spending power. Another Fed Governor, Frederic Mishkin argued at the same Jackson Hole conference that a fall in housing wealth could be a serious drag on consumer spending, assuming that the marginal propensity to spend out of housing wealth was 3.75 percent (a very precise number indeed).

Bottom line A 25 bps cut in the Federal Funds rate on September 18 is unnecessary, likely, but my no means a foregone conclusion. By the time Congress is done augmenting the Bush mini bail-out of financially stressed mortgage holders, there may be a fiscal stimulus worth about 0.5% of GDP. With elections looming, this fiscal stimulus could be enacted rather swiftly. The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions (albeit at spreads closer to long-run historical levels rather than at the anomalously low levels of 2003-mid 2007) and to provide a boost to asset markets. The US housing market is in structural trouble, with excess capacity in most categories that will take years to work off. But that is a small enough part of the US economy not to be a serious drag on overall activity in the years to come.

© Willem H. Buiter 2007



[1]Together, the three mortgage finance GSEs (Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks) have about 4.4 trillion dollars of on-balance sheet assets. Fannie May had about $2.6 trillion, Freddie Mac has about $820bn and the 12 Federal Home Loan Banks just over $ 1.0 trillion. Fannie Mae and Freddie Mac initiated the securitisation of home mortgages.

Labels: , , ,

The two Bs in the title of this post refer not to bed and breakfast, but to the rather less restful and nutritious contributions made on Friday, August 31 by President Bush in the Rose Garden of the White House and by Chairman Bernanke of the Federal Reserve Board, at the annual Jackson Hole Conference in Wyoming.

Both addressed the crisis in the US subprime mortgage market, falling US house prices, the wider turmoil in credit markets and the liquidity problems encountered by a growing number of diverse financial institutions. Bernanke listed the weapons in the Fed’s armoury and tried to outline the Fed’s contingent reaction function to new developments. Bush outlined a small bailout for financially distressed low and middle-income homeowners.

Bernanke’s ‘wait and you shall see’Chairman Bernanke first. He succeeded completely in what he said out to do: he said nothing at all new, but said it very well indeed. Ignoring the scholarly/historical bits, what is relevant to future Fed policy can be captured by the following quotes and their translations.

“…. if current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. We are following these developments closely.”

Translation: Even though the Fed is in Washington DC, we are not asleep at the wheel.

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

Translation: We can inject additional liquidity through open market purchases or at the discount window; we can cut the discount rate or the Federal Funds target rate, and we can widen the range of eligible assets we will accept as collateral in repos or at the discount window.

“… the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.”

Translation: An increase in credit risk spreads represents a tightening of monetary conditions, even if the Federal Funds target is unchanged. The Fed is aware of this.

“… in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.”

Translation: Never mind what we said following the August 7 FOMC meeting. That was then. This is now. HOWEVER, financial kerfuffles influence the setting of the Federal Funds target if and only if (and to the extent that) they have a material impact on our fundamental objectives, employment and price stability, going forward.

What does this mean for the likely future path of the Federal Funds rate?Most of the recent real economy data are robust, including the QII GDP growth rate of 4.0 percent (annualised) and robust personal income and personal spending growth in July. However, they extend no later than July 2007, and therefore do not capture any negative effect on consumer and investment demand of the August financial turmoil.

The Core PCE deflator index rose 0.1 percent in July 2007, keeping the 12 month rate of core PCE deflator inflation at 1.9 percent for a second month. Headline CPI also rose by 0.1 percent in July, and fell to 2.1 percent over a 12-month period, down from 2.3 percent in June. While both are north of the centre of the Fed’s assumed comfort zone (which ranges from 1.0 to 2.0 percent), they are low enough not to be a cause for embarrassment were the Fed to decide to cut the Federal Funds target on September 18.

Although if I were a voting member of the FOMC, I would vote to keep the Federal Funds rate constant, barring exceptional developments between now and September 18, I believe that the most likely outcome is a 25 bps ‘insurance cut’ in the Federal Funds rate. We shall see.

Bush’s small bail-outBy revealed preference, poverty in the USA is something this Republican Administration and Democratic Congress (like past Republican and Democratic Administrations and Congresses) can live with. The prospect of a couple of million homeowners being foreclosed upon during the year before a presidential election is, however, more that the body politic can stand – these people might well be voters. President Bush gave us the homeowners bailout ‘lite’ in his speech. The Congress will no doubt up the ante and turn this into a homeowners bailout ‘premium’.

Bush first gave a concise statement of the case against bailing out mortgage lenders, speculative investors in real estate and those who unwisely took on excessive mortgages. He then outlined a plan for bailing out the last-mentioned category.

“A federal bailout of lenders would only encourage a recurrence of the problem. Its not the governments job to bail out speculators, or those who made the decision to buy a home they knew they could never afford. Yet there are many American homeowners who could get through this difficult time with a little flexibility from their lenders, or a little help from their government. So I strongly urge lenders to work with homeowners to adjust their mortgages. I believe lenders have a responsibility to help these good people to renegotiate so they can stay in their home. And today Im going to outline a variety of steps at the federal level to help American families keep their homes.”

There are a number of aspects of these proposals that are interesting from an economic point of view.

(1) It represents a cyclically appropriate, albeit small (especially in the President’s version – the only one formally on the table) fiscal stimulus. That’s what is meant by “…a little help from their government”.

(2) The fiscal stimulus proposed by the President will be implement mainly through quasi-fiscal means. That means that they will not come in the form of on-budget tax cuts or increases in subsidies or other public spending. Instead they will be hidden in below-market mortgage interest rates, supported by Federal Guarantees, through subsidized mortgage insurance and other off-budget measures that are functionally equivalent to tax cuts or subsidies. The full budgetary impacts will be obscured and delayed.

That is clear from the central role assigned to the Federal Housing Association (FHA), the cornerstone of socialised housing finance in the USA. The FHA is a government agency that started operations in 1934 and provides mortgage insurance to borrowers through a network of private sector lenders. Bush proposes to expand a proposal he sent to the Congress 16 months ago that enables more homeowners to qualify for this insurance by lowering down-payment requirements, by increasing loan limits and providing more flexibility in pricing. There are obvious elements of subsidy in this proposal.

Already about to come online is a new FHA program (‘FHA-Secure’) that aims to allow American homeowners who have a good credit history but cannot afford their current mortgage payments to refinance into FHA-insured mortgages. Again, the unaffordable can only be made affordable through a Federal subsidy.

The President also proposes to change a feature of the US Federal income system that can hit homeowners who no longer can service their mortgages hard. Debt forgiveness counts as taxable income. Assume you have $100,000.00 worth of mortgage debt you cannot afford to service. Your house is worth $100,000.00 to the bank. If the bank were to forgive you your mortgage debt and take your house n exchange, you would still be left with income tax liability on the $100,000.00 of forgiven debt. That seems a bit rough. Of course, you could instead sell the house to the bank for $100,000.00 and use the proceeds of the sale to pay off the loan. No income tax would be due (there could, under certain conditions, be capital gains tax).

The US Congress is likely to expand on these proposals by letting Fannie May (or Federal National Mortgage Association) and Freddie Mac (or Federal Home Loan Mortgage Corporation), two Government Sponsored Enterprises (GSEs) created by the Congress that are at the heart of the US system of socialised housing finance, expand the scale of their operations, specifically by increasing the upper limit on the size of the mortgages they can extend or guarantee from its current level of $417,000.00.[1]

(3) It represents a redistribution of income towards those low and middle-income Americans that had taken on excessive mortgage debt. The bill is paid mainly by the shareholders of the mortgage lenders (that is what is meant by “… a little flexibility from their lenders,…” and by the American tax payer who will have to foot the bill of the increased subsidies attached to the loan guarantees and subsidised mortgage insurance offered by the FHA. If the Congress manages to get Fannie May and Freddie Mac involved in the game, the cost to the tax payer could turn out to be significantly higher.

(4) By subsidising excessive and imprudent borrowing, it reinforces the moral hazard faced in the future by low and middle income Americans pondering the size of the mortgage they can enforce (if the market-friendly President Bush is willing to bail us out today, would a more market-sceptical President Barack Obama or President Hilary Clinton not do so again tomorrow?)

(5) By leaning on the lenders to show greater leniency towards delinquent mortgage borrowers than would be required by the mortgage contracts and the dictates of the competitive environment, it will discourage future subprime lending and other higher-risk mortgage lending by banks and other mortgage finance institutions. This will further increase the role of the FHA, Fannie, Freddie, and the Federal Home Loan Banks, and will further strengthen the role of socialised housing finance in the USA.

(6) There is a reasonable prospect that Federal legislation and Federal regulation and supervision of the housing finance industry will be changed in such a way as to reduce the likelihood of the excesses, the mis-selling and the misrepresentations that became rampant especially during the past 5 years or so. There has been a serious failure by the regulators to stop the rogue mortgage lending practices that have proliferated, and not just in the subprime market. The Fed, both under Chairman Greenspan and under Chairman Bernanke is one of the institutions that bears responsibility for this regulatory fiasco.

It is, unfortunately, quite likely, that the legislative and regulatory changes we will get will amount to a Sarbanes-Oxley-style regulatory overshoot, that is, regulation of the ‘if it moves, stop it’ variety. This will discourage future lending to low-income or credit-impaired would-be homeowners even when such lending is fundamentally sound.

Parochialism in US economic policy

Both sets of remarks were amazingly parochial. The President clearly believes that, except for oil and Chinese imports, the US is a closed economy.

Chairman Bernanke’s text contains a few rather generic references to global matters, but rather less than the topic deserved. Surely the fact that so much of the subprime exposure ended up in European and Asian financial institutions must have made it easier for the US lending excesses to occur. One also has to recognise the importance of international regulatory arbitrage as a factor limiting the ability of national regulators to impose even mild disclosure restrictions (let alone more serious regulatory constraints, whether for prudential or consumer protection reasons) on internationally mobile financial institutions.

Even in a lecture on ‘Housing, Housing Finance, and Monetary Policy’, it is surprising not to find the word ‘exchange rate’ in a section of the lecture titled The Monetary Transmission Mechanism Since the Mid-1980s’. During the past 20 years, the US economy has become increasingly open, both as regards trade in real goods and services and trade in financial instruments. Transmission of monetary policy through the exchange rate undoubtedly has become more important, both for prices and for aggregate demand, during this period, and US real interest rates are increasingly influenced by global economic developments, as Governor Bernanke himself has pointed out in a lecture on the global saving glut.

When all is said and done, the entire construction sector in the US is 5 percent of GDP. The bit that is hurting badly, residential construction, is somewhere between 3 and 4 percent of GDP. Exports are 12 percent of GDP and growing in volume terms at an annual rate of over 11 percent. Import-competing industries are also doing well. The combination of a sharp nominal and real depreciation of the US dollar and continued rapid growth outside the US accounts for the strength of the externally exposed sectors of the US economy. It goes a long way towards offsetting the weakness of parts of the nontraded sectors, including housing. While increased credit risk spreads represent a tightening of monetary conditions, the weaker dollar represents a loosening of monetary conditions. There is no indication from Chairman Bernanke’s address that the Fed pays any attention to this in its actual policy deliberations. This is especially surprising in view of Chairman Bernanke’s recognition of these issues ‘in the abstract’, in a recent lecture.

Of course, housing troubles are not limited to the construction sector. Housing wealth is an important component of total net household financial wealth; real estate assets can be collateralised and thus are a ready source of consumer spending power. Another Fed Governor, Frederic Mishkin argued at the same Jackson Hole conference that a fall in housing wealth could be a serious drag on consumer spending, assuming that the marginal propensity to spend out of housing wealth was 3.75 percent (a very precise number indeed).

Bottom lineA 25 bps cut in the Federal Funds rate on September 18 is unnecessary, likely, but my no means a foregone conclusion. By the time Congress is done augmenting the Bush mini bail-out of financially stressed mortgage holders, there may be a fiscal stimulus worth about 0.5% of GDP. With elections looming, this fiscal stimulus could be enacted rather swiftly. The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions (albeit at spreads closer to long-run historical levels rather than at the anomalously low levels of 2003-mid 2007) and to provide a boost to asset markets. The US housing market is in structural trouble, with excess capacity in most categories that will take years to work off. But that is a small enough part of the US economy not to be a serious drag on overall activity in the years to come.

© Willem H. Buiter 2007



[1]Together, the three mortgage finance GSEs (Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks) have about 4.4 trillion dollars of on-balance sheet assets. Fannie May had about $2.6 trillion, Freddie Mac has about $820bn and the 12 Federal Home Loan Banks just over $ 1.0 trillion. Fannie Mae and Freddie Mac initiated the securitisation of home mortgages.

Labels: , , ,

Joint post by Willem H. Buiter and Anne C. Sibert. Virtually the same post appeared on September 2 on Martin Wolf’s Economists’ Forum.

In his column ‘Central Banks should not rescue fools’, Martin Wolf, Chief economics commentator of the Financial Times, characterises the credit crunch/liquidity crisis of August 2007 as a ‘lemons’ problem due to asymmetric information. We argue that this is not the case.

Consider the securities for which the liquidity crunch was most serious: collateralised debt obligations backed by US subprime mortgages (CDOs) and commercial paper backed by (not necessarily subprime) mortgages and hire purchase receivables such as credit card debt (ABCP). If the market failure was due to a “lemons” problem, then potential buyers of the assets that became illiquid must have suddenly realised that there was an asymmetric information problem in the markets for these assets and that they were on the wrong side of it. That is, potential lenders realised not only that they knew a lot less about the creditworthiness of the securities being offered than they had thought they knew, but that this increase in uncertainty was not shared to the same degree by the sellers of these securities. This discovery caused the market to shrink and to cease to function. Was this what happened?

It is true that the asset-backed securities in the markets that became illiquid are not homogeneous; the quality of the underlying assets (for example, mortgages) is not uniform. If the would-be sellers of the securities have private information about the quality of the underlying assets and are unable to reveal this private information to the buyers, then a lemons problem can arise in the following way. Potential buyers of the securities are only willing to purchase the securities if the price is no higher than what they would pay for securities backed by underlying assets of average quality. If the dispersion in the quality of the underlying assets is large enough, the sellers of assets backed by the best-quality underlying assets will be unwilling to sell at that price and withdraw from the market. Potential buyers know this and realise that the average quality of the underlying assets is lower than it would have been if the sellers with the best-quality underlying assets had not departed the markets. Thus, the price at which they are willing to buy securities falls and additional sellers of good-quality assets may leave the market, causing the purchase price to fall further. A continuation of this process can cause the market to shrink further and perhaps even to collapse entirely.

Is this what happened? Consider the case of mortgage-backed securities. There is certainly asymmetric information in the primary market for individual mortgages. Typically, the applicant for a mortgage knows more about his creditworthiness than the loan officer of a bank. In some subprime mortgage markets, the asymmetric information problem may have been on the other side. Smooth-talking salesmen may have convinced uninformed or gullible mortgage applicants to take on loans that the mortgage sellers knew to be in excess of the homeowners’ capacity to service.

Regardless of who has the informational advantage in the market for the original individual mortgages, when these mortgages get securitised there is an asymmetric information problem between the banks originating the mortgages and the special purpose vehicle (SPV) that buys the mortgages from the banks and then issues the securities backed by these mortgages. The SPV is unlikely to know as much about the quality of the underlying mortgages as the originator. When the SPV sells its asset-backed securities, the purchasers have little idea about the quality of the underlying assets that were pooled.

When the current holders of asset-backed securities try to sell them in the market, neither the sellers nor the buyers have superior information. The only parties with private information – that is, the original mortgage borrowers lenders — are not in the market or not in a position to make use of their superior, asymmetric information.

The recent illiquidity in financial markers is certainly an information problem, but it is not an asymmetric information problem. I think Martin and we agree that in July-August (perhaps even a bit earlier), there was a general realisation that the credit ratings granted by the main rating agencies to many asset-backed securities and structured financial products in general, were wildly generous. There therefore was an associated increase in the market’s perceived average probability of default for wide classes of securities. But the greater awareness of ignorance and the increased uncertainty are market-wide and symmetric, affecting would-be buyers and sellers equally. The private information that could have caused a lemons problem was destroyed by the process of securitisation and pooling.

It is not clear why the recent uncertainty caused such upheaval. Perhaps – for some reason — uncertainty has become more Knightian in that it has become less possible to attach a subjective probability distribution to the range of possible outcomes or even to describe the set of possible outcomes. Pervasive, Knightian uncertainty could be associated with the fear, panic and herding behaviour that caused market failure.

Illiquid markets prevent financial firms from raising cash by selling the securities that become illiquid. These firms will have to fund themselves in other ways and this may lead to a lemons problem. If firms try to raise money through unsecured loans or debt or through loans and debt secured against assets about which do indeed have private information, then asymmetric information may play a role in causing these sources of credit to fail. It will be interesting to uncover, when the history of this crisis is written, to what extent asymmetric information caused certain sources of credit to vanish. It played no role, however, in the drying up of the asset-backed security markets.

©Willem H. Buiter and Anne C. Sibert 2007

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Joint post by Willem H. Buiter and Anne C. Sibert. Virtually the same post appeared in Martin Wolf’s Economists’ Forum , on Sunday 2 September 2007.

Martin Wolf, Chief economics commentator of the Financial Times, in his column, ‘Central banks should not rescue fools’, criticises our Market Maker of Last Resort (MMLR) proposal (see (1) , (2) , (3) and (4)). Not surprisingly, we disagree with his comments and we respond and clarify.

Central banks should support key financial institutions with strong public goods features. These institutions include important financial markets and mechanisms that support these markets, such as the payments system and clearing and settlement systems. Central banks should not support or bail out financial businesses or households unless this is necessary to support key economic institutions (it is not helpful that financial businesses are sometimes referred to as financial institutions).

In Bagehot’s days, commercial banks accounted for the lion’s share of financial intermediation. They were the credit system and played a key role in the payments system. Support of the credit markets and the maintenance of a functioning payments system therefore required the support of commercial banks in a financial crisis. Thus, Bagehot advised that in times of crisis the central bank should lend (to commercial banks) freely, at a penalty rate and against good collateral (that is, collateral that would be good in normal times but has become impaired temporarily because of the crisis). A penalty lending rate and the collateral requirement serve to minimise moral hazard.

Today, a growing share of financial intermediation bypasses commercial banks completely, going through financial markets in which commercial banks are just one of many types of participants. It now becomes possible to support the credit system and key financial markets without supporting individual, or even particular types of financial businesses.

We propose that liquidity problems can be addressed by the central bank making a market for assets which would be liquid in normal times but are illiquid because of the crisis. The central bank can do this either by buying the asset outright or by accepting it as collateral against loans at the central bank’s discount window or in repurchase operations in the money markets.

Our proposal expands the set of what is generally considered “good” collateral for Bagehot’s Lender of Last Resort. We suggest that central banks accept a much wider range of assets as collateral than is currently the case. Specifically, they should accept securities that are below investment grade (‘junk’), and accept securities backed by impaired assets such as impaired subprime mortgages. The ECB’s self-imposed rules of practice prohibit accepting as collateral, either in repos or at its discount window, anything rated less than A-. The Fed is permitted to accept anything as collateral at its discount window, but has done little to enlarge its menu of eligible collateral.

We maintain Bagehot’s requirement that lending be at a penalty rate. Central banks should only offer to buy an illiquid asset at a punitive price, that is, at a price representing a severe ‘haircut’ or discount relative to what its fair or fundamental price would be with orderly markets. This could be implemented as follows. First, the monetary authority should clarify what kinds of assets it is in principle willing to purchase.

Martin objects that the central bank would have to end up dealing in and setting prices for complex structured instruments that it knows little or nothing about. Clearly, there would have to be a ‘positive list’, updated regularly, of securities eligible for discounting. Only systemically important instruments would have to be considered, not every over-the-counter concoction some quant has dreamt up. Then, the central bank would have to be active, even during normal times, albeit on a small scale, in the market for each of the eligible instruments. That way the central bank staff will acquire a familiarity with the instruments that will be helpful during disorderly market conditions. What we are recommending for this wide range of eligible instruments is what central banks routinely do in the foreign exchange markets, even when the exchange rate policy is a free float. The central bank would have to recruit staff with new skills, or retrain existing staff, to do this affectively.

The central bank should only deal with and lend to “eligible” counterparties. Eligible counterparties are all those who abide by a prudential regulatory/supervisory regime approved by the central bank. Financial businesses that do not abide by these regulatory and supervisory constraints cannot come to the discount window and will have to try their luck obtaining liquidity from those that do meet the prudential norms.

How can the central bank set a price in a market that has ceased to function? There are many ways of structuring markets or auctions in such a way that they become price or value discovery mechanisms. An example of such a mechanism – one which discovers the reservation prices of all potential sellers without the central bank having to have any superior knowledge of the fundamental determinants of the value of the illiquid security – is the Dutch auction.

For a given eligible instrument and a give set of eligible counterparties, the central bank would announce that it is willing to buy up to, say, $10bn (at face value) of an impaired asset. It would start the auction by offering to the asset at, say, one cent for each dollar of face value. All sales at that price would be accepted, up to the $10bn face value limit. If the total amount offered at one cent on the dollar were to exceed $10bn face value, there would be pro-rata sharing among those who made offers to sell. If less than $10bn face value is offered at one cent on the dollar, the central bank would increase its bid. Thus if, say, $2bn were offered, the central bank would allocate the $2bn to the sellers who accepted one cent on the dollar and then would offer to buy up to $8bn at, say, 2 cents on the dollar. The central bank would then continue this process, offering increasingly higher prices, until it had purchased the entire $10bn.

The central bank as Market Maker of Last Resort effectively performs the role of a publicly owned ‘vulture fund’, buying up distressed, illiquid assets from sellers desperate to realise some value somewhere. Martin argues that this job should be left to regular private vulture funds. We agree that if private vulture funds can do this in a timely matter, so much the better. There are times, however, when waiting for private vulture funds to step forward risks an avalanche of illiquidity that creates unnecessary and socially costly defaults and bankruptcies. In such circumstances, only the central bank has the deep pockets to make a market in an expeditious fashion.

© Willem H. Buiter and Anne C. Sibert 2007

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Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website