Two crucial inputs into Pillar 1 (Minimum Capital Requirements) of the proposed Basel II Framework for the International Convergence of Capital Measurement and Capital Standards have, if not gone belly-up, at least been severely compromised by the recent financial markets turmoil. They are the reliance on credit ratings provided by the internationally recognised rating agencies (currently Moody’s, Standard & Poor’s and Fitch) and the crucial role assigned to internal models in everything from stress-testing to marking-to-model illiquid assets.

It is clear that, as regard rating complex structured products, the three internationally recognised rating agencies have done a terrible job. That is in part because rating complex structured products is very difficult. There is more to the ratings performance however. There appears to be a systematic bias in the ratings. If rating were merely difficult, you would expect as many over-ratings as under-ratings. What we see instead, is a persistent bias: ratings seem to systematically over-estimate the creditworthiness of the rated instrument or structure. The reason for this must be the distorted incentive structure faced by the rating agencies. They are inherently and deeply conflicted.

• First, almost unique in any appraisal process, the appraiser in the rating process is paid by the seller rather than the buyer.

• Second, the rating agencies provide (remunerated) technical assistance/advice on how to design structures that will attract the best possible rating to the very issuers whose structures they will subsequently rate.

• Third, rating agencies increasingly provide other financial services and products than ratings (or ratings advice). As with auditors, there is the risk that the rating (audit) service may be subverted in the pursuit of remunerative sales of these other products.

I am not asserting that the rating process of complex financial instrument is unavoidably utterly corrupt and useless, although some of it probably is. Clearly, reputational considerations mitigate the conflict of interest faced by the rating agencies. The rating agencies have, for a long time, done a passable job of rating sovereign debt instruments and corporate entities. However, the principal-agent chain linking an individual or team working for some rating agency to the buyer of the security they rate is lengthy and opaque. The bottom line is that no-one any longer trusts the rating agencies’ judgement of the creditworthiness of complex structured instruments. That puts a huge hole in Pillar 1.

The recent financial turmoil has led to a demystification of quants and other high-tech builders and maintainers of mathematical-statistical models and algorithms. We have had a powerful reminder of the ‘garbage in – garbage out’ theorem. On many occasions marking to model has turned out to be marking-to-make belief or marking-to-myth. Wishful thinking dressed up in advanced mathematics remains wishful thinking. The incentives faced by the designers, maintainers and users of these models, and of those who calibrate their inputs have not been taken into account. Again conflict of interest is pervasive and inescapable.

With so many illiquid, non-traded instruments on their books (and in off-balance-sheet vehicles that may have to be brought on balance sheet again soon), many banks are confronted with the fact that ‘fair value’, when it cannot be measured objectively by a market price, is unlikely to be calculated fairly by techie employees of the bank whose activities are not understood by the bank’s risk managers or top management, and whose pay and prospects depend in a pretty obvious way on the numbers their models crank out. Again reputational considerations will mitigate the incentive to distort, but will not eliminate it. Turnover of quants, risk-managers and even top managers is so high that the restraining influence of reputational concerns is often weak at best.

What is Pillar 1 of Basel II without reliable and trusted rating agencies and without reliable and trusted methods for marking to model the illiquid assets of the banks? Not something I would use as a rule book for capital measurement and capital standards for banks. So whither now with Basel II?

Forcing the rating agencies to clean up their act is one necessary condition for Basel II to get back on track. This would require rating agencies to forsake all activities other than providing ratings. It also requires the end of the payment for the rating by the issuer of the security being rated. The only workable model would be payment out of a fund raised by a levy on the entire universe of securities-issuing and investing industries that rely on ratings.

As regards internal models and marking-to-model, I can see no way the cripling conflict of interest can ever be resolved for anything other than the simplest structured products – those for which even the CEO can understand the principles underlying the model and the numbers going in and coming out. This would mean that banks would not be allowed to hold on their balance sheets, or to be exposed to through off-balance sheet connections, complex structures whose valuation cannot be verified easily by third parties. This is tough and will be unpopular with the industry, but necessary for financial stability.

In any case, if a financial product is too complex for its valuation to be understood by the average Joe, it probably contributes negative marginal social value. Such complex products tend to be motivated by regulatory avoidance and tax avoidance considerations, and should be discouraged by regulatory design. True risk trading and risk sharing require simple, transparent instruments, designed for specific contingencies (states of nature), rather like elementary Arrow-Debreu securities. They don’t require convoluted bundles of heterogeneous opaque contingent claims.

Labels: International Trade, Monetary Policy, Terrorism

Labels: Economics, Financial Markets, Monetary Policy

As regards the preservation of financial stability and the health of the UK banking sector, the existence of the Lender of Last Resort Facility makes deposit insurance or other forms of deposit guarantees redundant. Even a run on the banks that drains the system of all its deposits will not force the hasty liquidation of illiquid bank assets.

Consider a system with a well-designed discount window, like the ECB’s Marginal Lending Facility or the Fed’s Primary discount window. Such a discount window accepts a wide range of collateral, including private assets, asset backed securities and illiquid assets, including non-marketable assets like pools of mortgages. It also provides credit for longer maturities than overnight (the Fed’s Primary discount window now can lend for up to one month). With such a well-designed discount window, accessible to all banks on demand, at a penalty rate over the official policy rate and against fairly valued collateral (and subject to an appropriate haircut on that valuation), the Liquidity Support Facility created for Northern Rock would have been redundant. The ECB would be wise, though, to extend its set of assets eligible as collateral to assets rated below the A category, including assets below investment grade (‘junk’). Northern Rock’s Liquidity Support Facility is what the Bank of England’s Standing (collateralised) lending facility should have been, and probably will become before long.

Until the UK’s Standing lending facility extends its list of eligible collateral and lends at longer maturities than it does now, I would encourage every UK bank to set up a subsidiary in the US and in the Euro Area, to be able to take advantage of the more generous definition of eligible collateral at the discount windows there, and the longer maturities.

Indeed, at the Fed’s Primary discount windows the list of eligible counterparties is, in principle, not restricted to banks. If the Board of Governors of the Federal Reserve System determines that there are “unusual and exigent circumstances” and at least five out of seven governors vote to authorize lending under Section 13(3) of the Federal Reserve Act, the Federal Reserve can discount for individuals, partnerships and corporations “notes, drafts and bills of exchange … indorsed or otherwise secured to the satisfaction of the Federal Reserve bank…”. This means that, should it decide to do so, the Fed can accepts cats and dogs as collateral at its discount window, and from any US-based individual, partnership or corporate entity. I would hurry to register my UK-based or Eurozone-based SIV or conduit in the US, to take advantage of this unique (discount) window of opportunity for liquifying the illiquid.

So if the chancellor’s decision to provide blanket cover for all UK deposit holders, free at the point of delivery but at a potential cost to the tax payer, was not about financial stability and safeguarding the UK banking system, what was it about?

It was about three things – two bad reasons for this intervention and one good one, in indeterminate proportions. (1) Protecting depositors for its own sake, that is, without any material benefit as regards financial stability; (2) Covering political posteriors; (3) Preserving consumer confidence and minimising the risk of recession.

The chancellor decided that the 100 percent guarantee for deposits up to £2,000 and the 90 percent guarantee for the next £33,000 worth of deposits provided by the Financial Services Compensation Scheme (that is £31,700 per person) was not enough. (Note that, even as unsecured creditors, the depositors holding deposits over the £35,000 FSCS limit could have expected to receive back something for their ‘uninsured’ deposits in the even of insolvency and liquidation of the bank).

As distributive justice, the chancellor’s blanket extension of the deposit guarantee seems bizarre. There are many persons in the UK that are much poorer than the depositors who will benefit from the chancellor’s largesse. Is it now the job of the state not just to prevent poverty, but to compensate for any decline in a person’s standard of living, or even to intervene whenever a person’s standard of living falls below the level (s)he hoped for or anticipated? I sense a deeply moralistic distinction being made between the undeserving poor (those who have no savings) and the deserving not-so-poor who have savings. We will compensate the bees but not the crickets. The deposit guarantee of course also benefits shareholders, but this is unlikely to have been a major consideration, as there were no long queues of shareholders outside the stock exchange, trying to dump their shares.

There is a ‘fixed cost of monitoring financial institutions’ efficiency argument for providing limited deposit insurance. Clearly, it makes no sense for everybody who has a deposit account with an average balance of a few thousand pounds or less to do extensive due diligence on the solvency and liquidity of the institution. Such information is a public good (it is ‘non-rival’) once it has been acquired by anyone; however, it is hard to disseminate. So it makes sense that not every small account holder goes through the cost and effort of verifying the safety of his account. The current FSCS limit of £35,000 seems quite adequate for the purpose of making sure that resources are not wasted doing due diligence for small accounts. Anyone holding more than £35,000 in a single bank account deserves to lose it if (s)he does not bother to find out whether the institution is safe.

As regard the covering of posteriors, it is clearly not an election winner to have the opposition in a position to put up posters picturing long queues outside some bank or building society, of people desperate to get their money out. The fact that depositors simply did not believe/trust the troika of the chancellor, governor and chair of the FSA to safeguard their money, even after they set up the Liquidity Support Facility, is deeply embarrassing for all members of the troika.

For the FSA, on whose regulatory watch Northern Rock and other mortgage lenders began to access the wholesale markets as a source of funding, and which did nothing to prevent the excesses that began to crop up in the mortgage contracts on offer (up to 125% loan-to-value ratios; loans up to six times annual household income etc.), the visibility of a bank run is a deeply embarrassing event even if, because of the Liquidity Support Facility, it does not threaten the viability of any bank. The Bank of England is, of course, not responsible for the regulatory and supervisory failings of the FSA. It has some responsibility, as an advisor to the government, for present and past chancellors’ failures to create a proper legislative and regulatory environment for the banking sector. Inevitably also, it will take a credibility hit, however unfairly, because ‘its’ Liquidity Support Facility did not suffice to stop the run on Northern Rock.

Maintaining confidence, especially consumer confidence, is the one good reason for the chancellor’s decision. People get scared when they see 1930s style queues outside banks of depositors wanting to put their money under the mattress rather than keeping it in the bank. This is the stuff of banana republics and countries in the early stages of transition, not what you expect to see in the country that hosts the financial capital of the world.

Some slowdown in consumer demand would be a good thing. A panic-and-fear-induced collapse of consumer demand (more than 60% of final demand) could cause a recession.

So the chancellor’s decision to guarantee all Northern Rock depositors (and by implication to guarantee all deposits in all UK banks and building societies) was motivated by (1) the political desire to pander to depositors, (2) political posterior covering and (3) the desire to prevent a collapse of consumer confidence and consumer demand. It would be interesting to know the weights attached to these three motives in reaching the decision.

Finally, by effectively granting 100 percent deposit insurance free of charge to all depositors in the UK, the UK banking system has been de-facto socialised to a significant extent. It would have been much cleaner to have used the US approach to this kind of problem. In the US, the Federal Deposit Insurance Corporation could have taken into full public ownership a bank in a position similar to Northern rock, and could have done so overnight. It would have re-opened immediately for existing business commitments and activities.

Once markets had become orderly again, and the value of the bank’s assets and liabilities had been established with some degree of confidence, the bank could have been privatised again as a going concern, sold to another bank or broken up and sold in bits an pieces. Unsecured creditors, including depositors with deposits above the deposit insurance limit (who in the US have priority over other unsecured creditors), would have to see how much the re-privatisation of the bank or the sale of its assets would yield. The old management would not be expected to play a role under public ownership. The former shareholders might get something back if the re-privatisation more than covered the cost of the operation, after all the other creditors had been paid.

Such a temporary transfer into full public ownership, which should be part of the competencies of the FSA, would be socialism in support of the market. It presents a sharp contrast with the chancellor’s socialism for the (richer) depositors and for the shareholders of Banks at risk of a run.

Labels: Economics, Financial Markets, Monetary Policy, Politics

Joint post by Willem Buiter and Anne Sibert. This post appeared first in the Financial Times, Comments & Analysis Page, Comment on September 16, 2007.

The Northern Rock bail-out was formally a joint decision of the Treasury, the Financial Services Authority and the Bank of England. However, their Memorandum of Understanding (MOU) states that “ultimate responsibility for authorisation of support operations in exceptional circumstances rests with the chancellor.” This makes sense: the taxpayer is on the hook when public resources are put at risk. Unfortunately, it is the Bank’s reputation that is damaged. It had to provide credit after the governor took a strong public stand against bail-outs.

Following rapid expansion financed by high-risk funding, Northern Rock depended on the government to survive. Three-quarters of its funds came from the wholesale markets instead of depositors. When global financial turmoil hit, Northern Rock could no longer refinance its maturing obligations. It had engaged in reckless borrowing; it gambled and lost. Now it must find itself a buyer with deeper pockets.

That the government bailed it out is hard to understand. The MOU states that a bail-out should only be undertaken if there is, “a genuine threat to the stability of the financial system”. The demise of the fifth-largest UK mortgage lender would hardly be a systemically significant event.

The Bank’s primary role is to ensure price stability. For this, it needs credibility. The Northern Rock debacle damages this credibility. Restructuring Lender of Last Resort responsibilities is necessary. The Bank should support key financial markets and institutions such as the payments and clearing and settlement systems. Bailing out individual banks should be left to the FSA, which has the expertise, and the Treasury, which has the power to tax. Ending the active role of the Bank as a lender of last resort would require only that the FSA have a credit line with the Bank, guaranteed by the Treasury, and a change in the MOU.

The Bank is not blameless in the Northern Rock debacle, however. A bail-out might not have been needed if the Bank had a more sensible collateral policy for its open-market operations and discount-window borrowing. The ECB accepts private securities rated at least A-; the Bank should too. If Northern Rock had a eurozone subsidiary, it could have borrowed from the ECB, using its high-grade mortgages as collateral.

The Bank should also intervene in the three-month, as well as the overnight, money market. Its own money market Objective 1 says: “Overnight market interest rates to be in line with the official Bank Rate, so that there is a flat money market yield curve . . . out to the next MPC decision date”. In early September, a month before the next MPC meeting, the one-month (unsecured) interbank rate should have been close to the policy rate of 5.75 per cent; instead, it was 6.68 per cent: just below three-month Libor. As the policy rate is unlikely to rise, this spread must be some combination of a pure term premium, a counterparty risk premium and a liquidity risk premium. We believe it reflects primarily liquidity risk.

Currently liquid banks are reluctant to make interbank term loans today, even at nearly seven per cent, because they fear that they and their borrowers may be illiquid three months from now. The Bank should inject liquidity with a three-month maturity to reduce the liquidity premium and kick-start lending. Accepting a wider range of eligible collateral – punitively priced, of course – would enhance the effectiveness of this.

We know that the chancellor authorised the Bank to support Northern Rock. But is the support uncapped and open-ended, as Northern Rock informs us? What is the premium? Exactly what collateral will be offered and how will it be priced? Taxpayers’ money is at risk. The chancellor should make public this information and if he does not, parliament should insist.

The Bank’s credibility is being sacrificed for a bail-out of a systemically insignificant mortgage lender that looks at least partially politically motivated. The chancellor wants to protect depositors and does not want a bank failure on his watch. Depositor protection, however, is the job of the FSA and the Financial Services Compensation Scheme. Redistribution of income is the Treasury’s province. If the Bank is part of the inevitably political bailout of individual banks, its independence in the realm of monetary policy could be compromised.

Labels: Economics, Financial Markets, Monetary Policy, Politics

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.

Labels: Economics, Financial Markets, Monetary Policy

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.

Labels: Economics, Financial Markets, Monetary Policy

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.

Labels: Economics, Financial Markets, International Trade, Monetary Policy

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.

Labels: Economics, Financial Markets, Monetary Policy

Labels: Economics, Ethics, Politics

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. It‘s not the government‘s 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 I‘m 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

Labels: Economics, Financial Markets, Monetary Policy, Politics