Page 3 of 4 Monetarism enters bankruptcy
By Henry C K Liu
Reserve Bank of Kansas City's Annual Economic Symposium at Jackson Hole,
Wyoming:
Importantly, the easing of some traditional institutional and
regulatory frictions seems to have reduced the sensitivity of residential
construction to monetary policy, so that housing is no longer so central to
monetary transmission as it was. In particular, in the absence of Reg Q
ceilings on deposit rates and with a much-reduced role for deposits as a source
of housing finance, the availability of mortgage credit today is generally less
dependent on conditions in short-term money markets, where the central bank
operates most directly.
Most estimates suggest that, because of the reduced sensitivity of housing to
short-term interest rates, the response of the economy to a given change in the
federal funds rate is modestly smaller and more balanced across sectors than in
the past. These results are embodied in the Federal Reserve's large econometric
model of the economy, which implies that only about 14% of the overall response
of output to monetary policy is now attributable to movements in residential
investment, in contrast to the model's estimate of 25% or so under what I have
called the New Deal system.
The econometric findings seem consistent with the reduced synchronization of
the housing cycle and the business cycle during the present decade. In all but
one recession during the period from 1960 to 1999, declines in residential
investment accounted for at least 40% of the decline in overall real GDP, and
the sole exception - the 1970 recession - was preceded by a substantial decline
in housing activity before the official start of the downturn.
In contrast, residential investment boosted overall real GDP growth during the
2001 recession. More recently, the sharp slowdown in housing has been
accompanied, at least thus far, by relatively good performance in other
sectors. That said, the current episode demonstrates that pronounced housing
cycles are not a thing of the past.
My discussion so far has focused primarily on the role of variations in housing
finance and residential construction in monetary transmission. But, of course,
housing may have indirect effects on economic activity, most notably by
influencing consumer spending. With regard to household consumption, perhaps
the most significant effect of recent developments in mortgage finance is that
home equity, which was once a highly illiquid asset, has become instead quite
liquid, the result of the development of home equity lines of credit and the
relatively low cost of cash-out refinancing.
Economic theory suggests that the greater liquidity of home equity should allow
households to better smooth consumption over time. This smoothing in turn
should reduce the dependence of their spending on current income, which, by
limiting the power of conventional multiplier effects, should tend to increase
macroeconomic stability and reduce the effects of a given change in the
short-term interest rate. These inferences are supported by some empirical
evidence.
Bernanke was still twiddling his theoretical thumb in
the comfort of his institutional bunker while the whole financial world was
falling under a credit fire storm. With the awesome data collection capability
at his disposal, the Fed chairman's radar apparently totally missed the
possibility of systemic collapse of the non-bank credit market on structured
finance from chain-reaction effects of rising subprime mortgage default.
Wealth effect reversed
As the housing bubble burst, home equity loans collateralized by inflated home
prices were putting most home mortgages under water and an increasingly large
number of home equity borrowers in default. The sudden reversal of the wealth
effect was about to destroy the global economy, albeit with a time lag, as
Bernanke gave his reassuring speech based on faulty economic theory.
Before the credit crisis developed in July 2007, institutional clients of
global money center banks had a range of non-bank options to access funds. Such
options included the US$1.2 trillion short-term commercial paper market
collateralized by solid asset price and cash flow prospects. Interest rates for
commercial paper were normally lower than bank credit rates. Borrowers used
banks credit mostly as a temporary backup in the unlikely event that a rollover
of maturing commercial paper debt faced unforeseen temporary difficulties.
The credit market went into shock when the commercial paper market abruptly and
effectively seized and stayed frozen to all borrowers in mid July. Banks
suddenly had to rely solely on inter-bank funding to provide promised credit to
clients at a time when cash supply was expected to be squeezed by the usual
year-end liquidity shortage. Banks all over the world whose costs of borrowing
are based on the London interbank offered rate (LIBOR) market found LIBOR
jumping to 202 basis points (2.02 percentage points) above US Treasuries in the
third quarter of 2007.
Only after the commercial paper seizure hit LIBOR did the Federal Reserve
belatedly realize that the credit market was not clearing efficiently. Half of
the world's outstanding finance of $150 trillion, which includes financing for
derivative trades, is routinely tied to LIBOR rates. The risk of global
recession from widespread toxic infection of the entire credit market caused by
rising defaults of US subprime loans was creating panic in the market. The Fed
and the Treasury, official guardians of a stable financial market, were the
last parties to know that a systemic crisis was about to implode and had only
hours to act from their offices in New York when government officials were told
by the management of major US financial institutions that they would be unable
to meet their global obligations when markets opened in Asia.
Again, an injection of liquidity to forestall an imminent financial crisis was
administered by the Fed, notwithstanding that the crisis was in essence an
insolvency problem of too much debt with insufficient revenue. Illiquidity was
merely the outcome, not the cause. Corporate profit, as measured by the US
Commerce Department, fell $19.3 billion in the third quarter 2007, as domestic
earnings dropped to $41.2 billion. Yet the drag from sagging US sales and huge
financial write-downs from credit losses were offset by still robust earnings
abroad, amplified by a weakening US dollar.
Operating profits for SP 500 companies fell 2.5% in the third quarter, the
first drop in more than five bubble years. Much of the damage was initially
concentrated in the financial sector, where operating earnings fell 25%, as
banks and brokerage houses suffered losses from subprime mortgages holdings and
related investments.
The credit crisis that imploded in July 2007 was not a Black Swan event that
could not be predicted. It actually began in late 2006 when inevitable
residential subprime defaults that had been warned of by a few lonely analysts'
voices years earlier were finally being reported in the general print media and
popular TV programs on finance. The general consensus continued to claim the
economy to be fundamentally sound. Pundits at the Wall Street Journal, CNBC and
Bloomberg told the clueless public to take advantage of buying opportunities as
the market headed south.
By the end of the first quarter of 2007, speculative institutional buyers of
investment properties at overblown prices began having problem accessing easy
credit to close their overpriced deals. Nervous investors in high-yield fixed
income debt began redirecting their funds towards risk-free Treasury notes and
bills, driving prices up and interest rates down. Balance sheet loans (cash
generated from operations) from banks and insurance companies were still
available but at far more conservative credit terms and higher rates. Still,
mainstream analysts were insisting the sky was not falling.
The pace of securitization, including commercial mortgage-backed securities
(CMBS) issuances, slowed moderately during 2006 and 2007 from the fast pace set
between 2002 and 2005, especially for high-leverage private sector issuers. The
trend was hailed as a successful soft landing by mainstream pundits while in
reality any slight loss of upward price momentum is lethal for a debt bubble.
The stock and bond markets reacted to the rising rate of delinquencies among
subprime residential borrowers as the housing bubble deflated. Investors lost
confidence in even the top-rated tranches of the securitized subprime loans and
all asset-backed securities became illiquid. Hedge funds managed by Lehman,
Bear Stearns, Merrill Lynch, Goldman Sachs and others that had purchased
subprime asset-backed securities (ABS) reported huge losses as their portfolios
were marked to market. Globally, off-shore hedge funds and major banks in
Germany and France that invested in subprime ABS also reported significant
losses. Investors seeking to increase returns had leveraged their
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
