Page 2 of
3 SUBPRIME
ICEBERG A YEAR LATER And the band played
on By
Julian Delasantellis
On Fox News, a
guest opined that the subprime crisis was a prime
reason why Bank of America should not offer credit
cards to illegal Mexican immigrants.
In
many dark corners of the far right blogosphere,
the blame is placed where it perennially is on
these sites - with Bill Clinton. Supposedly,
Clinton’s 1993-97 Secretary of Housing and Urban
Development, Henry Cisneros, regularly gave
speeches during his term calling for increased
minority home ownership, so, like a Manchurian
Candidate of the markets, the whole subprime mess
is nothing but a dastardly long term
Clinton/liberal machination to sabotage American
capitalism.
A somewhat more reasoned
assignment of blame (which, as I
have
said here frequently, is far more important in
modern-day, sharply politically polarized America
than finding solutions) posits that the blame for
the subprime mess lies with the fact that, during
the early years of this decade, the Alan Greenspan
Federal Reserve kept short-term interest rates too
low for too long.
Surface
merit On the surface, this argument seems
to carry some merit, certainly more than the one
that places the blame on a more than a decade old
Bill and (especially) Hillary Clinton plan to lead
an African-American army of urban undesirables on
an invasion of the gas barbecues and swimming
pools of the backyards of white suburbia.
It is said that inflation, like the huge
price inflation of US residential real estate this
decade up to 2006, is a monetary phenomenon, in
that it is caused by too much money chasing and
bidding for too few goods. Low short-term interest
rates foster monetary creation, in that they make
private bank lending into the general economy
easier.
Low short-term interest rates are
certainly what we had; the Federal Funds target
rate, currently at 3%, was under 2% from December
2001 to November 2004 - it even sank to 1% from
June 2003 to June 2004. Just try impressing on
young economics students nursed since the crib on
immediate gratification the value of savings and
thrift when banks are paying a 1% annual rate on
deposits, when, even with compound interest it
takes 72 years to double your money.
In a
speech to Friday’s Monetary Policy Forum, outgoing
president of the St Louis Federal Reserve Bank
William Poole seemed to endorse the view that the
Fed was too generous for too long: "With the
benefit of hindsight - and the importance of the
word 'hindsight' should be emphasized - it is not
hard to argue that the FOMC [the rate-setting
Federal Open Market Committee] was too slow to
raise the federal funds target after taking the
target down to 1% in 2003."
Of course,
Poole’s mea culpa contrition might have carried
more credibility had he not possessed the
reputation of most times thinking that interest
rates are too low; in the same passage he says
that the Fed also kept rates too low for too long
during the easing cycle that followed the failure
of the Long Term Credit Management (LTCM) hedge
fund in 1998. Probably left on the cutting room
floor of the 1996 science fiction classic
"Independence Day", when the President meets with
advisers debating what to do as alien spaceships
destroy American cities, is the scene that has
Poole advising that, whether or not the military
uses nukes on the invaders, the Fed must not lower
interest rates.
Above, I said that a more
appropriate appellation for what’s going on here
would be to call the entire thing the structured
finance crisis, rather than the subprime crisis.
By calling these events what they really are, it
aids in our understanding of them, maybe even
shines light on a solution.
Many times on
these pages I’ve written that the real,
economy-threatening dynamic of what’s going on
here lies not with the poor borrowers now being
thrown out of their houses but with what happened
when the mortgage paper started moving higher up
in the finance food chain. There it got chopped
up, minced, sliced and diced, into the new fangled
financial products we call structured finance, all
the while then becoming available to be used as
collateral for successive new rounds of even more
borrowing and lending.
Ghastly
sights Winston Churchill once said that one
thing you should never watch happening was the
creation of either sausage or legislation; to
these you can probably add the undesirability of
watching the creation of modern structured finance
products.
The international bank capital
regulation regime known as Basel II was designed
to prevent just this sort of private sector daisy
chain expansion of the money supply, by only
allowing new loans on the basis of the actual
collateral value of old loans. However, the smart
lads working in the structured finance departments
of all the biggest Western financial institutions
soon found the loophole they needed.
As I
explained last July, (Of termites and index
mania, Asia Times Online, July 3,
2007), the banks found that they could inflate the
values of their existing structured finance
products, in order to provide the collateral to
produce even more structured finance products,
through an arcane process called mark to model,
rather than the standard way of marking bank
assets to real values, called marked to market.
This was the process that generated the
tremendous wave of liquidity that smashed up
against the shores of American, and to a certain
extent world, real estate up to 2006. You could
say that the US Federal Reserve had a role in
this, not so much through its low interest rates
but through its acquiesce in the abandonment of
any pretense of prudent financial regulation that
followed upon the go-go laissez-faire
regulation-is-bad ethic of the administration of
George W Bush.
In an article in the
January-February edition of the New York Federal
Reserve Bank’s "Current Issues in Economics and
Finance", Tobias Adrian of the Bank’s research
department and Hyun Song Shin of Princeton
explained how this process acts as, in effect, a
monetary policy all by itself, frequently in
diametrical opposition to the preferred policy put
in place by the central bank.
We find that institutions increase
their leverage during booms and reduce it during
downturns. Thus, contrary to common assumptions,
financial institution leverage is pro-cyclical;
the expansion and contraction of balance sheets
amplifies, rather than counteracts, the credit
cycle. A closer look at the fluctuations in
balance sheets reveals that the chief tool used
by institutions to adjust their leverage is
collateralized borrowing and
lending.
Thus, even as the Federal
Reserve was raising interest rates from 2004 to
2006, hoping to rein in the growth of monetary
aggregates, the private financial sector was
expanding the money supply all by itself, creating
the excess financial liquidity that fueled the
housing bubble.
Adrian and Shin describe
how this monetary legerdemain worked to boost
prices of all assets in the economy, including,
and especially, real estate:
Increased demand for the asset tends
to put upward pressure on its price, there is
the potential for a feedback effect: the
stronger balance sheets lead to greater demand
for the asset, and this outcome in turn raises
the asset’s price and further strengthens the
balance sheets. Having come full circle, the
feedback process goes through another
turn.
Now, of course, the Fed is
lowering interest rates, taking 225 basis points,
2.5%, off the Federal Funds target rate since
September. They’re trying to counteract the
effects of the gathering subprime/structural
finance bust, but, once again, Adrian and Shin
explain how the private sector money creation
machine is working at cross purposes to what the
central bank desires.
During downturns, the mechanism
works in reverse. Consider a scenario in which
asset prices decline. Then, the net worth of
institutions will fall faster than the rate at
which their assets decrease in value. As the
institutions’ balance sheets weaken, their
leverage will increase. Since these institutions
are targeting pro-cyclical leverage, however,
they must attempt to reduce leverage in some way
- in some cases, quite drastically. How do these
institutions reduce leverage? One way is to sell
some assets, then use the proceeds to pay down
debt. Thus, a fall in the price of the asset can
lead to an increase in the supply of the asset,
overturning the normal supply response to a drop
in asset price.
If we further
hypothesize that greater supply of the asset
tends to put downward pressure on its price,
then there is again the potential for a feedback
effect. Weaker balance sheets lead to greater
sales of the asset, and this outcome in turn
depresses the asset’s price and leads to even
weaker balance sheets. But weaker balance sheets
will kick off another cycle of selling and price
declines.
This is the mechanism by
which the $400 billion of subprime losses, as
described by Friday’s Monetary Policy Forum, will
turn into the $900 billion in reduced lending from
the financial system to the general economy.
The analyses of Adrian/Shin, along with
that of Hatzius et al, sounds rather grim, but
Hatzius et al realize that there is a fairly
simple solution to the problem.
It's
all about money ... Like all problems in
economics, it’s all a question of, well, money.
The economy became used to getting its money fix
from the private sector, but now the financial
system just can’t print it like it used to. Until
those funds are replenished back into the system,
the damage will continue, no matter how many
realtors or stock market flacks you hear on TV,
panting like dogs on a hot day, that it’s a great
time to buy.
Hatzius et al propose two
solutions. One would be that private sector
lending contracts sufficiently that a bank’s
loans, a bank’s assets, fall back into line with
the proper ratios for what it has as its
liabilities.
Ouch. That’s what’s happening
now. That’s the origin of this new recession.
There’s every reason to believe that solving the
problem in this manner will be a long, and
increasingly painful process; as I’ve said here
many times, and as illustrated in Adrian and Shin,
falls in lending lead to more falls in asset
prices, which leads to more falls in lending; on
and on it goes-where it stops nobody knows, but
it’s got to be unpleasant.
The second
option is for the banks to recapitalize; instead
of shrinking the bank’s asset and loan portfolio
to match its now reduced capital base, why not
have the bank attract sufficient new capital to
support an expansion of lending?
Ever
since the crisis broke hard in August, I’ve been
saying that this function would be performed by
the $3 trillion or so of government controlled
foreign wealth, mostly that of Middle Eastern oil
and Asian export economy nations, that are pooled
into what is called "sovereign wealth funds"
(SWFs). (I first wrote about the prospect of SWFs
saving the markets last August When the big guns fail, call in
China, Asia Times Online, August 21,
2007.)
Last fall, it appeared that the
prediction was coming true, as the
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