Fed Intervention and Moral Hazard

Imagine living a world with no insurance, there's no health insurance, fire insurance, auto insurance, unemployment insurance, Social Security, nothing of this sort at all. As we know from countries such as China, when insurance is not widely available households tend to increase their savings, i.e. to increase their precautionary saving balances.

But in a world with insurance, consumers are able to reduce these precautionary savings considerably. In doing so, they can be more exposed to risk from large shocks. If you are relying upon your insurance company to pay for the loss if your house burns down, your car is wrecked, or you have a costly health problem, etc., and hence have not left sufficient available liquidity to cover these contingencies yourself, and if the insurance company does not pay off as expected, things could be pretty tough. With insurance, people do not leave as much margin for error along a lot of fronts, they reduce their precautionary balances, and failure of an insurance company to payoff as expected could cause severe financial distress, distress that might not have occurred without the dependence on insurance.

This is different than another way of increasing risk, moral hazard. If I get fire insurance, I can reduce my precautionary balances as described above, and this leaves me more exposed than before if the insurance company fails. But if I then start to use real candles on my Christmas tree, don't bother to get the fireplace cleaned, don't bother to clear the dry brush around the house, etc., then that is moral hazard.

Moral hazard is a form of market failure and, as such, we need to avoid it. One way is not to provide insurance at all. No insurance, no moral hazard, simple. But there are other ways of dealing with the problem that can reduce its negative effects without causing us to give up on providing insurance. For example, co-payments and deductibles are both ways of reducing moral hazard. The idea is to make the insured pay part of the cost when there is a payout so that they will reduce the incidence of avoidable risks.

Turning to mortgage and financial markets, I see nothing at all wrong with participants in those markets expecting the Fed to stabilize the macroeconomy. In essence, the Fed is providing insurance against volatility in the overall economy and of course traders are going to anticipate that if the economy turns downward, the Fed will adjust rates. They should expect that and take it into account in their decisions.

But just as with regular insurance, this can induce moral hazard and that seems to be what most of the discussion surrounding whether the Fed should intervene is about - by providing the insurance to the macroeconomy does the Fed also provide the motivation for moral hazard behavior (excessive risk taking)?

There is that chance, and likely that reality, but just as with regular insurance the solution is not to withhold coverage, i.e. for the Fed to do nothing in the face of an apparently weakening economy to avoid creating poor incentives going forward. We know a lot about how to solve moral hazard problems and there's no reason at all those cannot be applied to these markets to reduce this problem.

When necessary, the Fed needs to intervene to stabilize the macroeconomy, moral hazard or not. Just as you would anticipate your insurance company paying off if there was a fire, and just as you might face bankruptcy if it did not pay, participants in financial markets anticipate the Fed will provide insurance to the macroeconomy (as it always does), and they may face financial difficulties if it does not.

There's nothing wrong with financial market participants expecting a stable environment, and reducing their precautionary balances (e.g. their cash positions) in response just as you would reduce your precautionary saving. It's the moral hazard part we want to avoid and, as I noted above, there are many, many ways to intervene into these markets to reduce market failure from moral hazard in the future, and those can and should be applied whether the Fed intervenes now or not.

There is an exception to when insurance should pay off, of course, and that is if (for example) you willfully burn down your own house. I want to be careful here. If I have insurance, and a behavior is not ruled out and it causes a payoff, I have not crossed any moral lines, I have simply acted according to the economic constraints that are in place. If there's no deductible on my auto insurance and no co-pay, if everything is 100% covered, then I won't be so careful about how I park or about getting small dents, etc., they're covered. If the insurance company's customers then take excessive risks, and payouts are so high that the insurance company crashes, that is not the customers fault. The incentives need to be fixed to make the insurance viable.

Did participants in mortgage markets do the equivalent of burning down their own houses, or were they simply acting according to the constraints the insurance company (i.e. the Fed) had in place? I'm sure there were some who set the place afire themselves, but I believe the preponderance were simply behaving according to the rules of the game.

Payoff now, as promised, i.e. stabilize the economy if needed and don't worry about who gets bailed out in the process (but prosecute the arsonists). It may look like a big bailout, the Fed may have to intervene before signs of problems in the overall economy are evident due to lags in monetary policy, but there should be no hesitation about intervening to stabilize economic conditions.

We need to fix the markets so that the incentive to engage in moral hazard type behavior in the future is substantially reduced, no doubt about it. But what we shouldn't do is withhold insurance altogether just because we are worried about creating moral hazard problems in the future. That's not the best way to fix the problem.

Update: In comments, knzn adds:

We don't just want to prevent people from taking excessive risks; we also want to encourage people to take appropriate risks. In fact, the latter is what we mostly want to do: Because risk often cannot be sufficiently diversified, the risk-takers experience personal costs of failure that are not matched by the social costs.

Update: Martin Wolf and Robert Reich discuss the same issue. Martin Wolf first:

Central banks should not rescue fools, by Martin Wolf, Commentary, Financial Times: ...Ben Bernanke ... said ... he would use “all the tools” at his disposal to contain market turmoil and prevent it from damaging the economy. The Fed has its orders: save Main Street and rescue Wall Street.

Such panic-driven politicisation is almost certain to lead to both overreaction and the creation of bad precedents. What then would be the right response to this latest scrape that supposedly sophisticated financial markets have fallen into?

Policymakers must distinguish two objectives: the first is macroeconomic stability; the second is a sound financial system. These are not the same thing. ...

Everybody knows that the Fed’s job is to stabilise the economy and prevent deflation. Everybody knows, too, that the Fed will investigate the economic implications of the crisis in the credit markets at the next meeting of the open market committee. If prospects seem significantly worse, the Fed will, presumably, cut rates. ...

This brings one to the second objective: ensuring the functioning of the financial system. The question is how to help the system without encouraging even more bad behaviour. This is such an important question because the system has been so crisis-prone... I think of the underlying game as “seek the sucker”: sucker number one is persuaded to borrow too much; sucker number two is sold the debt created by lending to sucker number one; sucker number three is the taxpayer who rescues the players who became rich from lending to sucker number one and selling to sucker number two. ...

So what should the authorities do...? My answer is “nothing”. They should, of course, stand ready to provide liquidity to the market, at a penal rate (since insurance should never be free), and also to adjust interest rates to overall macroeconomic conditions. ...

Burned children fear the fire. If some of the biggest and most powerful institutions in the world have been playing with fire, they need to feel the burns. It is not the central banks’ job to rescue them... It is their job to preserve the banking system and the health of the economy. Neither seems now to be in grave danger.

Decisions made in panic are almost always bad ones. Stick to principles and let the masters of the financial system sort themselves out. They are paid enough to do so, after all.

My point is about protecting the macroeconomy, and about getting the microeconomic incentives correct, so in that sense I think we agree.

Next, Robert Reich, and again, I think we are in substantive agreement:

Stop the Hedge Fund Casinos, by Robert B. Reich, American Prospect: ...Ordinarily, central banks shouldn't bail out speculators. It's bad policy to make money cheaper -- and investments less risky -- after investors have been hoisted with the petard of their own foolishness. That only invites more foolishness next time.

Yet..., ordinary rules don't apply in extraordinary circumstances. That the inability of several thousand lower-income Americans to meet their mortgage payments set off a chain reaction leading to a worldwide credit crunch is ...[an] extraordinary circumstance. This one may require even more intervention by the Fed and other central banks around the world than we've witnessed already. ...

Americans are understandably nervous. Most American households have invested their savings in stocks and bonds. Most have also relied on the rising values of their homes as "nest eggs" when they retire. The fact that the housing bubble has burst while stocks and bonds have lost ground is likely to cause American consumers to cut their spending. Given that consumers comprise 70 percent of the economy, this could push America into a recession. ...

The ... Fed has to bail out the speculators, because we'll all suffer if it doesn't.

That doesn't mean, though, that the irresponsibilities now so clearly revealed in American financial markets should be excused or forgotten.

Hedge funds have been operating huge financial casinos without having to disclose what they're betting on, or why. Credit-rating agencies have cut corners or averted their eyes, unwilling to require the proof they need. They've been too eager to make money off underwriting the new loans and other financial gimmicks on which they're supposed to be objective judges. Banks and other mortgage lenders have been allowed to strong-arm people into taking on financial obligations they have no business taking on.

For the financial market to work well -- to ensure fair dealing and to prevent speculative excess -- government must oversee it. This mess occurred because nobody was watching. The Fed and other central banks now have to clean it up. But regulators in America, Europe and Asia have to make sure it stays clean. Hedge funds have to be more transparent. Credit-rating agencies must not have any relationship with underwriters. Banks and mortgage lenders should be better supervised. Finance is too important to be left to the speculators.

Comments

[robertdfeinman]

I think you need to separate the discussion into personal behavior and institutional behavior.

People have insurance to deal with catastrophic events. One cannot set aside enough money to replace a home or to pay for serious illness. A single treatment of cancer chemo-therapy can cost $100,000 these days. Most people will tell you that the fire insurance doesn't compensate for the loss of their personal history as contained in their possessions either.

With institutional behavior the situation is different. In general those with enough money to gamble in hedge funds and the like can take the hit. There will always be a few poor souls who will be bankrupted, but then this is also true of those who play the horses to excess.

On the other hand those who are placing the bets, that is the hedge fund managers and the traders at the big financial firms are not at risk. They are not using their own money and the worst that can happen to them is that they will lose their job.

To get back to the point that has been made before with regard to the sub-prime loans, the mortgage brokers, agents, home inspectors and rating agencies had no skin in the game. They took their fees and moved on.

The fault is that those captaining the boat are not on the bridge, but safely on shore radioing in directions. Nothing happens to them when the ship hits the iceburg.

[sw]

The problem with this analogy is that no one is punished when an insurance company pays to rebuild the burnt house. When the Fed comes to the rescue, savers get penalized.

[Not an Austrian]

You also miss an important fact. The Fed doesn't have a clue what is going on with the CDOs etc. All of these contracts are private financial documents that are not public. The regulators had a hands off policy in the markets. They most definitely did not "set the rules."

That, of course, is likely to change. But given that many of the financial players in these markets aggressively sought no regulation, the moral hazard problem here is absolutely huge and unsustainable for a financial system in the long run.

I think Bernanke should follow his theoretic arguments and wait until we actually see the real economy taking a hit. I have no problem with aggressive policy to support the economy, but prophylactic interest rate drops are most definitely not in order.

[David]

However, with auto insurance, the costs of the premiums aren't paid by people who don't own cars. And the rates are adjusted based on a driver's history. If we are talking about bailing out individual homeowners and investors, we are imposing costs on everyone. In addition, this would keep prices artificially high, further punishing people who aren't already in the market.

There are compelling reasons to publicly insure some things (health, natural disasters, etc). But I don't think getting people into houses they can't afford is a compelling public interest.

[Lee A. Arnold]

Mark, as a mere plumber, just let me comment that I think you are right. Except for hoping for proper regulation after this, which never happens, or gets rolled back under cover. You also have to engineer the bailout so the dollar doesn't drop precipitously, or we're going to have $100-a-barrel oil... Only mildly exaggerating... And also: WE SHOULD NEVER HAVE TO HEAR AGAIN that Social Security will be insolvent in 30 years, or that universal healthcare won't work, or that illegal immigrants are going to destroy the country, or any of the other FREE-MARKET LIBERTARIAN BULLSHIT that passes for an intellectual conversation in this country. No more smoke and mirrors... But I'm guessing that will never happen either! Pardon the language, but I'm a plumber.

says...

Why should the FED provide insurance against interest rate changes when there are fixed interest rate loans? Sure, those loans are more expensive but that's because they provide insurance against changes in the interest rate... duh!

[knzn]

David: "If we are talking about bailing out individual homeowners and investors, we are imposing costs on everyone."

And we are perhaps creating benefits for everyone, too, if the alternative to a bailout is a recession.

Not an Austrian: "I have no problem with aggressive policy to support the economy, but prophylactic interest rate drops are most definitely not in order."

Backward-looking policy is exactly what got us into this mess. If Greenspan had introduced "prophylactic interest rate increases" in 2003, much of the subsequent overleveraging might have been avoided. I don't see what is wrong with forward-looking policy.

sw: "The problem with this analogy is that no one is punished when an insurance company pays to rebuild the burnt house."

That's not true. The insurance company's other customers are punished, because premiums go up (unless the company sees the event as an isolated one that needn't figure in its underwriting).

robertdfeinman: Good point. The moral hazard argument is problematic if the people being bailed out are not the ones responsible for the bad behavior.

It may be my own fault for not reading enough, but I have yet to hear a clear example of the moral hazard associated with easing monetary policy in response to a liquidity crisis. We don't just want to prevent people from taking excessive risks; we also want to encourage people to take appropriate risks. In fact, the latter is what we mostly want to do: Because risk often cannot be sufficiently diversified, the risk-takers experience personal costs of failure that are not matched by the social costs.

[Winslow R.]

Mark wrote: "We need to fix the markets so that the incentive to engage in moral hazard type behavior in the future is substantially reduced, no doubt about it."

Given the Fed can turn ANY 'bad' investment into a 'good' investment by targeting certain asset classes, which is what they are doing, the ability to distinguish moral hazard has been blurred.

Just the need to switch from tsy secs to MBS indicates system failure even if it is within their charter. The system is compromised.

The system will continue to be compromised as long as the yield curve can be leveraged and that leverage concentrated by banks and their hedge fund buddies.

see graph on page 4 of the document (5 of the file)
http://www.levy.org/pubs/wp_511.pdf

to see how often the yield curve has been inverted for the time range from 1969 to 2006.

Anyone that can borrow short and lend long and leverage to the hilt will make a killing. The temptation of easy money, even for the short term, is too great to resist.

1) Is it possible to avoid building a financial system on leverage?

I say yes, but perhaps too extreme.

2) Could we at least avoid concentrating leverage so that monetary cycles can be more responsive to monetary policy without having to fear meltdown?

Yes, but the process is so very slow.

[Winslow R.]

Makin writes :

"Another aspect of the global financial crisis is the unwinding of the famous "carry trade," wherein Asian and other investors finance themselves in Japan at very low interest rates and invest the funds in higher-yielding securities generated largely by the now-chaotic and collapsing U.S. mortgage markets. The U.S. investment banks discovered this great game in 2004: sell to yield-hungry Asians mortgage-backed securities with yields above Treasuries. The Asians specified that the securities should be rated AAA, so Wall Street's financial engineers colluded with rating agencies Moody's and Standard & Poor's to create securities derived from collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) with a higher yield and a AAA rating. Large pools of money from Asia and oil-exporting countries were eagerly poured into mortgage and related investments, with the capstone being the Chinese government reserve fund's $3 billion investment in Blackstone's initial public offering for shares that have now dropped in value by more than 30 percent. "

http://www.aei.org/publications/pubID.26713/pub_detail.asp

[David]

knzn

Should the government have aggressively propped up stocks in 2000 to prevent the market from falling? We need to find a way to allow people to get on with their lives and to minimize the hard times ahead, but propping up an asset bubble hurts everyone but the asset owners.

There is nothing wrong with easing monetary policy in response to a liquidity crisis. But there IS something wrong with easing monetary policy in response to an insolvency crisis. If an entity is fundamentally underwater, giving them access to easy money will just prolong the inevitable crash and make that crash bigger. A simple example:

A guy takes out an interest only mortgage and buys a house that is overvalued. The rates are fixed for a couple years which he can afford, but the house loses value - he owes more than the house is worth. When the rates start floating, he can't afford the monthly payments. I think the sensible thing is for the bank to foreclose and for the guy to rent a place he can afford. However, if we ease monetary policy, maybe he can refinance and continue to lose equity for 2 more years at which point the bank will lose even MORE money foreclosing on him. All the while, the easy credit is keeping the home off the market where people who can actually afford it might buy it.

[knzn]

David: "Should the government have aggressively propped up stocks in 2000 to prevent the market from falling?"

With today's hindsight, I would say the Fed should have been a lot more aggressive than it was in response to falling stock prices. The occurrence of a subsequent economic slump is prima facie evidence that the error in that case was one of insufficient stimulus.

"There is nothing wrong with easing monetary policy in response to a liquidity crisis. But there IS something wrong with easing monetary policy in response to an insolvency crisis."

The difference between illiquidity and insolvency is not so clear cut, because insolvency can be a self-fulfilling prophecy. The fundamental value of assets depends on the condition of the economy, which depends on the Fed's reaction to a liquidity crisis, so a liquidity crisis, if badly handled, could turn into an insolvency crisis. That seems to me to be a good reason to prefer erring on the side of too much ease during an ambiguous (illiquidity or insolvency, to be determined later by looking back) crisis, rather than too little ease.

[David]

I live in the Bay Area (where the economy is doing well). Something like 11% of the households can afford the median house by traditional measures. This is not sustainable. And suggestions to the contrary are silly. Our economy would have to be growing as fast as China's for the housing prices on the coasts to be sustainable. The only way to prevent a correction (in nominal term) is massive inflation and that is cure much worse that the problem. The line between illiquidity and insolvency is a fuzzy one, but out here (and in other bubbly markets), we are very far from that fuzzy line.

[ndd]

Sorry, Dr. Thoma, I don't buy into your analogy at all.

An insurance company which has collected premiums is paying off a claim with its own money.

What you suggest is that some legbreakers go around to all the neighbors who didn't "use real candles on my Christmas tree, didn't neglect the fireplace, and didn't allow dry brush to pile up around the house," and shake them down to pay off the one who did.

No dice.

[esb]

The community of university-based economists has become far, far, far too comfortable with the creation of inflation, the use of inflation as a tool of behavioral incentivization and the dishonest reporting of the level of inflation ... and with the excessive creation of debt as the solution to the problem of, well, the excessive creation of debt.

The USA has just witnessed a doubling (and in some areas tripling) in residential real estate prices in a relative short number of years. Permit a nominal giveback of a third to a half of that increase and you will not have a moral hazard problem in the USA for a long, long time.

A recessionary year (2008) is reasonable price to pay for the purge.

[Not an Austrian]

knzn
"Backward-looking policy is exactly what got us into this mess. If Greenspan had introduced "prophylactic interest rate increases" in 2003, much of the subsequent overleveraging might have been avoided. I don't see what is wrong with forward-looking policy."

Backward looking policy did not get us into this mess. A ridiculous bias against market regulation got us into this mess. Anyone with a knowledge of economic history knows that economic stability requires heavy regulation of financial institutions and markets.

When it's side effects are minor I agree that forward looking policy is okay. When the side effects are worse than the disease, forward looking policy is a disaster.

[Not an Austrian]

knzn

The traditional way to address a liquidity crisis is to lend liberally at penalty rates. Lowering interest rates is not an intelligent way of dealing with a liquidity problem. It is a good way of creating an inflation/asset price problem.

[pcs]

You know I really have trouble understanding what has really changed on the macroeconomic level in the last few weeks. The new/existing home sales numbers have been anemic and on the downward slope for more than a year now. The same can be said for defaults… Anything else from the list of leading indicators does not seem to be much out of ordinary. Please do not tell me that we only now suddenly realized that housing downturn might push the whole US economy into recession. If that was not a concern six weeks ago, or six months ago, it should not be now, right?

The only difference that I can clearly see here is that one industry is swiftly slipping into recession – Financial. Now my question is if it is not Government job to favor and try to save any other US industry (try for example textile, steel, automotive, or numerous others that have been struggling recently), why does everybody screams about saving the Financial now?

I am sure that not saving them would be painful, but I do not think that saving them would help the overall economy either. The way I see it, the only result of making more money available to Wall Street would be start another bubble – this time back to the stock bubble fueled by LBO deals. After exhausting the consumers and leaving them with a mountain of debt while pocketing enormous fees, they will just move on and start destroying good companies with healthy balance sheets and leaving them with a burden of unnecessary debt.

Any rate cut(s) at this point would not do anything but continue the enormous misallocation of newly available funds from the Feds we have seen in the last few years. That process diverted a mind boggling amount of money from the general population that could spend it and from the companies that could develop new products and services to fill the new needs into something as unproductive as overbuilding houses and bidding their prices to the levels that left them essentially outside of the reach of average family.

[anne]

"The traditional way to address a liquidity crisis is to lend liberally at penalty rates. Lowering interest rates is not an intelligent way of dealing with a liquidity problem. It is a good way of creating an inflation/asset price problem."

This is precisely the nuttiness of Austrianism; an ideal expression of Austrianism in 3 sentences. Remember this, and save reading hundreds of thousands of words of nonsense.

[Not an Austrian]

Anne:

I've never read the Austrians. This is Bagehot. First economist to explain clearly the role of a central bank.

[donna]

But the insurance company usually doesn't give you gasoline and matches for your kids to play with.....

[Bobby]

People pay for insurance .... maybe this is the start of having auto, home etc insurance without paying a for it and let the government (taxpayers) cover it.

[im1dc]

The FedRes, AKA the Central Bank, is operating like a Central Bank of, for and by Wall Street Money Center banks, not of, for and by the people.

Disregard rhetoric and focus solely upon what they do.

[anne]

Oh, I understand, but ask why the Federal Reserve did just the reverse, lowering the cost of using the discount window? Trust me, I know you are not an Austrian, but your description passes perfectly.

[David]

Mark,

What is the proposed mechanism for an intervention that you and Reich favor? I doubt you'd dispute that real estate is far out of line with fundamentals in many markets. Do we just throw good money after bad and temporarily prop up unsustainable prices? Do we inflate away the debts? How exactly is the Fed going to "bail out the speculators" in a way that we can get back to fundamentals? Whether tulips, pets.com, or $800,000 starter homes, the party can't last forever.

[Not an Austrian]

Anne:

Nobody used the discount window before because it was always 1% above the FFR. Notice that recent discount window bank loans were at a penalty rate of 0.5% relative the the official FFR and 1% relative to the effective FFR.

I think Bernanke understands Bagehot, but we will see whether the loose money folk win this debate.

[RW]

The greatest moral hazard I see was already committed by the policy makers including the Fed and that was the weakening of Glass-Steagall
and other measures designed to create barriers against what has already occurred; e.g., banks and their allies with far greater information/leveraging power using my money to invest on their own account(s) ahead of me; they receive benefits and protections as putative servants of the economy but have become parasitic.

When elephants fight, the grass suffers, as the old proverb goes and the Fed appears to merely be the leader of the herd.

[knzn]

ndd: You make the same argument as “sw” above, and it’s still wrong. Insurance is a fairly competitive industry, and insurance companies have to maintain enough profitability to keep their business viable. Accordingly, it is ultimately not “its own money” that an insurance company uses to pay claims; it is the premiums of future policyholders (and to a large extent, past policyholders, because the insurance company will take moral hazard into account in its underwriting: premiums are high because the insurance company knows that some people won’t be careful).

Not an Austrian: “The traditional way to address a liquidity crisis is to lend liberally at penalty rates. Lowering interest rates is not an intelligent way of dealing with a liquidity problem. It is a good way of creating an inflation/asset price problem.”

If all that’s going on is a temporary liquidity problem, then fine, lend liberally at penalty rates. But there is more going on here (and I doubt that there are many examples of “pure” liquidity problems). For example, there is a re-pricing of risk. That means a larger spread between the interest rates (and the implicit shadow interest rates, when credit is rationed) that are relevant for growth/inflation and the policy rate. If the Fed doesn’t cut interest rates, then they are effectively following a tighter policy than they were a few months ago. Also, there is still some question as to whether it is possible to lend sufficiently liberally at penalty rates given the attitude that many institutions still have toward the discount window.

While you say that lax regulation is what got us into this mess, surely you must acknowledge that the interaction of lax regulation and backward-looking policy made the situation considerably worse than lax regulation alone would have. And I don’t see how the side effects of interest rate cuts today would be worse than the disease. There is little or no evidence that the US economy is much at risk for a significant inflation problem. As for asset prices, those are just what the Fed should not be concerned about except inasmuch as they affect the real economy and price inflation.

pcs: “I really have trouble understanding what has really changed on the macroeconomic level in the last few weeks…”

Among other things, credit spreads have risen (see my response to Not An Austrian above). Very little has changed in the real economy, but since financial variables affect the real economy (and inflation/deflation) with a lag, there is reason to be concerned about the ultimate impact of financial events taking place now. The effect probably won’t be visible for months.

“Any rate cut(s) at this point would not do anything but continue the enormous misallocation of newly available funds…”

It is not a misallocation if the alternative is an economy with slack resources.

David: “I live in the Bay Area (where the economy is doing well). Something like 11% of the households can afford the median house by traditional measures. This is not sustainable.”

It is not sustainable with the current set of residents, but there are plenty of rich people in the world who could afford to move there. And affordability is not fixed in stone; it depends on interest rates and incomes, which vary over time, so I’m not even sure it is not sustainable with (at least part of) the current set of residents. I seem to hear your point a lot from people in the Bay Area, though, and I don’t think it generalizes. Surely there are some overvalued markets in the US, and I’m pretty sure there are also some undervalued markets. Here in the Boston area we hear the word bubble a lot, but it doesn’t look to me like the value of my condo is much out of line with the rents charged on comparable units (discounted at an appropriate real interest rate).

[jr66]

The social investment in deregulation has been on the basis of the promise that the market will operate responsibly in a deregulated environment. It hasn't, so do we blame the market for making a promise it never had the self-discipline to fulfil, or ourselves for falling for the promise again, and thereby setting the wrong incentives. And in coming up with an answer, do we have the institutions or capacity to respond properly, and maintain that response over time? If you answer no welcome to the business cycle, if you answer yes, welcome to eternal disappointment.

[David]

"It is not sustainable with the current set of residents, but there are plenty of rich people in the world who could afford to move there."

Wow. If this doesn't describe the last stages of a Ponzi scheme, I don't know what does.

[T.R. Elliott]

There is an assumption in this discussion that the fed can provide enough liquidity to solve the real estate issue. It's not clear to me that is the case. Is it? knzn says we should have had more liquidity as the Nasday dropped. To what end? How much liquidity would have been required in order for people to realize that they made a huge mistake buying overpriced stocks? The bubble burst, and the only way the fed could have stopped that is with rip-roaring inflation. The nasdaq was overpriced.

Now we're looking at housing. It seems to me that according to most measures, housing is overpriced. People now are waking up to this fact.

What is the fed supposed to do in order to stop this? Sure, if the fed needs to lower interest rates to deal with the economy, so be it. But there is an assumption that this will solve the real-estate problems.

I certainly hope people are not proposing that the fed should race to prop up a particular asset class.

[ndd]

knzn:
Nobody put a gun to insurance policyholders' head and ordered them to purchase a policy. They made an economic decision, purchased the policy, and if the insurer pays of ITS MONEY, knzn, ITS MONEY that it has collected in voluntary premiums, out to the irresponsible fire risk, so be it. The Fed is not playing with "its" money. It is picking the pockets of everybody, just as if the insurance company in the last sentence went out and raided the bank accounts of others to create new involuntary policies.

No, I'm sorry, it is you who are wrong. There were people SHOUTING FROM THE ROOFTOPS "YOU'RE PLAYING WITH FIRE!!!!!" and there were "arsonists" in Dr. Thoma's words, and irresponsible homeowners with matches and gasoline cans starting megagasoline grills by the cordite stacked next to their McMansion, and they all ignored the shouters.
Now people like you are telling the people who saw exactly what was coming and warned about it at the top of their lungs for years that they must pay up to the arsonists and those whose steak and lobster barbecues destroyed their McMansions. Many of those same people you want to pay went without steak or lobster but were eating financial chicken instead inside their modest bungalows.

This is class warfare launched by the robber barons and the recklessly irresponsible against the sober and the responsible. I will have none of it.

[T.R. Elliott]

Correction. Instead of "How much liquidity would have been required in order for people to realize that they made a huge mistake buying overpriced stocks?"

I meant to say:

How much liquidity would have been required in order for people to not realize that they made a huge mistake buying overpriced stocks?

In other words, people realized stocks were overpriced. What interest rate would have changed that perception. I say none. We bastically had zero percent real interest, and the Nasdaq still fell.

So housing will likely fall as well. With caveats, since housing can be said to be tied more closely into fed set interest rates. But not so fast. Long term rates aren't set by the fed, and are likely to increase if inflation becomes a concern.

I think housing is coming down. And those who made a bad decision will pay a price.

[gordon]

In his previous post, “Who Should Pay the Price for the Popped Real Estate Bubble?”, Prof. Thoma noted that: ” We made mistakes in the regulatory environment, no doubt about it, and I hope we learn and fix the problems…”. However Prof. Thoma made no specific proposals for regulatory change in that post.

In this post, there is no mention of regulation as such, but instead there is reference to “moral hazard”. Prof. Thoma now says: ” We know a lot about how to solve moral hazard problems and there's no reason at all those cannot be applied to these markets to reduce this problem”. He makes reference to “…co-payments and deductibles are both ways of reducing moral hazard. The idea is to make the insured pay part of the cost when there is a payout so that they will reduce the incidence of avoidable risks”.

Like David, I think perhaps it is now time to get specific about what sorts of regulatory changes or moral hazard management techniques are needed to prevent this sort of situation recurring. I suspect the argument has gone as far as it is going to go on the basis of general principles and Austria. Time to get nitty-gritty.

[ndd]

Gordon: Here's a nice, easy one: the Fed should pay attention to asset prices in setting rates. The Economist magazine has been advocating this for years. If the Fed had done so, it would have raised rates aggressively to work against the stock bubble getting out of hand at the end of the 90s, and it would have done so again with regard to housing prices these last few years.

[quartz]

While the government in the form of the Fed or some other agency should take responsibility for supporting macreconomic stability that very much needs to be the case when there is irrational exuberance as well as when there is turmoil and crashing. In the last decade policy seems i have erred on the side of letting the market be the market when everything is booming, but only to engage when the run up becomes unsustainable. Further, we have a tax system and policies specifically tilted toward "rewarding risk takers" becasue they take risk, but in fact if the risk fails to pay off, the government steps into help. While agree the government should create an environment that encourages risk taking, to the extent tha the governemnt insures against or reduces risks, the rewards should be reduced commensurately.

[knzn]

ndd: “the insurer pays of … ITS MONEY that it has collected in voluntary premiums…. The Fed is not playing with "its" money. It is picking the pockets of everybody”

This is wrong for a couple of individually sufficient reasons. For one thing, just as you aren’t obliged to buy insurance, you aren’t obliged to hold your assets in the form of money. You may need to convert your assets to money for a few minutes when you buy or sell something, but the money won’t lose much value in that time. For the rest of the time, you could hold it all in the form of gold or whatever other durable asset you choose. And the only cost when the Fed creates money is the reduction in value of the existing money which people have voluntarily chosen to hold.

Moreover, even if people were forced to hold their assets in the form of money, that money isn’t going to lose value any faster because there is a crisis to which the Fed responds by easing. The point of easing is to avoid deflation, which would be a windfall for people holding money. You somehow seem to think that you people with your greenbacks buried in the back yard deserve any windfalls you get but somehow have cause to complain when anything doesn’t go your way.

“the Fed should pay attention to asset prices in setting rates”

I’m sure the Fed does pay some attention to asset prices in setting rates, because asset prices are leading indicators, as well as part of the transmission mechanism by which Fed policy affects the economy. I think perhaps it should pay more attention than it does, but only for that reason.

And I don’t agree that “it would have raised rates aggressively to work against the stock bubble getting out of hand at the end of the 90s, and it would have done so again with regard to housing prices these last few years.” At least I don’t think it would have done so to a much greater extent than it actually did (though perhaps it would have got the timing a little better). The Fed did raise rates in 1997 and 1999; it reversed during 1998, when asset prices were going down and the Fed could not know that the decline would be temporary. Similarly it raised rates during 2004-2006 as the housing boom was going on; the problem there was that its rate increases did not have as much immediate effect as expected on the housing market, in part because the long end of the yield curve didn’t cooperate.

What the Fed would have done differently if it were paying more attention to asset prices is that it would have eased more aggressively once the stock market began to tank in 2000.

I sometimes read theEconomist because there’s really no close substitute for it, but I find that the Economist often gets the economics wrong.

[bullbust]

Did participants in mortgage markets do the equivalent of burning down their own houses, or were they simply acting according to the constraints the insurance company (i.e. the Fed) had in place? I'm sure there were some who set the place afire themselves, but I believe the preponderance were simply behaving according to the rules of the game.

They did. Pure and simple.

And the Fed let them do it. Not only did the Fed let them do it, the Fed opposed people who pointed out the problem.

http://interfluidity.powerblogs.com/posts/1161746828.shtml

"..........Why should hedge fund be leveraged at all?

"What?!? Hedge funds are all about leveraged investment strategies!" I know, I know. But hear me out. Hedge funds are for rich people, with lots of capital and risk tolerance, right? So why shouldn't hedge fund investors — people with sophisticated access to capital and credit markets — lever themselves, investing in unlevered funds with their own borrowed money? Theoretically, unless hedge fund investors are trying to take advantage of their creditors by forcing them to bear much of the risk, the return characteristics of a leveraged fund and those of an unleveraged fund purchased with borrowed money are exactly the same. And while investors may enjoy letting their bankers share much of the downside of their investments, there's little reason to think this is good for the rest of us. It hardly seems fair for the public to bear systemic risk in order to enhance the private returns of the wealthy. If hedge funds were themselves unlevered, bank exposures to hedge fund risks would be much less (as investors would have to go bankrupt before banks could get stiffed), and better diversified (as the cost of a big fund meltdown would be spread among the many banks who lent to various investors, rather than concentrated in the one bank that lent to the fund).

...."

Alan Greenspan's Fed actively opposed hedge fund regulation. They also did nothing to regulate mortgage lending.

0% NINJA loans were advertised in every damn media possible - radio, web, newspapers - you name it. The Fed did not know about the fraud and the flipping? Yeah, right.

knzn
"And we are perhaps creating benefits for everyone, too, if the alternative to a bailout is a recession."

Are you? That seems debatable. I know that the banks and the hedge funders benefited nicely. Who else? All the others have is debt. The few who were owning the assets before the bubble made a lot of money by just idly living in their house.

You have this idiotic argument that people were kept employed in housing. I would argue that we could have achieved the same result by the Fed simply printing dollars and handing it out to anyone - say, to anyone who turned up at the local unemployment office and rendered the Star Spangled Banner, say $10 for each rendition. IT WOULD HAVE BEEN MUCH MORE EQUITABLE, THAN THIS GIANT HOUSING BUBBLE WEALTH TRANSFER SCHEME. Yes, this is about money in old bottles in coal mines.

And, yes I have read enough of your fiscal vs. monetary argument. About Bush being so-so. So what? You then go and rig a wealth transfer scheme?

Basically for people like you, this a vast abstract systemic exercise. You and your ilk forget what economics is about - it's about the wants and needs of individuals with heart and soul. We are not some pieces of stone for you to build and bust at your wish.

When will you get down from your ivory tower and understand that?

[knzn]

quartz: “we have a tax system and policies specifically tilted toward "rewarding risk takers" becasue they take risk”

Tilted compared to what? I think that if you compared our tax system to a lump sum tax, you would find that our system penalizes risk taking. The progressivity of the system means that when you get a big payoff, you pay a big tax, whereas if you lose, you don’t necessarily get a big rebate (or any rebate at all). And even a “flat tax” would probably have the same effect to some extent, because it is going to tax gains but not fully rebate taxes for losses. (There are the "tax loss carryforwards" and "averaging" and stuff, but I don't think those really work as well as they're supposed to.)

Now if you compare our system to one with the same tax brackets but no special rules for capital gains and such, then yes, ours is tilted toward rewarding risk takers, but I doubt the rewards are sufficient to make up for the fact that an income tax in general (at least in its practicable form) tends to punish risk-takers. And I personally don’t think that our tax rules are a very efficient way to reward risk takers even compared to another progressive tax system.

[Winslow R.]

bullbust: "Theoretically, unless hedge fund investors are trying to take advantage of their creditors by forcing them to bear much of the risk, the return characteristics of a leveraged fund and those of an unleveraged fund purchased with borrowed money are exactly the same. "

Please expand on your theory as it doesn't fit in my framework. Theoretically, I'd see a 10x levered hedge fund expanding their return on capital by 10x the difference between the cost of borrowed and loaned funds.

Bullbust wrote: "If hedge funds were themselves unlevered, bank exposures to hedge fund risks would be much less (as investors would have to go bankrupt before banks could get stiffed)"

If hedge funds were unlevered bank exposure would be zero unless the hedge fund was the bank.

says...

knzn

If middle income americans were the ones being asked to take risks you might be right. But the ones with the know-how -- either because they work in the industry or because they are rich enough to invest in hedge funds -- to take these risks have enough money to shelter a lot of their returns from taxes.

I don't think anyone needs to be too concerned about the US system over-taxing financial risk takers.

[bullbust]

knzn:
You somehow seem to think that you people with your greenbacks buried in the back yard deserve any windfalls you get but somehow have cause to complain when anything doesn’t go your way.

Your ivory tower is soo high, you have lost sight of reality. Who has greenbacks buried?

The reason asset prices needs to come down is so that it is line with income, so that people don't end up at the loan shark like subprime deals.

And the only cost when the Fed creates money is the reduction in value of the existing money which people have voluntarily chosen to hold.

Again, you have lost touch with reality. You think the really rich hold money? Or care? They persist on low yields from large asset holdings. ( Of which I think you are one, or an academic on tenure)

The only people who lose when the Fed eases are those whose wages don't keep up with the resulting inflation, and people on fixed income.

Tenure and security are really evil for academics who get involved in public policy- it makes them lose touch with the real world.

[knzn]

bullbust: “I know that the banks and the hedge funders benefited nicely.”

Some of the hedge funds are going broke. People seem to imagine that if the Fed cut interest rates a little bit, it would be this huge bailout for everyone who took excessive risks. There may be a few hedge funds for whom an easing would make the difference between success and failure, but the bulk of the risk-takers are either going to take losses (often ruinous ones) in any case or succeed in any case. The main effect of Fed easing would be to reduce the extent to which the failures spill over onto innocent victims in the rest of the economy.

“You have this idiotic argument that people were kept employed in housing. I would argue that we could have achieved the same result by the Fed simply printing dollars and handing it out to anyone…”

That’s fine, and if you get elected dictator of the US, I will support your plan to have the Fed hand out dollars to patriotic singers on the unemployment line. But unfortunately that’s not going to happen. You’re saying that a certain policy is a bad policy simply because you can imagine a better policy. My criterion for the difference between a good policy and a bad policy is not “How does it compare to the best possible policy?” but “How does it compare to the policy that would most likely have been followed in its place?” and I can assure you, your Star-Spangled Banner policy is not it.

[Robert]

Dr. Thoma clearly understands that a lot of people are in dire circumstances. What I am not sure that he understands is that those circumstances have been getting worse because of reduced income and increased inflation. They were not getting better when interests rates were at 1%, 2%, 3% 4% or 5%. Maybe more money flowing to the upper income brackets at a lower interest rate is not making it to those who need it most.

I would suggest that, rather than pumping up another bubble and inflating that helps landlords like me, we create a national policy that focuses on creating good jobs, or paying more for the lousy jobs that are available.

[bullbust]

Please expand on your theory as it doesn't fit in my framework.

Thats not my theory, it's Waldman's, (follow the link)

Case A - investor puts X, hedge fund borrows 9X,

Case B - investor puts X, investor borrows 9X, and investor puts 10X into the hedge fund.

In both cases, 10X is invested, investors are levered 10 times.

But in case B, hedge funds cannot incite a systemic crisis by threatening banking failures. Theoretically, that can happen in case A too,(because it's the same bank that lends to investors too)but then, the investor's assets are first in line to bear the risk. These are, after all, rich investors.

In case A, it's the banking system that is put at risk. Then the Fed has to bailout the banks, and hence the investors get out too, as a side effect(This is what knzn and Mark Thoma is proposing)

You may end up bailing out the banks in case B, but there is no free ride for investors. They will end up paying.

[bullbust]

Theoretically, that can happen in case A too
..that can happen in case B too..

[bullbust]

That’s fine, and if you get elected dictator of the US,

That's rich. From someone who is advocating that the Fed manipulate the whole of the economy - and all the people in it.

[knzn]

bullbust: “you have lost sight of reality. Who has greenbacks buried?...You think the really rich hold money?...”

I was reacting to ndd’s claim that “the Fed…is picking the pockets of everybody” Of course there is nobody with greenbacks buried, but I was trying to imagine who could be this “everybody” that ndd mentions.

“The only people who lose when the Fed eases are those whose wages don't keep up with the resulting inflation, and people on fixed income.”

The first category doesn’t really lose, because their wages would have risen even more slowly (or most likely not at all, or even fallen, or they would have been laid off) if not for the monetary stimulus. The second category does lose, but again there is my second point, which is: why do such people have the right to expect a windfall when a deflationary event happens? And even my first point, those on a fixed income have, in some way or another (by buying a fixed annuity or accepting a job with a non-indexed defined benefit pension) chosen to have a fixed income; they have voluntarily tied their fortune to the value of money, just as people voluntarily buy insurance.

(And for the record, I work in the private sector. If I were an tenured academic, I'd use my real name.)

[knzn]

[end italics]yes?

[David]

knzn

you said:
"those on a fixed income have ... chosen to have a fixed income; they have voluntarily tied their fortune to the value of money"

Couldn't one just as easily say:
those who bought houses voluntarily tied their fortune to the value of real estate

Except, unlike real estate, the Fed has made it public policy of fighting inflation. I fear that loose fiscal policy would lead to inflation (non-real estate prices aren't falling) which would lead to another boom in the short run and stagflation in the long run. I wasn't around for many of those days, but it doesn't sound pretty.

[David]

maybe this will do it

[Winslow R.]

Thanks, missed the part about borrowed investors on the first pass, must be late.

[knzn]

Robert: “…people are in dire circumstances….those circumstances have been getting worse because of reduced income and increased inflation. They were not getting better when interests rates were at 1%, 2%, 3% 4% or 5%.”

For many of the people in dire circumstances, those circumstances did get better when interest rates were low (or later on, because interest rates had been low). Many people who would not otherwise have had jobs, were able to get jobs because the low interest rate policy caused the economy to recover. A lot of those were bad jobs, but they’re still better than no job (otherwise people wouldn’t have taken them).

The circumstances have been getting worse for many, but it’s a long shot to blame the Fed for that. Most of the price increases have been due to rising energy prices, and I don’t see any mechanism by which easy monetary policy would reduce the incomes of working people.

“a national policy that focuses on creating good jobs”

What would that policy be, exactly? I think, in general, easy money is precisely the way to create good jobs, because it makes investment cheap, so that businesses can create the capital needed for high-paying jobs, and it weakens the dollar, so that high-paying jobs in the US can compete better with foreign jobs. It didn’t work this time around in the US – but perhaps it did: I bet you that there would be even fewer good jobs if the Fed had not run its low interest rate policy. Unfortunately there are other things going on that worked in the other direction, though it’s difficult to ascertain exactly what: part of it is the world’s excess savings, which found its way to the US and prevented the dollar from weakening sufficiently; part of it was what you might call “investment fatigue” after the 1990s boom; etc.; part of it was the fact that the US increasingly competes with countries with a lot of low-skilled labor, so the relatively low-skilled labor within the US became less valuable; etc. (Wages for college graduates have been rising.)

David, What tag did you use to close the italics?

“non-real estate prices aren't falling”

They aren’t rising much either. Non-energy commodities have been in a bear market since mid-2006. Consumer prices other than energy have been quite tame.

But I’m not sure I understand what you’re trying to argue.

[bullbust]

The first category doesn’t really lose, because their wages would have risen even more slowly (or most likely not at all, or even fallen, or they would have been laid off)

Again that massive idea of control, of treating humans as a homogeneous piece of putty to be manipulated, that they would prefer the Fed easing, rather than other sort of actions to deal with what claim would happen.

How does the Fed get to decide for all people? From when did the Fed get to decide what people want, rather than being the Reserve bank? What sort of democratic accountability and representation does the Fed have to do such things as its bubble blowing?

What was it doing when hedge funds were making money putting the ban king system at risk? Are you claiming that they did not know - these masters of the economy?

Are you so far above the masses, that you don't feel the Fed kicking us around by it's stupid bubble philosophy?

Anyone who claims that blowing bubbles and mopping it up is necessary to prevent recessions, to maintain employment, is part and parcel of the racket. Each of this bubble and bust transfers more and more to the top.

The Fed has simply become a tool of the wealthy. What Bush has done to the govt, Alan and his successors are doing to the Fed.

[David]

close italics: /i

I'm arguing that I don't think we are headed for a general deflationary episode if we don't get looser monetary policy. So loose policy, while it may help in the short run, would be disastrous in the long run (stagflation).

Also, markets need transparency to operate efficiently. The Fed has been fighting inflation for years and people and corporations have made decisions anticipating inflation to stay below ~3%. If they suddenly change gears and decide their role is to prop us asset bubbles, it will cause big disruptions.

[Robert]

I think, in general, easy money is precisely the way to create good jobs, because it makes investment cheap, so that businesses can create the capital needed for high-paying jobs, Right, mortgage brokers, investment bankers, real estate agents, home builders, commercial construction (but not the blue color workers), our best mathematicians go into finance instead of science and engineering. Yeah, easy money is so good for the country.

Sadly, the alternative is defense spending: well paid production jobs that cannot be sent overseas. Does not require cheap money, just deficit spending.

Pity that there is not much in between.

Most of the price increases have been due to rising energy prices, Um huh. Higher education, health care, home ownership (not in the CPI), insurance, day care - things people need if they are going to move out of poverty. Those prices are rock steady - nothing to worry about there.

says...

bullbust says...
"Please expand on your theory as it doesn't fit in my framework.

Thats not my theory, it's Waldman's, (follow the link)

Case A - investor puts X, hedge fund borrows 9X,

Case B - investor puts X, investor borrows 9X, and investor puts 10X into the hedge fund."

The problem with this is that after the depression (when case B was used with a vengeance) the Fed was given the right to limit investor leverage. Under current margin restrictions the investor is legally restricted to borrow only X.

Maybe after the fallout we can give the Fed the ability to regulate everybody's leverage.

[Robert]

Here it is! I'm with Uncle Ben (and maybe Keynes) on this one. Let's build a navy that is not only more powerful than all of the world's other navies put together, let's make it twice as powerful! And billion dollar aircraft, lets design and build a lot more of those. We can throw money away on $700,000 houses in the California desert built with illegal immigrants, or we can through it away on big defense spending- what's the difference?

Bernanke used the phrase in his speech in a section explicitly discussing Fiscal Policy:
"Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money."

http://www.minyanville.com/articles/helicopter-bernanke-home+prices-C-BAC-/index/a/13901

[bullbust]

Under current margin restrictions the investor is legally restricted to borrow only X.

I think what is implied is that the investor being accredited, can raise that 9X amount, if they want to, not about 1X being margined or levered. The exact mechanism of the loan is unimportant, as long as the investor is liable for the loan, and will become bankrupt, before the bank has to pick up the tab. There is no free ride. Obviously, this works only because the investors themselves are well-heeled accredited investors. Otherwise it would be like the 0 down, NINJA mortgages took out by flippers

[cm]

David: "$800,000 starter homes"

During the big home-buying frenzy I saw a number of non-starter homes in that price range. Or so one would think, many of them sold quickly.

[reason]

Just to but in here, I find the premise here a bit out of whack. Surely, we are not talking about individual risk but systemic risk. So surely the analogy is not correct. The Fed is not responsible for insuring individual risk, but it is responsible for ensuring the whole financial community doesn't sink together.

If you like we are talking about the fire brigade, not fire insurance.

[reason]

So yes I agree with "not an austrian", regulation is the real story. We need less inflamable material out there.

[ndd]

knzn: "You somehow seem to think that you people with your greenbacks buried in the back yard deserve any windfalls you get but somehow have cause to complain when anything doesn’t go your way."

I'd like people to notice the excellent example of Republican-style spin in the above sentence. Exactly WHO is calling for a bailout? That's right, knzn. And who is he calling to bail out? That's right, rich investors and greedy or reckless spendthrifts who now find that "things haven't gone their way." So, the bailout for people whose speculations have suddenly blown up becomes an entitlement, the natural and proper order of things, and opposing it becomes "complain[ing] when things don't go your way."

And as to the difference between money and insurance policies, my copy of the US Constitution, Article I, Section 8 says: "The Congress shall have the power . . . to coin Money [and] regulate the Value thereof...." I.e., money is a public good. Debasing it to bail out speculators picks the pockets of those who didn't join in the ponzi scheme.
When you find the provision of the US Constitution making insurance policies public goods, let me know. I won't be holding my breath.

[Michal Lehuta]

I got the point with moral hazard. I didn't quite get across why Fed (or any insurance company for that matter) should be still in place though.. (I bet there are reasons..)

[im1dc]

More shoes dropping,

State Street Corporation's stock fell 4 percent Tuesday after two reports raised concerns about the bank's exposure to the recent turmoil in the credit markets.

link: http://tinyurl.com/26oj6l

Barclays shares dropped sharply Tuesday after a report that the bank had hundreds of millions of dollars in exposure to the U.S. mortgage market through deals arranged by its investment banking arm.

link: http://tinyurl.com/ynltr9

Politicians, regulators and financial specialists outside the United States are seeking a role in the oversight of American markets, banks and rating agencies after recent problems related to subprime mortgages.

link: http://tinyurl.com/2fk92u

[knzn]

David: "I don't think we are headed for a general deflationary episode if we don't get looser monetary policy. So loose policy, while it may help in the short run, would be disastrous in the long run (stagflation)."

There's room for disagreement about the effects of Fed policy, but frankly, I don't think we are close to either a deflationary or an inflationary episode. At this point I think the goal of maximum employment calls for easing. And I think that, without the intervention that the Fed has done thus far, the risks would have shifted toward deflation. Deflation is a lot worse for the economy than inflation, so it's reasonable to lean on the side of too much stimulus rather than too little.

I used the /i tag in my comment too, but for some reason it didn't work for me.

Robert: "mortgage brokers, investment bankers, real estate agents, home builders, commercial construction"

Well, those are good jobs. I know the blue collar jobs created in this recovery have not generally been good, and as I said, there are other factors during this business cycle that have prevented easy money from having its usual beneficial effects, or which outweighed those effects. This business cycle has been one example among many. In just about every other business cycle, easy money has had the effect of creating (or stemming the destruction of) good blue collar jobs (though it was often counterbalanced by tight money later in the cycle).

"Higher education, health care, home ownership (not in the CPI), insurance, day care"

The cost of home ownership went way down in 2002 when interest rates went down; the subsequent rise largely compensates for that decline. As for the other things, of course you can cite some prices that have gone up. On the other hand, some prices (clothing, computers, &c) have gone down. My point is that if you exclude the effect (including the indirect effect) of energy prices, there is not much net inflation.

ndd: "Republican-style spin"

I may have to become a Republican if the Democratic party is being taken over by people with kooky ideas like yours. Unfortunately, though, the Republican party has been in the hands of lunatics for the past 30 years.

"rich investors and greedy or reckless spendthrifts"

Mostly not. The main point of easing is to avoid damage to innocent victims, and even with easier money, most of the rich people who made reckless investments are going to get clobbered anyhow. It's kind of like, if your house is burning, we should all help you put the fire out before it gets to our houses. You're still going to end up with a partially burnt house.

[im1dc]

IMO, here is an example of what is wrong with today's RE market and why RE in the formerly hot markets is out of line with actual values.

Home Buyers Forced to Change Tactics

By Dina ElBoghdady, Washington Post Staff Writer

Wednesday, August 29, 2007

The credit crunch has turned $417,000 into the magic number for home buyers shopping for mortgages.

Rattled investors have become reluctant to buy loans for more than that amount -- known as jumbo mortgages -- and that in turn has pushed some lenders to raise interest rates. Caught in the middle are potential home buyers who are getting walloped by higher rates or shut out of the market.

The phenomenon is particularly significant in Washington, where half the homes sell for more than $417,000. Here, home buyers are figuring out how to adapt to the new circumstances by making larger down payments or splitting their purchase into two loans to dodge higher rates. Others are sitting tight until the rates go down.

The course they take can have deep implications for the mortgage industry, the housing sector, and by extension, the economy. If too many potential jumbo-loan borrowers wait it out, chances are the excess supply of homes on the market will swell, further dragging down prices. Home values fell in 15 of 20 large metropolitan areas in the second quarter from a year earlier, according to a report yesterday from S&P/Case-Shiller. They fell 7 percent in the Washington area.

About 24 percent of mortgages granted in the District, 14 percent in Virginia, and 10 percent in Maryland were jumbo loans in 2005, according to the most recent Mortgage Bankers Association data available. Sixteen percent of all new mortgages last year were jumbo loans, according to the trade publication Inside Mortgage Finance.

"Lenders are all putting our collective heads together to come up with a new way to get borrowers into houses," said Bill McGoey, a senior vice president at American Partners Bank, owned by the thrift holding company Federal City Bancorp of the District. "There are tools that we've been using forever, but we've had to tweak them to suit the current situation."

That tweaking benefited Melissa Pool, who took out a jumbo loan to purchase a new $950,000 loft in Arlington. Her father, Otis Pool, helped arrange the logistics but said the experience "kind of put me in a tizzy."

Pool said his daughter signed a contract for the loft a few months ago while it was under construction, but as the closing date approached and the jumbo rates jumped, her mortgage company, First Savings Mortgage, arranged an alternative.

Her loan officer advised her to apply for a piggyback mortgage, meaning two loans. She made a $350,000 down payment, as planned. Then she split the remaining $600,000 between a first loan for $417,000 and a second at a higher interest rate for the balance.

The combined rate of the two, 6.875 percent, was about half a percentage point lower than the jumbo loan would have been, the mortgage company said....

link: http://tinyurl.com/yqn3af

SOLUTION: Melissa Pool should have found another place to purchase in D.C. for less than $417,000 after deducting her $350,000 down payment or less than $767,000 total.

[Winslow R.]

The problem with Mark's etc. philosophy is that it short circuits the political process.

Instead of a recession/depression bringing about real structural reform we instead get 25 years of wealth consolidation.

Smooth the cycles and let the tilt continue.

Too many economists have taken this sleep potion and distributed it to the people they drive around. Economists have fallen asleep at the wheel while their passenger pockets have been picked. As long as the passengers don't mind living with near empty pockets the game continues.

[bullbust]

The Punch Bowl Caucus

The motley collection of gazillionaires, conservatives, and industrialists begging the Fed to cut interest rates.
By Daniel Gross
Posted Monday, Aug. 27, 2007, at 6:07 PM ET
....
The Punch Bowl Caucus, whose members hail from all over and hold different ideological views, share a common belief: that the Federal Reserve, by reducing either or both of the interest rates it controls, can turn the clock back to the halcyon days of 2005 and 2006, when home values moved in only one direction, when defaults were nonexistent, and when credit to homebuyers, consumers, and, above all, to hedge fund operators, ran downhill like a mighty stream.
...

CNBC commentator James Cramer founded the caucus with his now-famous capitalist manifesto on Aug. 3. ...urged the Fed to act on behalf of the greatest among us—"My people [that is, hedge fund operators, private equiteers, and assorted tycoons] have been in this game for 25 years. And they are losing their jobs and these firms are going to go out of business"—as well as the least among us. "Fourteen million people took a mortgage in the last three years. Seven million of them took teaser rates or took piggyback rates. They will lose their homes."
......
desperate manufacturers banded together to form a Midwestern chapter. Ford CEO Alan Mulally and Chrysler CEO Robert Nardelli may be new to Detroit, but they've quickly adopted the local custom of looking to Washington when sales begin to slump.....(Falling housing prices and less-forgiving credit markets are making more Americans think twice about tapping home equity to finance $30,000 car purchases.) So on Aug. 16, Nardelli suggested it would be a good idea if the Fed were to cut rates. The following week, Ford CEO Mulally obliquely echoed (subscription required) Nardelli's call.
...
supply-siders were organizing their own punch bowl chapter, which has a unique bylaw: The government should never intervene in the economy, unless it is to bail out hedge funds and investment banks.......
......
The caucus has had its biggest recruiting successes in the housing sector. In announcing the formation of this chapter, Angelo Mozilo, CEO of Countrywide Financial, ..... said that the punk housing market would undoubtedly lead the nation into recession—an event that should inspire cuts in the Fed funds rate....
.....
Martin Wolf, chief economics commentator of the Financial Times, formed an international auxiliary. Wolf appealed to Americans' vanity and missionary zeal. He pleaded with Bernanke to forget about the sufferings of gazillionaires like Angelo Mozilo, and think about poor Chinese peasant...Americans must spend to keep the world's factories humming. And to do so, they need cheap credit.
..........
The Punch Bowl Caucus holds as an organizing principle that the Federal Reserve can provide a real and psychological boost to markets—and hence minimize or obviate entirely the fallout of natural economic occurrences such as asset bubbles and the business cycle...
....
finance types should know that cheap money, credit on demand, and endless leverage aren't the cure for a hangover caused by too much cheap money, leverage, and credit on demand.

[im1dc]

Pop Quiz:

Which presidential candidate said:

“Washington needs to stop acting like an industry advocate and start acting like a public advocate”.

I wish to point out to Mark Thoma, et. al., that the attitude expressed in the above sentiment is precisely that which I have been arguing here the past few days.

[im1dc]

Times Up

Pop Quiz:

Which presidential candidate said:

“Washington needs to stop acting like an industry advocate and start acting like a public advocate”.

Senator Barak Obama said that.

link: http://www.ft.com/cms/s/0/9fd5e4de-558e-11dc-b971-0000779fd2ac.html

or http://tinyurl.com/29hv3g

[Winslow R.]

A step further.

During the last 25 years of 'extend the cycle' and 'avoid recession' we have seen depression era regulations fall by the wayside in the name of 'financial innovation' and 'competitiveness'.

Too bad so many who should be watching out for the public interest drank the kool-aid. Too many who drank the kool-aid want the game to continue just as it is.

If real structural reform to the current system can be bought about without a recession/depression, I am all ears.

Those that desire to 'tinker' at the margins of the current system need to explain why they think concentration of leverage did not directly lead to wealth consolidation.

[im1dc]

Here is a link to a graphic depiction of the mortgage Reset problem. Its a color bar chart that visually depicts 'how much' and 'how long' and it separates out Agency, Jumbo, Alt-A and Subprime mortgages.

Really, its a must see:

ARM Reset Charts

"Here is a chart from BofA analyst Robert Lacoursiere via Mathew Padilla at the O.C. Register. Please see Mathew's discussion from June 29th: BofA Analyst: Mortgage correction just 'tip of the iceberg'."

link: http://calculatedrisk.blogspot.com/

[Bernardo Aito]

Dear editor,

your argument about "taking into account" the payouts of "insurance" (i.e. the Fed rate cut) is crystal clear.

In my view, however, you underestimate a potential cost that investors may not interiorize every time they take excessive risks: that is, the cost of volatility. Volatility is bad in finance because it undermines the credibility of financial markets. And financial markets, rather than being just casinos where people make fortunes out of change (for investors), is a mechanism through which firms gather money to make investments. It is (also, and in big part) thanks to financial markets that economies grow. For this reason, financial markets shouldn't be volatile.

So you say that, after all, investors are maximizing their payout when they take excessive risk (fair enough: if investors are aware that the FED will "stimulate" as soon as the risk of recession approaches, they will probably risk as much as they can, and the expected outcome in case of financial crisis is: loss net FED's easing).

What investors might not take into account is that, in case of crisis, of course the FED will intervene afterwards, but meanwhile people will have lost money, firms will have closed for lack of funds (becasue people will have withdrawn them from financial markets). Analysts will have written pages of commentaries about bear markets (in this way undermining further the confidence of investors and consumers). The costs of a financial crisis, therefore, should not only be calculated as the losses of speculators, but also as the losses of those medium-small firms who have interests in financial markets.

I think the FED shouldn't bail out speculators because the damage the latter produce by taking excessive risks is excessive, and it isn't totally borne by them (but also by small firms and consumers). The FED's role in general should be that of holding the economy as less volatile as possible. However if as you say, correctly, the FED "promises" to cut rates after every bubble bursts, risk taking will never decrease and with it volatility will remain high forever.

It is in nobody's interest, to conclude, that volatility remains high. And those financial bulls (speculators but also bloated bankers) must once and for all be the sole to pay for their excesses. And they shall not take these high risks anymore, for the sake of credibility of finance.

Best Regards.

[d_rumsfeld]

-knzn,

Can you please explain to me how an easing of interest rates will increase the intrinsic demand for housing? Housing vacancy rates are at all time highs, housing inventory is at all time highs, rental vacancies are hovering near all time highs, and homeownership rates are at all time highs. It is very very clear from the data that supply is currently exceeding demand. Long-term interest rates are still very close to historic lows. Speculation and demand for second houses prompted the excess buying of the last few years and it is currently unsustainable. Unless you are proposing that the entire population needs a vacation home, these homes are not going to be absorbed by Americans anytime soon.

Given these dynamics, it seems absolutely true that the housing and mortgage industries will be going through a recession regardless of monetary policies for at least 2 years.

[gordon]

Winslow R. says: "Too many economists have taken this sleep potion and distributed it to the people they drive around. Economists have fallen asleep at the wheel while their passenger pockets have been picked".

Alas, Winslow R., the impending Presidential election in the US is likely to make the situation worse still. From about now onwards, a lot of economists who think they have a chance of a Govt. job under President Hilary will be carefully avoiding any comment which could possibly irritate Wall St. or Main St. or the Military-Industrial Complex or Israel. Chances of fearless commentary will diminish until the spoils are sorted out after Nov. 2008. Then maybe some of those who didn't get a 'phone call will indulge in a little sniping at those who did.

[skeptonomist]

What caused the liquidity crisis? In a word, deregulation:

http://www.prospect.org/cs/articles?article=whats_behind_the_subprime_disaster

How many debacles do we have to overcome before mindless deregulation is discredited?

[Winslow R.]

Skeptonomist with a perfect link to

"There is an instructive model being used in Massachusetts. Since 1989, an agreement between local banks and the Massachusetts Housing Partnership has used the leverage of the federal Community Reinvestment Act to fund $1.5 billion in interest subsidies on more than 10,000 mortgages for moderate income homebuyers. There are careful loan underwriting standards, minimum down-payment requirements, and ongoing credit counseling by non-profit agencies. Nobody is in the program to get rich. According to Clark Ziegler, executive director of the program, there have been just 37 foreclosures in 17 years, despite the fact that most borrowers earn less than 65 percent of median income. But here's the kicker. Not one of the local banks that signed the 1989 accord is still in business -- all have been swallowed up in mergers with out-of-state banks. And the unregulated mortgage companies that now dominate the business are exempt from the Community Reinvestment Act, and not one even participates in the program. "

No need for banks, these programs only need access to an account at the Fed.

"We don't yet know how serious this credit panic will turn out to be, because so much regulation has been repealed, inviting a repeat of the 1920s, and possibly of 1929. For over three decades we’ve tested the claims made for lender deregulation, and deregulation has flunked."

Time to admit the system in its current form has failed.

[jp]

Sorry, but the analogy of the Fed to private insurance companies is a terrible one.

Individuals don't have to get insurance, and if they want it, they can choose from hundreds of insurance companies for what suits them. Like any other good, individuals must pay for this insurance.

Depository institutions have no choice but to subject themselves to the Fed, and even if they wanted to choose from a list of competing central banks they couldn't. There is just the Fed. Unlike private insurance, there is no cost to the banks for inclusion in the Fed's insurance policy. Any bailout will be paid by newly issued money. This places the costs for the insurance squarely on the entire population of currency holders ie. it socializes other people's mistakes.

Some people use dictionary.com to check for spelling mistakes. I'd suggest you use analogy.com next time you're tempted to make a spotty analogy, but I don't think it exists.

[reason]

jp...
see my comment about fire brigade. But you are wrong about banks not paying a cost for Fed insurance. That is what banking regulation is about. Too bad the reason for that regulation has been forgotten.

[knzn]

d_rumsfeld,

I don't necessarily disagree that "the housing and mortgage industries will be going through a recession regardless of monetary policies for at least 2 years" -- at least for the range of reasonably likely monetary policies. But I think that Fed policy (and anticipated Fed policy reflected in longer-term interest rates) can affect the length and severity of that recession. When interest rates go down, it make house-buying (at any given price) a more economical proposition for anyone who is on the margin between buying and renting (and there are surely a lot of people on or near that margin). That means that, with lower interest rates, a smaller drop in prices is required before inventories start shrinking, so the recession is shorter and less severe.

When you say "Long-term interest rates are still very close to historic lows," that's actually precisely the reason that I do think interest rates can have a significant effect on housing prices. The lower interest rates are already, the more impact a decline in interest rates will have. To see this in an extreme, stylized example, consider if one were to fully finance a $600,000 home with a non-amortized mortgage. Compare a 12% to an 11% interest rate: the monthly payments go from $6000 to $5500, not a large percentage difference, and if you can afford the house at 11%, you can probably afford it at 12%. Now compare a 2% to a 1% interest rate. The monthly payments get cut in half from $1000 to $500. That could make a big difference in affordability. (And to make it even more extreme, consider if the interest rate goes from 1% to 0%.)

Of course the contrast is less extreme with a normal amortized mortgage, but when you take into account the equity you build with an amortized mortgage, the theoretical calculations are the same. Differences in low interest rates still make a bigger difference in the mortgage payments than differences in high interest rates, and differences in low interest rates also make a bigger difference in how much equity you build (or how much equity you lose, if you expect prices to go down). So to the extent that people can afford the payments, lowering interest rates when they are already very low has a big effect on the attractiveness of buying a house.

[calmo]

I dunno knzn. The lower interest rates are already, the more impact a decline in interest rates will have. Do you discount the 16 incremental Fed advances and the miniscule effect on long term rates--the ones that impinge on mortgage rates, without a thought then? [Have you no decency?] Is it possible that the historical relationship will remain somewhat unhinged? Could it be that some global aspects are being masked and that the Fed no longer has the control it once did?
Is this the gamble: the Fed "loosens" (unduz belt)...but the mortgage rates don't notice (pants stay up!)...causing more than some embarrassment (the continuing conundrum), some real fear and what could be worse than this: loss of credibility --the Dangerfield Fed.

[knzn]

Calmo, It certainly seems to be the case that the Fed is having a lot of trouble influencing long-term interest rates, but the link hasn't been entirely broken. After a few years of trying, the Fed managed to get long rates down, and then after a few years of trying in the other direciton, it managed to get long rates up. Ultimately, I think the link should still be pretty strong: Investors like the People's Bank of China and the Saudi Arabian Monetary Authority can show a lot of inertia in the short run, but eventually they respond to the shape of the yield curve.

[calmo]

Thanks for the reply knzn and I appreciate your counter point language ("unbroken link" vs "un-hinged") and recognition of those foreign CBs.
Do you figure the building that is going on in Dubai

http://images.google.ca/images?q=Dubai&hl=en&client=firefox-a&rls=org.mozilla:en-US:official&hs=rbC&um=1&sa=X&oi=images&ct=title

is part of that "short run inertia" and we will soon see similar progress in New Orleans when these foreigners come to their senses and realize that the USA is still the best place to invest?

http://images.google.ca/imgres?imgurl=http://newsimg.bbc.co.uk/media/images/44085000/jpg/_44085293_womenvigil_getty416.jpg&imgrefurl=http://news.bbc.co.uk/2/hi/in_pictures/6969090.stm&h=300&w=416&sz=36&hl=en&start=18&um=1&tbnid=37rVoWQlC_Jk3M:&tbnh=90&tbnw=125&prev=/images%3Fq%3DNew%2BOrleans%2B%2Bphotos%26svnum%3D10%26um%3D1%26hl%3Den%26client%3Dfirefox-a%26rls%3Dorg.mozilla:en-US:official%26hs%3Dzzr%26sa%3DX

Hard to believe that the Fed in dropping interest rates will attract more of that foreign investment, no?