Mishkin: Outlook and Risks for the U.S. Economy

Here's the last part of Federal Reserve Board Governor Frederic Mishkin's detailed assessment of the outlook and risks facing the U.S. economy:

Outlook and Risks for the U.S. Economy, GovernorFrederic S. Mishkin, FRB: ...In my remarks this evening, I will review the current economic situation and outlook and make some specific observations about recent developments in financial markets. ...

Let me shift gears and discuss developments in financial markets. As you know, the recent turmoil had its beginnings in the subprime mortgage market. The development of the subprime market in the 1990s was an important financial innovation that enabled borrowers with higher credit risk to obtain mortgages that previously were unavailable to them. This expansion appears likely to have been a significant factor in raising the rate of homeownership from 64 percent, the level in 1994, to about 68 percent currently. In addition, subprime and other nonprime lending played an important role in the high volume of home sales in the mid-2000s. Indeed, data collected under the Home Mortgage Disclosure Act indicate that about 25 percent of the loans used to purchase single-family, owner-occupied homes in 2005 were high-priced loans, including primarily subprime and some near-prime mortgages.

However, as has been the case in previous instances of rapid financial innovations, adequate mechanisms to control excessive risk-taking may not have been in place during the subprime market’s greatest growth. One innovation, further development of securitized products, gave mortgage lenders greater access to the capital markets and spread risks more broadly. However, securitization also widened the separation of the originators from the ultimate holders of the loans--that is, those who bought securities backed by loans. In this setup, a classic principal-agent problem can arise if originators (the agents) do not have a sufficient incentive to shield the owners of the securities (the principals) from suffering higher-than-expected losses.

Against a backdrop of continued strong investor demand for high-yielding securities, some lenders began loosening underwriting standards for subprime mortgages in late 2005. Loans to subprime borrowers were approved with high loan-to-value ratios and incomplete income documentation. Had house prices kept appreciating, loan-to-value ratios would have fallen and some borrowers would have been able to refinance, perhaps into a prime loan with a lower interest rate. But, instead, as the housing market softened and interest rates rose, delinquencies in the adjustable-rate subprime market began to soar and reached nearly 15 percent in July. Among other types of nonprime mortgages, delinquencies on fixed-rate subprime mortgages have been fairly steady at less than 6 percent; rates on mortgages in alt-A pools have increased to nearly 3 percent, up notably from the 1 percent rate of only a year ago.

The rise in delinquencies in the subprime market has led to the collapse of some large subprime lenders and inflicted substantial losses on holders of subprime residential mortgage-backed securities (RMBS) and of some collateralized debt obligations (CDOs). As a result, underwriting standards have been tightened, and fewer households are qualifying for subprime loans. In addition, some borrowers apart from the subprime segment are reportedly finding it more difficult to qualify for loans or are having to pay more for them. These developments have contributed materially to the drop in demand for housing this year. Without a doubt, they also have caused significant hardship for many individuals and families.

Recently, we have watched the deterioration in financial conditions extend beyond the subprime market. Investors appear to have reassessed their outlook and their tolerance for risk, especially for structured financial products and for securities of highly leveraged firms. Bond spreads--especially those for speculative-grade debt--widened substantially in June and July, and the volatility of equity prices increased as well. In mid-August, following several events that led investors to believe that credit risks might be larger and more pervasive than previously thought, the functioning of financial markets, including short-term and interbank funding markets, became increasingly impaired. Notably, many asset-backed commercial paper programs found rolling over their paper increasingly difficult. To help restore orderly conditions, the Federal Reserve in recent weeks has increased the provision of reserves, cut the discount rate, and changed its usual discount-window lending practices in order to facilitate term borrowing, together with other measures.

Stepping back from the rush of unfolding events, we are seeing a pattern that occurs from time to time. Financial markets and institutions perform the essential function of channeling funds to those individuals or firms having the most productive investment opportunities. However, an increase in uncertainty and concerns about the quality of information can lead investors to pull back from financial markets and restrict productive lending--with potentially adverse implications for real activity. That is essentially the story I laid out in a paper delivered at the Kansas City Fed’s Jackson Hole conference about ten years ago.

In my view, such an increase in uncertainty is an important part of what we have observed recently and stems from heightened concerns about the value of financial securities related to certain types of loans, about who is holding these securities, and about how a revaluation of these securities might affect the balance sheets of various financial intermediaries. Consequently, investors have become less willing to put funds into various financial markets, particularly into the more opaque segments of those markets.

As best we can tell thus far, the imprint of these developments on economic activity appears likely to be most pronounced in the housing sector. However, economic activity could be affected more severely in other sectors should heightened uncertainty lead to a broader pullback in household and business spending. That scenario cannot, in my view, be ruled out, and I believe it poses an important downside risk to economic activity.

I also believe that the process of adjustment that is under way in financial markets--of investors reassessing the outlook for risk and their tolerance for that risk--will ultimately create a more solid financial footing for the real economy. But in the meantime, the FOMC is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

Comments

[calmo]

Ok, it's nearly official now: housing has almost spilled over into other sectors of the economy:However, economic activity could be affected more severely in other sectors should heightened uncertainty lead to a broader pullback in household and business spending.
And they are still working assiduously on our behalf. Watching. But in the meantime, the FOMC is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.
How long before Mish notices commercial real estate problems?
A transcript of a speech to the Money Marketeers of NYU...ok, some slack for that I suppose...but honestly, I'm pining for Mr. Bottom of the Eighth after the first paragraph.

[Mark Thoma]

Bottom of the 8th's latest:

http://dallasfed.org/news/speeches/fisher/2007/fs070910.cfm

[calmo]

See Fisher is so...quotable (too quotable, this isn't going to fit on 1 post I bet)I do not believe the Federal Reserve's job is to protect specific risk takers who failed to protect themselves from potential downside wounds. The Federal Reserve's job is to protect the system itself. [starting with the brains of the outfit: members of the FOMC]

I suspect the markets will be unsparing in their treatment of the most egregious of those who engaged in risky financial behavior. There is little that regulation can or should do to interfere with letting that treatment run its course. [Amaranth CEO is up and running another HF to prove this point.]

First, financial institutions will quickly adapt to defeat any regulation that is poorly designed, morphing into new, vaccine-resistant strains. [ Isn't this a wonderful depiction of the Finance Industry? bacteria ]

I would be wary of any regulatory initiatives that interfere with market discipline [the throwing of over-ripe fruit?] and attempts to protect risk takers from the consequences of bad decisions for fear of creating a moral hazard [gasp!] that might endanger the long-term health of our economic and financial system simply to provide momentary relief. [ so FED thumb-twiddling is an art form due to the miraculous healing powers of market discipline...the SEC is a curiosity. tis ]
And then there follows some very interesting remarks about the home of most of those "illegal aliens", Mexico

my economic perspective on Mexico was forged in part by the four years I spent as deputy U.S. trade representative in the Clinton administration, negotiating with Mexico on the implementation of NAFTA.

Three-fifths of Mexico's imports, most of which are manufactured goods, are from the U.S., and two-thirds of all foreign direct investment into Mexico comes from U.S. investors. More than 90 percent of Mexico's exports are destined for the United States. Mexican workers provide a significant part of the economic muscle that makes the U.S. economy so mighty,, and Mexico is a critical part of our industrial base, feeding the supply lines of American businesses.

The outlook continues to be favorable for border population and job growth, both in Texas and the states to our west. Real progress, however, will require greater productivity and increased wages. [Love this...crumb for labor]

There is an irrefutable [ only for dummies] positive link between education and income. Wages are low on the border because education levels are low.
Dr. Singh came to San Antonio and started his own engineering business—Karta Technologies—a company he just sold for a cool $65 million.[Compare that HF manager's $1.7B 1 yr heist and weep]

[dd]

Calmo, how did you miss this?
"I am only partway along in studying the entrails of the Beige Book..."
Wonder if he burns incense and chants incantations.

[calmo]

I did miss that, I did!
So hard not to skim Fisher...because after a few minutes, you know this comedian is too.
It's the penalty of entertaining (compare "informing", "stimulating", "inspiring", "engaging") your audience (which I feel Fisher does excessively): they learn to be entertained and dismiss the notion that you might have anything serious to say --much to their relief. (And after Mish, mine too.)
Still, I did not know that his connection to Mexico was this intimate (NAFTA).[How many are inspired to examine the history of the rise and fall of the Fisher souffle?] And I am just tickled with this cover for the businesses hiring those poorly educated "illegal aliens", Mexican workers provide a significant part of the economic muscle that makes the U.S. economy so mighty,, and Mexico is a critical part of our industrial base, feeding the supply lines of American businesses.
And so The Wall will be built with plenty of holes in it...using that Mexican muscle of course.

[Lafayette]

Media Hype: Mexican workers provide a significant part of the economic muscle that makes the U.S. economy so mighty

I am used to superlative exaggeration from the "World's Greatest Democracy!" ... but sometimes too much is too much. Like the above blather, cited.

What would make the US economy "mighty" is if Americans were willing to do the work immigrants do, which is mostly grunt work. But, they aren't willing.

With time, immigrants who become Americans do precisely that -- they fill in the niches native born Americans wouldn't touch with a ten foot pole. If paid only food and shelter, they'd be easily classified as slaves. (And, I'll bet if we scratch hard enough, we'd find such operations today.)

Most take the escalator up the class structure by means of hard work ... and pick up a nationality along the way. Some make a few bucks and head home. (The latter are better called migrants since they don't stick around long enough to immigrate.)

This is what immigrants have done for centuries. And, in one form or another, they HAVE contributed to the economic vitality of the nation.

Maybe the first generation. I doubt the second generation has quite the same aspirations as their forebears. (They find a ten foot pole ... ;^)