U.S. Federal Reserve Balance Sheet Worries Paul Volcker

Former U.S. Federal Reserve Chairman Paul Volcker warned the Fed’s independence and credibility could be harmed by the many different sorts of assets it took on to its balance sheet to stave off a credit crisis.

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Europe and US want a stronger dollar

U.S. and European officials have come together in the belief that the U.S. dollar should strengthen against the euro, following more than a year of sharp decline.

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Iran “central banker of terrorism”

At a hearing of the United States Senate’s Finance Committee, a senior official in the US Treasury Department has called Iran “the central banker of terrorism”.

Outlining some of what Iran is known to be doing to support anti-American and anti-Israeli fighters, the under-secretary for Terrorism and Financial Intelligence, Stuart Levey, said Iran “uses its global financial ties and its state-owned banks to pursue its nuclear and ballistic missile programs, and to fund terrorism.”

He also told lawmakers that Iran used front companies and “cut-outs” to “engage in ostensibly innocent transactions that are actually related to its nuclear missile programs.”

“We have seen Iran’s banks request other financial institutions take their names off of transactions when processing them in the international financial system. This practice, which is even used by the central bank of Iran, is intended to evade the controls put in place by responsible financial institutions and has the effect of threatening to involve those financial institutions in transactions that they would never engage in if they knew who or what was really involved,” Levey said.

Levey heads the Office of Foreign Assets Control (OFAC), which is responsible for tracking money being filtered into terrorist groups. In all, since June 2005, the OFAC has identified 51 entities and 12 individuals as proliferators of weapons of mass destruction, of whom 36 entities and 11 individuals were tied to Iran, nine entities and one individual were tied to North Korea and three entities were tied to Syria. Levey told senators that efforts to cut off money to Al Qaeda had shown success - especially in the last 18 months. He cited senior al-Qaeda leaders’ complaints that they had suicide bombers ready to go but no money to finance operations.

Click here to read the full statement.

United States presidential election, 2008: Herbert Hoover’s Ghost Haunts Markets

In a her Bloomberg column, Amity Shlaes finds that Bear Stearns evokes the crash of 1929 and the Great Depression that followed it.

“Within 24 hours, Representative Rahm Emanuel, an Illinois Democrat, was weighing in with his own 1930s comparison. Roosevelt had pulled a country out of Depression and united it; President George W. Bush was doing the opposite, he said.

You get the picture: Bush is like Hoover, the do-nothing. Democrats are like Roosevelt, the activist. It’s worthwhile to go back to that Depression period to see what people actually did or didn’t do and who resembles whom. The reality differs from the cartoon.”

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Paulson plan to combat credit market problems

The Wall Street Journal reports that U.S. Treasury Secretary Henry Paulson today will announce a broad proposal to overhaul regulation of U.S. financial markets. The article says the reforms could eliminate or merge major institutions - including the Securities and Exchange Commission - and might seek to strengthen the authority of the U.S. Federal Reserve.

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Demons On Wall Street

Top columnist and macroeconomics expert Sebastian Mallaby writes in  the Washington Post that modern financial engineering has become harder to defend in the wake of Bear Stearns.

March 24, 2008
Washington Post

“One year ago, with spectacular timing, a Wall Streeter named Richard Bookstaber published a book on financial engineering. He called it A Demon of Our Own Design, and his argument was that a new breed of ‘quants’-or ‘quantitative’ number-crunchers like him-had created a system too complex to be manageable. The risks embedded in swaps and options were understood by only a handful of math geeks, and a miscalculation in one corner of the markets could send shock waves globally. Until a week ago, Bookstaber seemed unduly glum. But in the wake of Bear Stearns, modern financial engineering has become harder to defend.

Bookstaber seemed too pessimistic because he understated the ability of Wall Street players to check and balance one another. Yes, modern finance had an alarming tendency to load debt upon debt, so the effect of a mistake was magnified. But the financial engineers who created these tottering cash towers had an incentive to stop building before the whole thing keeled over. If a bank borrowed too much, lenders would shut off the taps and clients would refuse to buy its swaps, options and synthetic bonds: Nobody wants to do business with a bank that is one shock away from bankruptcy. So financial engineers would certainly take risks. But scrutiny from fellow engineers at other firms would prevent them from overdoing it.

Even a year ago, reasonable people disagreed about whether these checks and balances were sufficient.”

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The U.S. Federal Reserve New Alphabet Soup

by Vincent R. Reinhart, former director of the Federal Reserve Board’s Division of Monetary Affairs (2001-2007)

Over the past few weeks, the Federal Reserve added to its alphabet soup of new facilities to deal with ongoing strains in financial markets. Taken together, these programs represent a clever gamble to provide large institutions some time to get their financial houses in order. Fed officials have effectively rewritten the rules on the role of a central bank in a market economy.

First, the mnemonics. On March 14, 2008, the Federal Reserve extended access to its discount window to a non-depository, Bear Stearns, for the first time since the 1930s. (The discount window is the Fed’s lending facility, where loans are made at a rate above the federal funds rates and can be secured with a wide variety of collateral.) According to the Federal Reserve Act, lending to such an individual, partnership, or corporation (an IPC) requires the affirmative vote of five of the governors of the Federal Reserve Board.

Moreover, the Federal Reserve must attest that there are “unusual and exigent” circumstances and that failure to lend would impair the economy. On March 16, 2008, the Federal Reserve granted other investment banks access to its lending facility.

On the prior Tuesday, the Fed had introduced a new program called the Term Securities Lending Facility (TSLF), under which it will loan some of the Treasury securities currently on its balance sheet to key financial market participants in return for other securities as collateral. The term of these transactions is 28 days, and the fee paid for the loan of Treasury securities will be set in an auction.

For the past few months, the Fed has been holding regular auctions for depositories of its discount window credit, also for a term of 28 days. This is referred to as the Term Auction Facility (TAF), in which depositories bid for credit. Earlier this month, these auctions were bumped up to total $100 billion per month. To put that sum in perspective, the amount of discount window loans outstanding this month will likely be nine times the previous monthly record from 1919 to the inception of the TAF (see the nearby chart). And if the TAF continues at its recent pace through June of this year, the Federal Reserve will have extended a greater volume of loans over the first eight months of the program than it had cumulatively lent over the prior 90 years.

Last but not least, the Fed also announced that it will loan another $100 billion in the form of 28-day term repurchase (RP) agreements. RPs are the bread-and-butter of a central bank’s open market operations. In the typical RP, the Fed lends money to its dealer counterparties for a fixed term, taking collateral in the form of Treasury securities or the debt and mortgage-backed securities of the government-sponsored lenders, Freddie Mac and Fannie Mae.

If we tally up all these new programs, the Federal Reserve appears willing to commit almost one-half of its balance sheet, around $400 billion, to promote the renewed health of financial markets.. Given its open-ended invitation for investment banks to follow the Bear Stearns route and tap the Fed’s discount window, it may wind up committing even more.

Why do Fed officials think these programs will work? To households, mortgages are the obligations that make home purchases possible. But to financiers, mortgages are collateral. Those loans are pooled together so that their combined payments provide a steady stream of income in a variety of mortgage-related securities. The problem is that mortgage defaults of the magnitude we are now experiencing even dry up payments to “safe” securities. Some of those securities are quite complex and difficult to price. Even worse, they are held in part on balance sheets of financial institutions that are opaque and difficult to understand.

Investors have withdrawn from the entities they fear are tainted by these losses. But because they cannot pin down precisely who bears the brunt of the losses, the retreat from risk taking has been spread across a broad front. As a result, there is no effective market price for some of these securities-because the market has disappeared.

Losses across large financial firms could mount considerably beyond what has already been announced. If so, those firms will have to retrench to conserve their capital. Credit will be more expensive and harder to get.

Ultimately, the industry needs more capital. That infusion may come from elsewhere in the private sector: possibly from hedge funds and long-term investors, or from official sources abroad. (Here another mnemonic comes to mind-SWF, or sovereign wealth funds.) But if it does not come from those sources, it will likely require government intervention, which is the way banking crises around the world are often resolved.

The Federal Reserve is using its balance sheet as a safe harbor for the financial industry until that capital arrives. It is doing so by transforming mortgage - related securities - for which there is currently no effective market-into something useful. Financial institutions can now pledge them with the Federal Reserve in open market operations (via RPs) or at the discount window (via the TAF and IPC lending). Or, they can swap those securities for Treasury securities via the TSLF. For 28 days, those firms get better assets on their balance sheets, which allow them to postpone the unloading of their mortgage-related holdings.

Let’s be clear: the Federal Reserve is accepting an unprecedented degree of credit risk.

If one of its counterparties fails in the 28-day window of an outstanding transaction, the Fed will potentially be left holding illiquid mortgage paper. Such unusual policies cannot be extended indefinitely. Financial institutions have to come to grips with their losses, and their management has to swallow hard and find more capital, which is likely to be very costly. They should not use the Fed’s largesse as an excuse to delay.

Reprinted with kindly permission of The American Enterprise Institute.

Private Profits, Public Risks

In an op-ed in The Wall Street Journal, former White House counsel for President Reagan, Peter J. Wallison, says government-sponsored enterprises (GSEs) have contributed to the turmoil in the mortgage market.

“The fall in housing prices and mortgage values has exposed a serious flaw in the idea that private, shareholder-owned, government-sponsored enterprises (GSEs) can be effective instruments of government policy.

Two such GSEs, Fannie Mae and Freddie Mac, were chartered by Congress decades ago to create and operate a secondary market in residential mortgages. Initially government corporations, they were sold off to shareholders (Fannie was privatized in 1968, Freddie in 1986) in order to prevent their purchases and sales of mortgages from affecting the federal budget. This limited privatization created a unique hybrid enterprise: a shareholder-owned company that was supposed to act like a government agency.”

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All eyes on the U.S. Federal Reserve

The U.S. Federal Reserve meets today and market watchers are predicting that Ben Shalom Bernanke, Chairman of the Board of Governors of the United States Federal Reserve, will cut the board’s benchmark interest rate by perhaps 1 percent or more.

The Wall Street Journal reports that Washington will likely respond to a spiraling market crisis with a “heavier hand”- including corporate bailouts, fiscal incentives, and new regulation.

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U.S. Dollar plunges to record low

Bad U.S. sales data added to recession concerns as the dollar fell to record lows the euro and reached its lowest point against the Japanese yen since 1995. Gold also reached record highs, topping $1000 per ounce for the first time in its history.

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U.S. to reform credit rules

The Wall Street Journal reports the top financial officials in the United States of America today will release a broad policy blueprint for staving off a full-fledged credit crisis.

“The nation’s top economic policy makers plan to release today their broadest blueprint yet for avoiding a recurrence of the credit crunch now threatening the economy.

Their recommendations extend to nearly every niche in the credit markets — from mortgage brokers to the Wall Street firms that package home loans into securities, to the credit-rating firms that assess the risk of those securities, to the regulators who police the system.”

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U.S. Federal Reserve takes radical action

The U.S. Federal Reserve took action to boost liquidity and stave off market meltdown. The Fed said it would offer the bond market $200 billion in Treasury bonds for a month at a time, accepting ordinary triple-A rated mortgage-backed debt as collateral.

Several major global central banks followed suit with similar moves.

The Wall Street Journal calls the move a “surgical strike” in response to a growing wave of investors selling out of mortgage-backed securities. Global markets made heady gains on the news, and U.S. stocks posted their largest single day of gains in over five years.

Despite the move and the market gains, experts remained skeptical about the prospects for quick economic recovery. The economist Nouriel Roubini writes on his blog that many of the world’s most prominent economists are now subscribing to his estimates - formerly considered extreme - that U.S. financial losses could top $1 trillion.

Updated probabilities of recession

If we did go into a recession, something that’s always possible for the U.S. or Europe, we could lower interest rates and expand the money supply without worrying about the price of gold. (Professor Jeffrey D. Sachs)

Dear Colleagues,

I have updated the probabilities of recession. You can find them here.

I have posted the probabilities, the data used, and a technical note.

If you have any questions or any problems accessing the information, please let me know.

Best,

Marcelle Chauvet

Director, Latin American Studies Program & Associate Professor
Department of Economics, University of California Riverside, CA 92521
Phone: (951) 827 1587
E-mail: chauvet@ucr.edu  
Homepage: http://faculty.ucr.edu/~chauvet/mc.htm

Areas of Expertise: Economic growth in the U.S. has become significantly less volatile since 1984 and recessions are occurring less frequently, Professor Marcelle Chauvet says. She has developed a real-time recession prediction model and is consulted frequently by the U.S. government, foreign governments and the international business community. Using that model she predicted the end of the 2001 recession 16 months before the National Bureau of Economic Research announced the recession was over. Chauvet’s research focuses on macroeconomics and econometrics, and she is particularly interested in measuring and explaining business cycles, monetary policy, modeling risk premia on financial assets and their interactions with the real economy, and understanding the dynamics of long-run growth and development.

Selected publications:

“A Comparison of the Real-Time Performance of Business Cycle Dating Methods,” with Jeremy Piger, Forthcoming, Journal of Business Economics and Statistics, 2008.

“Forecasting Recessions Using the Yield Curve,” with S. Potter, Journal of Forecasting, 24, 2, 2005.

“Recent Changes in the U.S. Business Cycle,” with S. Potter, Manchester School, Vol. 69, No. 5, 2001, 481-508.

“An Econometric Characterization of Business Cycle Dynamics with Factor Structure and Regime Switches,” International Economic Review, Vol. 39, No. 4, November 1998, 969-96.

“Calling the Business Cycle,” with James Hamilton and Kevin Hassett, The American Enterprise Institute Press, Forthcoming, 2008.

“International Business Cycles: G7 and OECD Countries,” with Chengxuan Yu; Economic Review, Federal Reserve Bank of Atlanta, First Quarter, Vol. 91 No. 1, 2006, 43-54.

“Leading Indicators of Country Risk and Currency Crises ” The Asian Experience,” with Fang Dong, Economic Review, Federal Reserve Bank of Atlanta, First Quarter, Vol. 89, No. 1, 26-37, 2004.

Other Activities:

Associate Editor, Journal Macroeconomic Dynamics, 2003 - present

Member, “Brazilian Business Cycle Dating Committee” (CODACE - Comitê de Datação de Ciclos Econômicos), Brazil.

How to Stop the Mortgage Crisis

An op-ed by Martin Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, professor at Harvard and member of The Wall Street Journal’s board of contributors

The Wall Street Journal, March 7, 2008

“The potential collapse of house prices, accompanied by widespread mortgage defaults, is a major threat to the American economy. A voluntary loan-substitution program could reduce the number of defaults and dampen the decline in house prices — without violating contracts, bailing out lenders or borrowers, or increasing government spending.

The unprecedented combination of rapid house-price increases, high loan-to-value (LTV) ratios, and securitized mortgages has made the current housing-related risk greater than anything we have seen since the 1930s. House prices exploded between 2000 and 2006, rising some 60% more than the level of rents. The inevitable decline since mid-2006 has reduced prices by 10%. Experts forecast an additional 15% to 20% decline to correct the excessive rise. The real danger is that prices could fall substantially further if there are widespread defaults and foreclosures.”

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United States presidential election, 2008: Implications of Economic Trends for Workers, Families, and the Nation

Former senior economist at the Federal Reserve Bank of Dallas and the White House’s Council of Economic Advisers Alan D. Viard says annual income stats mislead when assessing middle class well-being.

TESTIMONY - February 13, 2008
United States House of Representatives - House Committee on Appropriations, Subcommittee on Labor, Health and Human Services, and Education

Chairman Obey, Ranking Member Walsh, Members of the Subcommittee; it is an honor to appear before you today to discuss, “Implications of Economic Trends for Workers, Families, and the Nation.”

I would like to make three major points:

Despite the rise in inequality during the last few decades, real incomes have risen significantly in the middle of the income distribution. Real incomes have also risen at the bottom of the income distribution, although at a very slow pace.

The existing federal tax system is highly progressive, with a small group of high-income taxpayers bearing a large portion of the federal tax burden.

Due to economic mobility, annual income can be a misleading measure of wellbeing. A significant portion of households with low incomes in any given year experience large income gains in later years.

Real Incomes Have Risen in the Middle of the Income Distribution

Some observers have claimed that the middle class has experienced falling living standards in recent decades, as their incomes have failed to keep up with inflation. The best evidence demonstrates, however, that real incomes have risen significantly in the middle of the distribution, although not as rapidly as at the top of the distribution. Real incomes have also risen in the bottom of the distribution, although those gains have been extremely small.

To assess this issue correctly, it is necessary to use a measure of the overall economic status of middle-income Americans. Incomplete measures can yield misleading results.

For example, the Bureau of Labor Statistics’ measure of average hourly earnings of production and non-supervisory workers has often failed to keep pace with inflation. At best, however, that measure reflects households’ before-tax cash wage income, which is only part of the picture. To obtain a comprehensive measure of the economic resources available to households, it is necessary to include their other sources of income–fringe benefits, property income, and government benefits–and to subtract their tax payments. Even the Census Bureau’s measure of household money income is incomplete, because it omits fringe benefits, in-kind government benefits, and capital gains and does not subtract tax payments.

Click here to view the complete testimony.

Bearing Down - The coming recession

Desmond Lachman doubts that monetary policy can stem the looming recession.

by Desmond Lachman

Wall Street estimates that bank losses stemming from bad lending behavior will range anywhere from $500 billion to $1 trillion. These numbers dwarf the losses from the savings-and-loan crisis of the 1980s.

Until very recently, most Wall Street analysts were in denial about the prospect of even a mild economic recession, let alone a serious and prolonged one. Ever optimistic, they turned a blind eye to the onset of the worst U.S. housing bust since World War II. They also minimized the gravity of the subprime mortgage crackup, the subsequent credit crunch (which has been plaguing the U.S. banking system since mid-2007), and the approximate doubling of global oil prices to around $90 a barrel.

Now that practically every economic indicator is signaling recession-from rapidly falling home prices to abysmal Christmas spending figures to declining employment growth to tightening bank lending standards-Wall Street analysts are conceding, reluctantly, that America might experience a recession in the first half of 2008.

However, they are all too quick to reassure us that this recession will be short and shallow, with a slowdown in the first half of the year to be followed by an early and vigorous rebound in the second half of the year. In making that forecast, they are pinning much hope on two things: the Federal Reserve’s recent decision to slash interest rates aggressively and the $168 billion fiscal stimulus package announced last week on Capitol Hill.

It would be wonderful if the Wall Streeters were right this time in their sanguine prognostication. The sad truth, however, is that all the important clues are pointing in the opposite direction. The main forces driving us toward a recession-high oil prices, a serious credit crunch, and the bursting of a major asset price bubble-are operating in combination with each other. At the outset of America’s three previous recessions-in 1981, 1990, and 2001-these forces were operating separately. Therefore, it seems reasonable to expect that a recession today will be longer-and more painful-than the postwar average (around nine months).

Steven Roach of Morgan Stanley argues, correctly, that the present housing market bust is affecting a very much wider swath of the U.S. economy than did the dot-com bust (which led to the 2001 recession). After all, the combined output of the housing sector and housing-related industries accounts for roughly 10 percent of the total U.S. economy-a considerably larger share than technology investment. And there is every reason to believe that national home prices will fall by at least another 10 percent in 2008, under the weight of record inventories of unsold homes, the scheduled resetting of adjustable rate mortgages, and a severe tightening of mortgage lending standards. These facts alone suggest that a 2008 recession will be more serious than the one in 2001.

In a similar vein, the present credit crunch is far more debilitating than was the savings-and-loan crisis of the mid-1980s. For while the credit woes of the 1980s were largely confined to the savings-and-loan sector, today’s credit problems seem to be much more pervasive, going well beyond subprime mortgage lending. Indeed, Wall Street estimates that bank losses stemming from bad lending behavior will range anywhere from $500 billion to $1 trillion. These numbers dwarf the losses from the earlier savings-and-loan crisis.

The optimists are hoping that the 2.5 percentage point cut in interest rates over the last few months, coupled with the recently announced fiscal stimulus package, will soon turn the economy around. But they choose to forget that interest rates had to be cut by 5.5 percentage points (to as low as 1 percent) following the dot-com crash before the economy began to recover. They also choose to overlook the troubled state of today’s banking system, which may reduce the efficacy of interest rate cuts this time around.

The good news is that both the Bush administration and the Federal Reserve have finally (if belatedly) grasped the urgency of the present situation. This indicates that they will do whatever it takes to prevent the U.S. economy from succumbing to the sort of vicious cycle that crippled the Japanese economy after the bursting of its asset price bubble in 1990. Yet monetary and fiscal policies often take a long time to have their full effect on economic activity. Indeed, at this late stage, it’s doubtful that either the administration or the Fed can prevent a nasty recession.

About the author: Desmond Lachman joined The American Enterprise Institute after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the IMF’s Policy and Review Department and was active in staff formulation of IMF policies toward emerging markets. Lachman has written on topics such as economic policy, fund arrangements, monetary reform, import restrictions, and exchange rates.

Reprinted with kindly permission of The American Enterprise Institute.

Subprime Crisis

Germany’s finance minister said to ministers from the Group of Seven financial leaders that total financial losses from subprime mortgages could top $400 billion and that central banks may need to make more emergency cash injections.

The comments come amid speculation that the European Central Bank may be increasingly willing to cut rates. Thus far it has stood pat as the U.S. Fed and the Bank of England have made cuts.

Prospects for the U.S. Economy in 2008

In remarks last Thursday, Dr. Janet L. Yellen, the president and CEO of the Federal Reserve Bank of San Francisco, outlined the major risks she sees threatening U.S. growth over the coming year. Yellen said further housing market declines, a weakening job market, and lingering troubles in the financial sector continue to pose big problems.

Speech to the Chartered Financial Analysts of Hawaii

by Dr. Janet L. Yellen, February 7, 2008

Good evening, and thanks for inviting me to be part of CFA Hawaii’s Annual Economic Forecast Dinner tonight. As President of the Federal Reserve Bank of San Francisco, it’s my responsibility to be in touch with what’s happening to the economy throughout our District, which includes Hawaii and eight other Western states. I do this both by monitoring developments and by visiting in person. I must say that this responsibility gives me particular delight when it comes to this beautiful and diverse state. For many years, my family and I have come to these islands for the perfect getaway, and, though I’m not able to stay for much R&R this time, simply being here in Hawaii adds a special kind of pleasure to this business visit.

Tonight I am giving my first speech of the year. And though the year is only seven weeks old, a great deal has already happened in the realm of monetary policy. On January 22, the Federal Open Market Committee cut its main policy rate-the federal funds rate-by three quarters of a percentage point. Then, on January 30, at the scheduled meeting, the Committee voted to cut the policy rate again, this time by half a percentage point to 3 percent. Taking these actions together with those that began last September, the Committee has cut that rate by a total of 2¼ percentage points.

The purpose of these actions is to stimulate demand in the face of the combined impact of the severe contraction in housing and the related financial market disruptions. While housing construction has been weak for more than two years, its effects did not spill over to most other sectors until fairly recently. That’s why we used to talk about a “dual economy,” with housing notably weak, but other sectors doing well. However, financial markets became disrupted in the middle of last year, which has not only intensified the housing slump, but also has tightened credit conditions for some households and businesses. The combined impact has led to slowing more broadly through the economy. It is this broader slowdown that has elicited Federal Reserve actions in recent months.

In my remarks today, I plan to discuss my views on policy and on the prospects for the nation’s economy this year and beyond.

Financial markets

I’d like to begin with a discussion of the disruptions in U.S. and global financial markets, because they influence not only the economy’s most likely course but also the risks that could alter that course. In my view, these disruptions are likely to continue for some time. In other words, I think they have laid bare some fundamental issues with the structure of the financial system that will require significant adjustments.

The financial disruptions are centered in the markets for asset-backed securities. The aim of such instruments is to diversify and spread risk, potentially enhancing economic welfare by broadening access to credit and lowering its cost. These instruments have been around a long time. For example, for many years, when a bank originated a mortgage, instead of holding it on its books, it may have sold the mortgage to one of the government-sponsored agencies, Fannie Mae or Freddie Mac. The agencies, in turn, would then bundle that mortgage with other similar mortgages into a security. The virtue of this mortgage-backed security is its liquidity-that is, it can be traded in financial markets. Since around 2003, private investment banks and commercial banks have increasingly been involved in securitizing mortgages and other assets as well. This business has grown dramatically, securitizing many types of underlying loans and, importantly, about 75 percent of all subprime mortgages in 2006.

Advances in financial engineering have led to new and complex forms of asset-backed securities. For example, CDOs, or collateralized debt obligations, package multiple mortgage-backed securities-essentially securitizing several already securitized bundles of long-term debt instruments. Typically, they include tranches-literally, “slices”-of mortgage-backed securities with different exposures to risk based on a prioritization of the payments from the underlying mortgage securities, and are a type of “structured credit.” There are even instruments, known as CDO2, that consist of tranches based on holdings of other CDOs, rather than “simple” mortgage-backed securities, and CDO3 that, as you might now guess, consist of tranches based on holdings of CDO2.

To deal with the complexity of these instruments, many market participants, including financial institutions and other sophisticated investors, relied to a great extent on credit rating agencies for assessments of the risk. However, last summer, to the surprise of many, the rating agencies announced a set of substantial downgradings of highly rated tranches of a number of subprime mortgage-backed securities in light of rapidly rising delinquencies in some types of those mortgages. These downgrades raised concerns not only about mortgage-backed securities themselves, but also about the quality of rating agencies’ evaluations of risk in other structured credits. As a result, investors grew wary, as they had trouble knowing what risks were embedded in these instruments, how to price the risks, and who would ultimately bear the risks. The consequence is that the markets for many such assets are now highly illiquid and all but closed for new business.

With the benefit of hindsight, it is now apparent that underwriting standards slipped substantially in the United States as house prices soared. For example, permissible combined loan-to-value ratios edged up during 2005 and 2006. And no- or low-documentation loans-so-called “stated income” loans-became more prevalent. Such loans might have performed reasonably well if house prices had continued to rise, but once house prices leveled off and then began to decline, the stage was set for trouble.

The financial turmoil has spread beyond the mortgage market in part because structured credits have been based on a wide variety of underlying loans, such as business loans, including the loans used to finance the recent wave of leveraged buyouts, or LBOs, commercial real estate, student loans, credit card loans, and subprime mortgages, to name a few.

The bottom line is that, in recent years, the financial system has gone through a significant restructuring that made evaluating and pricing risk difficult. The reverberations of the resulting financial disruption are still with us. I’d like to describe some of them now.

As investors have sought to shun risk, there has been a worldwide “flight to safety,” leading to a strong demand to hold U.S. Treasury securities-the safest and most liquid instruments in the world. This demand has contributed to a sharp decline in interest rates on Treasuries. Of course, these rates also have declined because of the Committee’s moves to ease policy.

However, the potential stimulatory effects of this drop in risk-free Treasury rates have been offset in many cases by another key feature of the financial turmoil, namely, a sharp rise in interest rate risk spreads, as riskier borrowers have had to pay higher premiums to compensate lenders for a perceived increase in the probability of default or losses in that event. On the corporate side, prime borrowers have actually experienced some net decline in interest rates since the shock first hit-that is, even though risk spreads are higher, they have been more than offset by lower Treasury rates. However, issuers of low-grade corporate bonds with greater credit risk, in contrast, face notably higher interest rates.

The mortgage market has been the epicenter of the shock, and, not surprisingly, greater aversion to risk has been particularly apparent there, with spreads above Treasuries increasing for mortgages of all types. Although borrowing rates for low-risk conforming mortgages are now lower than they were before the financial shock hit, fixed rates on jumbo mortgages are higher on net. Subprime mortgages remain difficult to get at any rate. Moreover, many markets for securitized assets, especially non-agency mortgage-backed securities, continue to experience severe illiquidity; in other words, the markets are not functioning efficiently, or may not be functioning much at all.

The turmoil is reverberating in depository institutions as well.1 One problem is an unanticipated buildup of mortgages as well as LBO-related loans on their balance sheets. These loans were in the pipeline for securitization but could not be sold. This problem has hit banks in part because they themselves were involved in creating structured credits that held mortgages and the leveraged loans that they had originated. In addition, they face problems with some structured investment vehicles, or SIVs, that they had sponsored and backstopped to hold and fund portfolios of securitized assets through the issuance of asset-backed commercial paper. When the SIVs were in danger of failing, the banks were concerned about reputational effects and decided to rescue them by taking the underlying assets back onto their own balance sheets. Furthermore, as investors have pulled back from the markets for asset-backed securities, the value of these securities and CDOs has fallen dramatically, so banks and other financial institutions have had to write down their values, which has shrunk their capital and driven their stock prices down.

Another problem for bank balance sheets is that credit losses have been edging up.
The latest reverberation involves monoline financial guarantors. These companies guarantee the timely payment of principal and interest due on various types of securities, including structured credits. The guarantees can increase the credit rating of the covered securities and thus increase the value of those securities on banks’ balance sheets. The problem today is that the guarantors are reporting sizable losses because of the increased riskiness of the securities they are covering. Those losses can affect the guarantors’ capital positions and even their own credit ratings. A rating downgrade of a guarantor reduces the value of its credit enhancements and lowers the price of the covered securities. Holders of those securities such as banks then have to take write-downs to reflect the lower value of the securities.

Fortunately, the banking system entered this difficult period in a strong position. Most institutions were extremely well capitalized. However, the combination of unanticipated growth in assets and in write-downs has put increased pressure on banks’ capital positions. Given their concerns about capital adequacy and their increased caution in managing liquidity, it is not surprising that they are tightening credit terms and restricting availability. At first, the focus was mostly on mortgages, but now it has spread to other kinds of loans, including home equity lines of credit, credit cards, and other consumer credit, as well as business loans. The tightening of credit is also a response to a now noticeable deterioration in credit quality, particularly for subprime mortgages; the losses in other parts of the consumer loan portfolio remain at relatively low levels from an historical perspective, but they, too, have edged up.

Finally, equity markets have hardly been immune to recent financial turbulence. Broad U.S. equity indices have been very volatile, and, on the whole, have declined since August, representing a restraint on spending. More recently, some of these declines have occurred as profits have come in below market expectations for some financial firms due to write-downs of the value of mortgage-backed securities.

My overall assessment is that the turbulence in financial markets is due to some fundamental problems that are not likely to be resolved quickly. The effects of these problems have now made credit conditions tighter throughout most of the economy’s private sector, and this will restrain spending going forward. The impact hit economic activity mainly in the fourth quarter, and so far, it has been starkly negative. After robust performance in the second and third quarters of last year, growth slowed significantly in the fourth quarter-to a pace of only ½ percent. This brings me to the outlook for the economy.

Economic outlook

Current indicators point to continued anemic growth for at least the first half of this year as well as significant downside risks even to those weak expectations. As I mentioned at the outset, though the prolonged slump in housing construction did not spill over significantly to the rest of the economy during 2006 and much of 2007, when combined with the recent financial market turmoil, it has been central to the emergence of today’s slow-growth environment. And the course of its resolution will be a key factor in the economic outlook.

Forward-looking indicators of housing activity strongly suggest that the downward cycle may be with us a while longer. Housing permits and sales are dropping, and inventories of unsold homes are at very high levels. Those inventories could rise even higher as foreclosures continue to mount. I’m not referring only to foreclosures on subprime adjustable-rate mortgages, which, as we all know, have increased sharply over the past couple of years. More recently, we’ve begun to see increases in foreclosures on subprime fixed-rate mortgages and even on prime adjustable-rate mortgages.

Within this Federal Reserve District, housing has been harder hit in some areas than in others. For example, builders and homeowners in parts of Arizona, Nevada, and the inland regions of California have seen some of the worst of the downturn, watching prices fall and equity evaporate as homes sit unsold for extended periods.

Hawaii has been near the opposite end of the spectrum. Indeed, the sales pace for existing homes actually increased during the first nine months of the year compared with the same period in 2006, reflecting healthy economic conditions in the state, and a lower exposure to the subprime mortgage market. Subprime lending accounted for only about a fifth of mortgage originations in Hawaii in 2006, compared to about one-third in parts of Arizona, California, and Nevada. Nevertheless, the foreclosure rate has risen sharply here, although it remains well below rates in the harder-hit states. Following several years of double-digit appreciation rates, prices on existing homes in Hawaii largely flattened out by the end of 2007, but have not shown the declines that are evident in some other parts of the District.

On the national level, housing construction probably will continue to contract through the end of this year. It is true that the residential construction sector is a fairly small piece of the overall economy and is unlikely to cause significant overall weakness in and of itself. But the fallout from the housing cycle has many dimensions, and in the fourth quarter there were signs of spillovers to other sectors of the economy, most worrisomely, to consumer spending. This sector is a huge part of the economy-about 70 percent-and its growth slowed to a rate that is somewhat below its long-run trend in the face of spillovers from the housing market and rising energy and food prices.

Looking ahead, developments related to housing are likely to continue to put a strain on consumers. For example, house prices have fallen noticeably and the declines have intensified. Moreover, futures markets for house prices indicate further-and even larger-declines in a number of metropolitan areas this year.

With house prices falling, homeowners’ total wealth is declining, and that could lead to a pullback in spending. At the same time, the fall in house prices may constrain consumer spending by lowering the value of mortgage equity; less equity reduces the quantity of funds available for credit-constrained consumers to borrow through home equity loans or to withdraw through refinancing.

Indeed, it would not be surprising to see even more moderation over the next year or so, as consumers face additional constraints due to the declines in the stock market, the tightening of lending terms at depository institutions, and the lagged effects of previous increases in energy prices. National surveys show that consumer confidence has plummeted. And I have been hearing comments and stories from my business contacts in the retail industry that are also downbeat. The rise in delinquency rates across the spectrum of consumer loans is strongly indicative of the growing strains on households.

Finally, another negative factor for consumption is that labor markets have softened. In recent months, growth in employment from a survey of business establishments slowed sharply, actually falling in January, and many other indicators point in the same direction. Slower job growth will have a negative impact on the disposable income available to households and therefore will provide an additional restraint on consumer spending.

Slower growth in consumer spending has already started to affect the Hawaiian economy. Up to last year, Hawaii enjoyed an extended run of robust growth in the tourism industry, spurred primarily by visitors from the U.S. mainland. This helped Hawaii achieve the lowest unemployment rate in the nation during 2004 through 2006. Last year, tourist visits actually dropped a bit, largely because fewer mainlanders came over. Employment growth in the state has slowed accordingly, and the unemployment rate is up by more than a percentage point from its remarkable low of 2 percent at the end of 2006. Nevertheless, economic conditions remain sound by historical standards, and the state appears well-positioned to weather any further spending reductions by U.S. consumers.

With the domestic consumer likely to be pretty hobbled, it is tempting to look at consumers beyond our own borders to be a source of strength for economic activity. Foreign real GDP has advanced robustly over the past three years. With the dollar falling well below its level of a year ago, U.S. exports have done very well; partly for this reason, U.S. net exports-exports minus imports-which consistently held growth down from 2000 to 2005, actually gave it a lift over the past couple of years. I expect net exports to remain a source of strength. But some countries-especially in Europe-are experiencing direct negative impacts from the ongoing turmoil in financial markets. Others are likely to suffer indirect impacts from any slowdown in the U.S. A slowdown here could well produce ripple effects lowering growth there through trade linkages, and recently this factor has been reinforced by a worldwide drop in stock prices.

Economic policies are another important factor in gauging the economic outlook. As I have noted, the FOMC has eased the stance of monetary policy substantially in the past five months. Moreover, there is considerable talk in Congress about passing a fiscal stimulus package to help the economy. If such a bill is passed soon, it could provide notable stimulus in the latter half of this year.

Even with such policy stimulus, the overall economy is still likely to turn in a very sluggish performance this year, expanding by a rate well below potential and creating more slack in labor markets. At 4.9 percent, the unemployment rate is already slightly above my estimate of its sustainable level. Slow growth this year would most likely push unemployment even higher.

To sum it up, for the next few quarters, I see economic activity as weighed down by the housing slump and the negative factors now impacting consumer spending. It remains particularly vulnerable to the continuing turmoil in financial markets. My comments haven’t even touched on possible slowdowns in business investment in equipment and software and buildings. I see the growth risks as skewed to the downside for the near term. In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop-that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution. Indeed, an important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold.

Now let me turn to inflation. The recent news has been disappointing. Over the past three months, the personal consumption expenditures price index excluding food and energy, or the core PCE price index-one of the key measures included in the FOMC’s quarterly forecasts-has increased by 2.7 percent, bringing the increase over the past 12 months to 2.2 percent. This rate is somewhat above what I consider to be price stability.

I expect core inflation to moderate over the next few years, edging down to around 1¾ percent under appropriate monetary policy. Such an outcome is broadly consistent with my interpretation of the Fed’s price stability mandate. Moreover, I believe the risks on the upside and downside are roughly balanced. First, it appears that core inflation has been pushed up somewhat by the pass-through of higher energy and food prices and by the drop in the dollar. However, recently, energy prices have turned down in response to concerns that a slowdown in the U.S. will weaken economic growth around the world, and thereby lower the demand for energy.

Another factor that could restrain inflationary pressures is the slowdown in the U.S. economy. This can be expected to create more slack in labor and goods markets, a development that typically has been associated with reduced inflation in the past.
A key factor for inflation going forward is inflation expectations. These appear to have become well-anchored over the past decade or so as the Fed’s inflation resolve has gained credibility. Very recently, far-dated inflation compensation-a measure derived from various Treasury yields-has risen, but it’s not clear whether this rise is due to higher inflation expectations or to changes in the liquidity of those Treasury instruments or inflation risk. Going forward, we will need to monitor inflation expectations carefully to ensure that they do indeed remain well anchored.

Monetary policy

Now let me turn to monetary policy. The federal funds rate has been cut by 2¼ percentage points since September and now stands at 3 percent. With near-term expected inflation of just above 2 percent, the real-inflation adjusted-funds rate is around 1 percent or slightly lower, which represents an accommodative posture.

I believe that accommodation is appropriate because the financial shock and the housing cycle have significantly restrained economic growth. While growth seems likely to be sluggish this year, the Fed’s policy actions should help to promote a pickup in growth over time. I consider it most probable that the U.S. economy will experience slow growth, and not outright recession, in coming quarters. At the same time, core consumer inflation seems likely to decline gradually to somewhat below 2 percent over the next couple of years, a level that is consistent with price stability.

However, economic prospects are unusually uncertain. And downside risks to economic growth remain. This implies that, going forward, the Committee must carefully monitor and assess the effects of ongoing financial and economic developments on the outlook and be prepared to act in a timely manner to address developments that alter the forecast or the risks to it.

U.S. Federal Reserve writes a new economic script

The U.S. Federal Reserve cut its benchmark interest rate by half a percentage point yesterday and signaled it may cut rates further if that is necessary to stave off a recession.

The cuts come on the heels of emergency cuts of three-quarters of a point last week and represent a curtailment of the Fed’s “gradualist” policy, in which it had generally sought to make incremental adjustments of one-quarter point at a time.

The Economist deemed the measure “aggressive activism” and says it represents a new policy script for the Federal Reserve.

Asian markets responded tentatively to the rate cut in mixed trading this morning, uncertain whether lower interest rates would be enough to overcome lingering credit problems.

The Boston Globe reports the rate cuts could translate to “lower credit costs for consumers and businesses, relief for homeowners with adjustable rate mortgages, and a better chance to halt the economy’s deterioration.”

But experts say a slew of problems remain and add that rate cuts aren’t a cure-all. One potential problem is inflation, which remains relatively low in the United States but could spike due to a combination of rate cuts, rising energy prices, and the falling dollar.

Reforming the Regulation of Financial Services

A Luncheon Address by Steve Bartlett, President and CEO of The Financial Services Roundtable

American Enterprise Institute, Washington, D.C., January 28, 2008

In November 2007, the Financial Services Roundtable published The Blueprint for U.S. Financial Competitiveness, a report that recommended ways to counteract the gradual decline in U.S. financial services competitiveness because of excessive regulation, litigation risk, and lack of regulatory coordination.

Since then, many financial services organizations have provided comments and recommendations to the U.S. Treasury Department, which is developing its own recommendations for reform.

How closely do the comments of financial institutions and financial services organizations line up with the recommendations of the Financial Services Roundtable? Is there a developing consensus for reform, or are there continuing divisions within the financial services industry?

The Financial Services Roundtable has analyzed the submissions to Treasury and compared them to its own Blueprint. At this luncheon speech, Steve Bartlett, the Roundtable’s President, outlined the conclusions of this study.

Read full story.

5 Myths about that depressing R(ecession)-Word

Kevin A. Hassett, Director of Economic Policy Studies at the American Enterprise Institute, argues that people believe that a recession is just around the corner because far too many myths about recessions have made their way into popular culture.

by Kevin A. Hassett

The Washington Post, January 20, 2008

Early economic studies seemed to confirm the view that the economy has become less volatile over time, with some estimates implying that the severity of recessions declined by 75 percent roughly around the end of World War II.

When Scottish historian Thomas Carlyle branded economics the “dismal science” in 1849, he gave it a name that would stick. (Some theorize that he picked on economists since, like most Scots back then, Carlyle had never visited a dentist.) Fortunately for economists, 1849 was a pretty good year. If Carlyle had seen how economists behave during recessions, he probably would have dubbed their subject something far worse.

Economists have the same occupational hazard as baseball managers and football coaches: Every person on the street knows their job better than they do.

And if you listened to the economic stimulus package talk last week from the White House and Capitol Hill, not to mention Federal Reserve Board Chairman Ben Bernanke, you could be forgiven for thinking that the recession is just around the corner. But the main result of all this chatter is that far too many myths about recessions have made their way into popular culture.

1. We’re already in a recession.

The truth is, nobody knows. The responsibility for declaring the stages of the business cycle is informally held by that most dreaded of concepts - a committee of economists. The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) uses a number of economic indicators, including personal income, unemployment, industrial production and sales and manufacturing volume, to determine the health of the economy. It’s not true that they declare a recession if economic growth is negative for two quarters in a row. If it were that simple, we wouldn’t need a committee.

If you want to know about the state of the economy in real time, you can’t rely on the NBER. If the NBER did the D.C. weather forecast, here’s how it would work. The bureau would gather precipitation data from every neighborhood, then interview residents to make sure that the data are accurate. After much deliberation, it would tell us whether it had rained last month. Same with recessions: The NBER’s pronouncements historically come long after recessions have begun, a whopping seven months on average. By the time the bureau announced the recession of 1991, it had already ended.

It’s impossible to tell whether the NBER will make a pronouncement anytime soon. Right now, we only have enough data to assess the economy accurately through last November. The best available real-time indicator of recession, a model developed by economist Marcelle Chauvet of the University of California at Riverside that has correctly called every postwar recession without ever giving a false signal, clearly indicates that the economy was not in recession in November. Things certainly have deteriorated since then, but it is an open question whether they have deteriorated enough. A recession may have started. Or it may not have.

2. The stock market tanks during recessions.

Not so. With the economy heading south during recessions, the conventional wisdom is that stock prices drop as well. Stocks usually drop before a recession, something that may be happening now. However, the market tends to look ahead and starts to respond favorably to the expected end of a recession long before it occurs. Influential economist Donald Luskin of Trend Macrolytics recently ran the numbers and found that stocks have produced an average return of 12.1 percent in post-World War II recessions. This is only slightly below the average return outside recessions.

3. Recessions used to be a lot worse.

Lunchroom economic conversations are inevitably graced with at least one statement from an old-timer along the lines of: “In my day, we walked 10 miles in the snow just to get to the recession.” In fact, the nature of recessions hasn’t changed much over the years.

Early economic studies seemed to confirm the view that the economy has become less volatile over time, with some estimates implying that the severity of recessions declined by 75 percent roughly around the end of World War II. However, a prominent study by University of California at Berkeley economist Christina D. Romer demonstrated that the problem really was that prewar data collectors had not advanced to the exalted level of data-geekdom of today’s professionals. When important changes in data-collection methods and inconsistencies in the historical definition of the business cycle were accounted for, it emerged that recessions before World War I and since World War II have been just about equally severe.

While the past three recessions may have seen slightly smaller drops in economic growth on average, there is no guarantee that the next one - when it arrives - will be mild. The superstitious might even say that we are due for a whopper.

Recessions probably have become less frequent. In terms of duration, the average recession since World War II has lasted about a year. The past three recessions - in 1981-82, 1990-91 and 2001 - lasted about a year as well.

One factor that has clearly not helped is government discretionary fiscal policy, like the economic stimulus packages currently being considered on Capitol Hill. You might think that the brilliant postwar discoveries of economists wou