Bailout Bandwagon

Yesterday’s commentary, Major Policy Shift — or Politics as Usual?, was picked up in Alan Abelson’s Up and Down Wall Street column in Barron’s:

"WHAT IS MORE THAN PASSING strange is that Mr. Bush chose seemingly at the last minute to do his "to the rescue" bit the very morning that Fed Chairman Ben Bernanke was slated to address housing and its discontents at Jackson Hole, Wyo. We’re not really into conspiracy theory, but at the very least, you can reasonably hazard that the White House cabal had a pretty good notion, if not an actual copy, of what Mr. Bernanke intended to say. That suggests two likely possibilities.

The first is that while pretty much assuring the world he’d cut rates expeditiously, both his tone and caveats seem too measured to satisfy the political fire-eaters (a.k.a. advisers) surrounding — some might call it smothering — the president. The second is those same devious types, reckoning correctly that even Mr. Bernanke’s tempered expression of concern about the parlous state of housing and the mortgage mess would give stocks a shot-in-the-arm, were determined that Mr. Bush get a big helping of the credit.

Barry Ritholtz, the canny market watcher and proprietor of the eponymous Ritholtz Capital Partners, also finds the timing of the president’s remarks "intriguing." He points out that not only did they upstage Mr. Bernanke’s eagerly awaited speech, but they came on the eve of a three-day weekend, the last day of the month and the last day of the fiscal year for some financial firms.

If you’re "introducing a major economic policy initiative that was going to address a major issue," he wonders, "wouldn’t you wait until Tuesday? It’s only four days away," and he notes that "this is a huge vacation week and many people aren’t around." Which, we might interject, makes for a very thin market, all the more likely, as those wily advisers were no doubt aware, to produce a rousing response to the slightest hint of a bail-out for hard-pressed homeowners and, of course, lenders as well.

To Barry, it all smacks of politics rather than policy, as well as a desire to give a lift to big investment banks, precisely when they could use one most. The group, as you may have noticed, has been floundering badly of late, both in the marketplace and the stock market.

THE IRONY IS THAT MR. BUSH’S proposals may have served a function in goosing a very nervous stock market but aren’t likely to yield much else than disillusionment.

A hedge-fund manager quoted by Barry sums it up rather persuasively: "I don’t see anything in Bush’s plan that will change the insolvency of the home buyer. The ‘system’ is illiquid (and that ‘problem’ was addressed by the central banks two weeks ago), but the ‘borrowers’ are insolvent. Nothing I’ve seen yet changes that fact. Nothing. Besides, has this administration, which doesn’t believe in government programs, ever done anything well bureaucratically?"

Softening the tax bite on mortgage write downs and allowing homeowners who are delinquent by more than three months and who have a decent credit history to switch into a Federal Housing Administration loan carrying a lower interest rate will effect modest fixes, but are no big deal. Certainly, given the wretched condition of housing, the inexorable decline in home prices and the prospect of a huge resetting upwards of adjustable-rate mortgages over the next 12 months, with a big spike in March ’08, we’re talking Band-Aids rather than serious relief.

Now that the president, however tentatively, is officially on board, the bailout bandwagon is sure to pick up speed, volume and passengers, particularly with an election year looming. That could mean, as the sharp rise in the price of gold, up over $7 an ounce on Friday, gives fair warning, a rash of fiscal fecklessness, fresh debasement of the dollar and that most unenviable of economic combinations — no growth and inflation.

What it doesn’t mean is a return to the good old days of easy and just about free credit and all the nice bubbly things that went with it. Nor, we fear, does it portend even a modest rebound in housing in the next 12 months. The party’s definitely over and no one’s sorrier than we are. It sure was fun to watch."

Glad I wasn’t the only one who found that timing suspicious . . . 

>

Source:
Bailout Bandwagon

UP AND DOWN WALL STREET 
ALAN ABELSON
Barron’s MONDAY, SEPTEMBER 3, 2007   
http://online.barrons.com/article/SB118860258217115202.html

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  1. Chief Tomahawk commented on Sep 1

    Yes, the election year is going to make things quite interesting with regards to the housing situation and what plans get pitched.

  2. Eclectic commented on Sep 1

    Anybody intrigued by the timing of that press release is too e-a-s-i-l-y intrigued… maybe like splash would be an intrigue wrought by dive.

    I would say that AA needs to be careful and not lick his fingers after flipping Roget’s pages… They might be conspiratorially dusted with some nerve toxin, or in this particular case of cerebral shortcoming, lead poisoning:

    http://www.lead.org.au/fs/fst28.html

    I think you’re stretching a bit here, although I have no doubt the nature of Bernanke’s speech (if not an entire copy) was available to the WH beforehand.

    Now, let’s review:

    -The speech was long ago scheduled in a far away joyful and happy time when the most intriguing thing about the conference was probably whether breakfast would have hash browns or potatoes O’Brien.

    -Conspirators, Bush and Bernanke, would’ve needed to engineer a worsening liquidity crisis with such subtle timing as to place the most significant crack-up just prior to the Friday Bernanke speech, and just prior to a trading Friday, at the end of a quarter and on the last day for lo, 3 long days of insecurity about the afforementioned crack-up.

    -Someone would’ve needed to slip the word to Herb Greenberg not to be so impolite as to ask the Chairman for clarification of a new divination, one the Chairman likely ordained in trance-like devotion to trying to offer a solution to parties unable to construct solutions of their own. Such is the greatest contribution a teacher can make, no matter that the targets of the effort are un-teachable, or they’ve just been playing dumb for convenience.

    I’d rather be Eclectic (in fact, heck, I *am* Ec-lectic) and criticize when it’s appropriate but give credit when it’s due.

  3. Rob Dawg commented on Sep 1

    Relabelling insolvency illiquidity doesn’t change the problem. But then the entire focus is on the symptom not the problem anyway.

  4. dblwyo commented on Sep 1

    There’s the timing question and the substance questions. Clearly Ben and the Fed want to NOT lower rates while easing the liquidity problems. Also clearly sub-prime is becoming a major political problem (opportunity). The question on the latter is a) are the proposals significant – I’d argue as as Barry does that they are window-dressing. Worse they are dangerous. And b) whether a workable proposal is likely to be forthcoming. The last three years have seen first a bubble in real-estate and other assets based on leverage and the slow unraveling of the housing boom. We’re going to get something and we likely won’t like it. Worse from an investor’s point of view is that all the proposals on the table make the underlying moral hazard risks stronger and mean a renewal of leverage based buyouts, buybacks and loss avoidances.
    These are going to be very interesting times.

  5. dblwyo commented on Sep 1

    There’s the timing question and the substance questions. Clearly Ben and the Fed want to NOT lower rates while easing the liquidity problems. Also clearly sub-prime is becoming a major political problem (opportunity). The question on the latter is a) are the proposals significant – I’d argue as as Barry does that they are window-dressing. Worse they are dangerous. And b) whether a workable proposal is likely to be forthcoming. The last three years have seen first a bubble in real-estate and other assets based on leverage and the slow unraveling of the housing boom. We’re going to get something and we likely won’t like it. Worse from an investor’s point of view is that all the proposals on the table make the underlying moral hazard risks stronger and mean a renewal of leverage based buyouts, buybacks and loss avoidances.
    These are going to be very interesting times.

  6. blam commented on Sep 1

    It’s just bad luck that the bubble economy is un-winding 18 months before we get rid of supply side cabal. Bad luck, I tell you.

    The housing collapse is only a symptom of the real disease, a credit bubble collapse. The cupboard is bare. No more debt capacity to be engineered unless it is replacement at a lower price for both money and assets. Greenspan and Weil’s version of the world is reaching it’s logical conclusion.

    The great deflation, created by the platform corporate structure and forestalled by CB financial manipulations across the world these last five years, is the ghost haunting wall and broad.

    The mercantilists will have to pony up with credit soon to keep it going, which they will do. Indigenous consumerism isn’t in their vocabulary. There exists parallel supply chains in the world, the old expensive one in the west and the shiny new one in the east. Without the credit bubble, they both will not survive. This is the specter of things to come that visited Greenspan, and his corporate cronies, in 2002. Without the destruction of personal savings and explosion of consumer bubbles, the reality of supply side deflation would have been much more apparent, before now.

    Inflation or deflation, pick yur pizen. Support or collapse of the asset price bubble.

  7. John commented on Sep 1

    I think you all are losing what has and is happening . Our word for repaying our debt has been greatly diminished . The chinese are being burned for our easy credit and buying and they are not going to be burned twice . So the panic is that all the leverage smart ass hedge funds did is going to crumble . We have killed more people then we have helped in the world and now people are actually really excited about forclosing on our house , not to own it , just to watch us suffer , its takes money to buy guns and we are going to have much less of it soon , which in turn will greatly reduce our ability to wage war . China has a 500 year plan , we have ceo’s buying expensive shower curtins.
    PS : I would not want to be the guy’s that have to tell the chinese that I’m not paying them back , they have a way of taking it really personal , hope they can’t find your island now that the BOC can’t find 10 billion .

  8. Werner Merthens commented on Sep 1

    Could it be that the tortured psyche of the perennial pessimist has to wrestle with the fact that the most dire predictions for the stock market failed to materialize yet again?

    Under that theory it will naturally seek solace in conspiracies and ponders possibilities of foul play.

    ~~~

    BR: No. This was but a minor distraction, one that is likely to have de minimis impact.

    I will note that ad hominum attacks reveal more about those who make them than and the weakness of their arguments than the actual subject at hand . . .

  9. zell commented on Sep 1

    Bravo Barry! Amen Blam! Werner: the stock market is just a side show to what is going on. Better to read up on tectonic plates.

  10. Winston Munn commented on Sep 1

    These comments are a reproduction from my earlier post but I thought them cogent to this discussion and to what blam said above:

    “Taking the overall viewpoint, we have a debt expansion-requisite economic system that has been able through globalization to surpress real wages in order to inflate corporate profits but is in the end dependent upon those very surpressed to increase debt-burden to sustain the expansion.

    Inflation (phantom profits) will quickly turn to deflation (phantom losses) if credit expansion is not quickly restored – and that is what will turn out to be the Bernanke Put: when consumer spending is affected we will see his Greenspan side.”

    This current debate is not about the U.S. stock market – it is about systemic risk.

    The present conditions are far removed from bullish booyahs or bearish boo-boos, and to marginalize the discussion with either is to display lack of depth of understanding.

  11. Katherine commented on Sep 1

    Excellent, clear summary of current economic trends at safehaven.com. See the article “Just Roll With It” by PF.

  12. Katherine commented on Sep 1

    Sorry – That’s Contrary Investor at PF.

  13. jz commented on Sep 1

    It’s spelled c o o r d i n a t i o n

    It’s neither unconstitutional nor illegal

    It’s useful

  14. JZ commented on Sep 1

    This quote was in Bernankes speech on friday. I haven’t heard anything about this on national tv or the papers. It seems to me to be a big part of the Fed not dropping rates. Please give some feed back..

    “Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past. These results are embodied in the Federal Reserve’s large econometric model of the economy, which implies that only about 14 percent of the overall response of output to monetary policy is now attributable to movements in residential investment, in contrast to the model’s estimate of 25 percent or so under what I have called the New Deal system. ”

  15. Robert commented on Sep 1

    Coordination – Two posts up put it concisely. Of course Ben doesn’t want to drop rates, so they (He and Bush) colluded and came up with a plan to surgically rescue the economy. Will it work? Maybe. I’m still betting on a 1/4 point rate cut, possibly 1/2, but I would not be surprised to see Ben hold rates steady and play the waiting game. Only time will tell whether he waits too long or not.

  16. DavidB commented on Sep 2

    Gold traditionally rallies around this time of year. Unless that lap dog is moving 20 – 50 bucks a day I wouldn’t put much trust in its crisis forecasting abilities these days. Someone managed to slip a leash on that beast and drug its puppy chow

  17. Eclectic commented on Sep 2

    JZ,

    I’ll tell you that I’m nearing completion of an entire review and interpretation of Bernanke’s speech. When you later read it (if you do), you should then regain any loss of context you might experience here from not having read my entire interpretation:

    First, let’s source the speech to the Federal Reserve’s Website:

    http://www.federalreserve.gov/boarddocs/speeches/2007/20070831/default.htm

    I’ve done that since my remarks are referenced to his speech, but I can’t reproduce his links to footnote references which you should be aware of.

    To your question. Quoting you:

    “This quote was in Bernankes speech on friday. I haven’t heard anything about this on national tv or the papers. It seems to me to be a big part of the Fed not dropping rates. Please give some feed back..” end quote.

    Here’s the feedback you requested:

    From the speech, I’ll quote Bernanke without notation and then ***make my own comments identified with asterisk:

    Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past.9 These results are embodied in the Federal Reserve’s large econometric model of the economy, which implies that only about 14 percent of the overall response of output to monetary policy is now attributable to movements in residential investment, in contrast to the model’s estimate of 25 percent or so under what I have called the New Deal system.

    ***Basically he’s saying to us all, including Senators Schumer and Dodd, and to Wall Street and the White House, that since much of the economy of the USA is dependent on the residential construction industry and allied industries, and further since monetary policy has less effect now on residential housing than it did under the New Deal system and long before the securitizations industry developed, that we’re viewing potential changes in the Fed Funds rate as having relatively more effect than they likely can have in the current environment. Thus expectations for Fed Funds cuts are possibly overwrought.

  18. Eclectic commented on Sep 2

    THE BERNANKE SPEECH: AN ECLECTIC VIEW

    The speech found here (footnote references only available at the Federal Reserve’s Website publication):

    http://www.federalreserve.gov/boarddocs/speeches/2007/20070831/default.htm

    This is a complete line-by-line review (although consolidated text is left in paragraphs) and interpretation of the Bernanke speech at Jackson Hole last Friday. In performing the review, I have taken the freedom to alter paragraphs or paragraph breaks, although I have not changed any of Chairman Bernanke’s words or heading. I suggest one should print the speech in its entirety and reference it as you read my comments regarding my personal interpretation of what the speech means. Mr Bernanke’s words will not carry quotation marks, except where he uses them. You may assume that all paragraphs not beginning with asterisks in this fashion (***) are completely his words, and that all such paragraphs identified with asterisks are my own. I have omitted only the Federal Reserve boilerplate heading (Please begin):

    Remarks by Chairman Ben S. Bernanke
    At the Federal Reserve Bank of Kansas City’s Economic Symposium, Jackson Hole, Wyoming
    August 31, 2007

    Housing, Housing Finance, and Monetary Policy

    Over the years, Tom Hoenig and his colleagues at the Federal Reserve Bank of Kansas City have done an excellent job of selecting interesting and relevant topics for this annual symposium. I think I can safely say that this year they have outdone themselves. Recently, the subject of housing finance has preoccupied financial-market participants and observers in the United States and around the world. The financial turbulence we have seen had its immediate origins in the problems in the subprime mortgage market, but the effects have been felt in the broader mortgage market and in financial markets more generally, with potential consequences for the performance of the overall economy.

    ***Key words: preoccupied, turbulence, subprime, broader and consequences.

    In my remarks this morning, I will begin with some observations about recent market developments and their economic implications. I will then try to place recent events in a broader historical context by discussing the evolution of housing markets and housing finance in the United States. In particular, I will argue that, over the years, institutional changes in U.S. housing and mortgage markets have significantly influenced both the transmission of monetary policy and the economy’s cyclical dynamics. As our system of housing finance continues to evolve, understanding these linkages not only provides useful insights into the past but also holds the promise of helping us better cope with the implications of future developments.

    ***I’ll go ahead and blow my cover and tell you that in his concluding remarks to this speech he’ll re-state a core observation that he’ll now begin to make the case for in this long epistle of over 5,400 words. That observation is in two parts: 1)- The mortgage securitizations industry has developed in a way and to a magnitude (supported also in other speeches) that has now limited the effectiveness of monetary policy to react to instability in the housing market, and 2)- Past relationships (or correlation) between the housing industry and the overall economy have de-linked in the current decade.

    Recent Developments in Financial Markets and the Economy

    I will begin my review of recent developments by discussing the housing situation. As you know, the downturn in the housing market, which began in the summer of 2005, has been sharp. Sales of new and existing homes have declined significantly from their mid-2005 peaks and have remained slow in recent months. As demand has weakened, house prices have decelerated or even declined by some measures, and homebuilders have scaled back their construction of new homes. The cutback in residential construction has directly reduced the annual rate of U.S. economic growth about 3/4 percentage point on average over the past year and a half. Despite the slowdown in construction, the stock of unsold new homes remains quite elevated relative to sales, suggesting that further declines in homebuilding are likely.

    ***No comment required.

    The outlook for home sales and construction will also depend on unfolding developments in mortgage markets. A substantial increase in lending to nonprime borrowers contributed to the bulge in residential investment in 2004 and 2005, and the tightening of credit conditions for these borrowers likely accounts for some of the continued softening in demand we have seen this year. As I will discuss, recent market developments have resulted in additional tightening of rates and terms for nonprime borrowers as well as for potential borrowers through “jumbo” mortgages. Obviously, if current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. We are following these developments closely.

    ***No comment required.

    As house prices have softened, and as interest rates have risen from the low levels of a couple of years ago, we have seen a marked deterioration in the performance of nonprime mortgages. The problems have been most severe for subprime mortgages with adjustable rates: the proportion of those loans with serious delinquencies rose to about 13-1/2 percent in June, more than double the recent low seen in mid-2005.1 The adjustable-rate subprime mortgages originated in late 2005 and in 2006 have performed the worst, in part because of slippage in underwriting standards, reflected for example in high loan-to-value ratios and incomplete documentation. With many of these borrowers facing their first interest rate resets in coming quarters, and with softness in house prices expected to continue to impede refinancing, delinquencies among this class of mortgages are likely to rise further. Apart from adjustable-rate subprime mortgages, however, the deterioration in performance has been less pronounced, at least to this point. For subprime mortgages with fixed rather than variable rates, for example, serious delinquencies have been fairly stable at about 5-1/2 percent. The rate of serious delinquencies on alt-A securitized pools rose to nearly 3 percent in June, from a low of less than 1 percent in mid-2005. Delinquency rates on prime jumbo mortgages have also risen, though they are lower than those for prime conforming loans, and both rates are below 1 percent.

    ***Quoting Bernanke directly: “The problems have been most severe for subprime mortgages with adjustable rates: the proportion of those loans with serious delinquencies rose to about 13-1/2 percent in June, more than double the recent low seen in mid-2005. The adjustable-rate subprime mortgages originated in late 2005 and in 2006 have performed the worst…” end quote. It’s not much of a surprise that most of the problems center on ARMs done in subprime from approximately 2005-2006, because that’s when the industry ratcheted up to take advantage of the loss of constraints ordinarily imposed on it by rational investors being responsible about evaluating risk. Later you’ll see that Bernanke uses the term “friction” in place of how we typically use the term “constraint.” The industry ramped up to take advantage of what might be considered the opportunity of a lifetime. Human emotional and psychological momentum took over and there was no stopping it until it hit a brick wall. We got some valuable insight into this process from poster “R” who kindly revealed some of its inner workings here: http://bigpicture.typepad.com/comments/hedge_funds/index.html

    Investors’ concerns about mortgage credit performance have intensified sharply in recent weeks, reflecting, among other factors, worries about the housing market and the effects of impending interest-rate resets on borrowers’ ability to remain current. Credit spreads on new securities backed by subprime mortgages, which had jumped earlier this year, rose significantly more in July. Issuance of such securities has been negligible since then, as dealers have faced difficulties placing even the AAA-rated tranches. Issuance of securities backed by alt-A and prime jumbo mortgages also has fallen sharply, as investors have evidently become concerned that the losses associated with these types of mortgages may be higher than had been expected.

    ***Because, as we were shocked (or, naïve if you prefer) to learn, AAA-rated doesn’t necessarily mean that all the assets represented in the tranch are equivalent. There may be toxic waste that is a component of the tranch as well. Investors who have any doubt about how much is there simply avoid the investment completely if possible. Again, this is really evidence of the industry’s inability to monitor itself and place reasonable constraints in place for not allowing this to happen and diminish the integrity of securitization products which ultimately can affect the integrity of the overall financial system.

    With securitization impaired, some major lenders have announced the cancellation of their adjustable-rate subprime lending programs. A number of others that specialize in nontraditional mortgages have been forced by funding pressures to scale back or close down. Some lenders that sponsor asset-backed commercial paper conduits as bridge financing for their mortgage originations have been unable to “roll” the maturing paper, forcing them to draw on back-up liquidity facilities or to exercise options to extend the maturity of their paper. As a result of these developments, borrowers face noticeably tighter terms and standards for all but conforming mortgages.
    As you know, the financial stress has not been confined to mortgage markets. The markets for asset-backed commercial paper and for lower-rated unsecured commercial paper market also have suffered from pronounced declines in investor demand, and the associated flight to quality has contributed to surges in the demand for short-dated Treasury bills, pushing T-bill rates down sharply on some days. Swings in stock prices have been sharp, with implied price volatilities rising to about twice the levels seen in the spring. Credit spreads for a range of financial instruments have widened, notably for lower-rated corporate credits. Diminished demand for loans and bonds to finance highly leveraged transactions has increased some banks’ concerns that they may have to bring significant quantities of these instruments onto their balance sheets. These banks, as well as those that have committed to serve as back-up facilities to commercial paper programs, have become more protective of their liquidity and balance-sheet capacity.

    ***This paragraph is an essential description of the current liquidity crisis, but it may not fully depict the actual magnitude of risk the financial system faced during this time. It would take a greater capability than I have to render any competent opinion of just what those risks entailed. I doubt Mr. Bernanke could ever express any dire threats we faced or might yet face. Authorities in government can never do this, and upon considerable personal reflection, I’m quite sure I never could either were I in their place. We must all understand it is much like them having this reservation pre-established as a condition of employment. They should make responsible statements, yes… however they do not have the freedom to express themselves in anything like the candid manner we may.

    Although this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. In part, these wider losses likely reflect concerns that weakness in U.S. housing will restrain overall economic growth. But other factors are also at work. Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex payoffs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities. More generally, investors may have become less willing to assume risk. Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress. On the positive side of the ledger, we should recognize that past efforts to strengthen capital positions and the financial infrastructure place the global financial system in a relatively strong position to work through this process.

    ***No comments required.

    In the statement following its August 7 meeting, the Federal Open Market Committee (FOMC) recognized that the rise in financial volatility and the tightening of credit conditions for some households and businesses had increased the downside risks to growth somewhat but reiterated that inflation risks remained its predominant policy concern. In subsequent days, however, 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 became increasingly impaired. Liquidity dried up and spreads widened as many market participants sought to retreat from certain types of asset exposures altogether.

    ***No comments required. I would only be making entirely subjective observations. Those opposed to, and those in favor of, other FOMC actions, including changing the Federal Funds rate, may each use this same statement to support their individual positions.

    Well-functioning financial markets are essential for a prosperous economy. As the nation’s central bank, the Federal Reserve seeks to promote general financial stability and to help to ensure that financial markets function in an orderly manner. In response to the developments in the financial markets in the period following the FOMC meeting, the Federal Reserve provided reserves to address unusual strains in money markets. On August 17, the Federal Reserve Board announced a cut in the discount rate of 50 basis points and adjustments in the Reserve Banks’ usual discount window practices to facilitate the provision of term financing for as long as thirty days, renewable by the borrower. The Federal Reserve also took a number of supplemental actions, such as cutting the fee charged for lending Treasury securities. The purpose of the discount window actions was to assure depositories of the ready availability of a backstop source of liquidity. Even if banks find that borrowing from the discount window is not immediately necessary, the knowledge that liquidity is available should help alleviate concerns about funding that might otherwise constrain depositories from extending credit or making markets. The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets.

    ***From all we can learn, these were indeed tactics designed to “address unusual strains in money markets.” For, without them, and under worsening conditions had they not been employed, a liquidity crisis might have extended into the availability of good federal funds. In other words, the “right NOW cash” that is still heavily used in everyday commerce. It’s discount window availability, while we have been told it has not been heavily used, is still likely to have had favorable effects on the negotiability of assets traded between financial institutions. I’ll use this analogy: Suppose you were a used car dealer considering a bid from a potential seller of some vehicle. Were you to assume it could not later be sold under any circumstances for any price, you’d probably avoid even bidding. However, should you be aware that, were you to bid successfully and purchase the vehicle into inventory, that you could later be assured of selling it to an intermediary at some rational, if not premium, price… then you would be much more likely to transact the purchase with that particular seller. I suspect a similar confidence has resulted from the use of the discount window and from the Fed’s more aggressive invitations for its use.

    It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In a statement issued simultaneously with the discount window announcement, the FOMC indicated that the deterioration in financial market conditions and the tightening of credit since its August 7 meeting had appreciably increased the downside risks to growth. In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.

    ***Mr. Bernanke quite emphatically expresses a refusal to conduct any sort of action that could be deemed a bailout of any lender or investor. Again, here, the interpretation of his statement is likely to be subjective and viewed by different armed camps according to their purposes, intentions or hopes.

    The incoming data indicate that the economy continued to expand at a moderate pace into the summer, despite the sharp correction in the housing sector. However, in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.

    ***If they expect the economy is in some reversal, then obviously shorter-term signs of it that might ordinarily be given lesser weighting become more important for considering policy changes.

    Beginnings: Mortgage Markets in the Early Twentieth Century

    Like us, our predecessors grappled with the economic and policy implications of innovations and institutional changes in housing finance. In the remainder of my remarks, I will try to set the stage for this weekend’s conference by discussing the historical evolution of the mortgage market and some of the implications of that evolution for monetary policy and the economy.

    No comments required.

    The early decades of the twentieth century are a good starting point for this review, as urbanization and the exceptionally rapid population growth of that period created a strong demand for new housing. Between 1890 and 1930, the number of housing units in the United States grew from about 10 million to about 30 million; the pace of homebuilding was particularly brisk during the economic boom of the 1920s.

    ***Roaring Twenties – industrial revolution in the USA, post WW I, is reaching into international dominance – lots of houses.

    Remarkably, this rapid expansion of the housing stock took place despite limited sources of mortgage financing and typical lending terms that were far less attractive than those to which we are accustomed today. Required down payments, usually about half of the home’s purchase price, excluded many households from the market. Also, by comparison with today’s standards, the duration of mortgage loans was short, usually ten years or less. A “balloon” payment at the end of the loan often created problems for borrowers.2

    ***Even limited sources of mortgage financing couldn’t slow the boom, since people were more resourceful and thrifty and purposeful about acquiring houses and homesteads than today’s population is. Too, they were better with budgeting and saving, more competent to contribute labor into construction, more value conscious, and the job and wage markets gave them confidence to bridge tight budgeting conditions in order to obtain their objective of owning their own homes.

    High interest rates on loans reflected the illiquidity and the essentially unhedgeable interest rate risk and default risk associated with mortgages. Nationwide, the average spread between mortgage rates and high-grade corporate bond yields during the 1920s was about 200 basis points, compared with about 50 basis points on average since the mid-1980s. The absence of a national capital market also produced significant regional disparities in borrowing costs. Hard as it may be to conceive today, rates on mortgage loans before World War I were at times as much as 2 to 4 percentage points higher in some parts of the country than in others, and even in 1930, regional differences in rates could be more than a full percentage point.3

    ***Let’s face it. There really wasn’t a dedicated and specialized mortgage market in those days. In many cases farmers might pledge their land as partial collateral for a loan and some component was largely a signature loan based on the veracity of the borrower and how well he and his creditworthiness was known to the banker, or private lender. Sometimes he borrowed the money on that basis, then acquired his own building materials and built the house himself. Regardless of the cash flow return on the note, the banker or lender’s equity was growing all the while, generally facilitating the rolling over of the note if needed. This was the general circumstance of acquiring housing for many of my own immediate ancestors back three generations.

    Despite the underdevelopment of the mortgage market, homeownership rates rose steadily after the turn of the century. As would often be the case in the future, government policy provided some inducement for homebuilding. When the federal income tax was introduced in 1913, it included an exemption for mortgage interest payments, a provision that is a powerful stimulus to housing demand even today. By 1930, about 46 percent of nonfarm households owned their own homes, up from about 37 percent in 1890.

    ***Mortgage interest deduction – the real howitzer of homeownership. It’s more likely that Osama bin Laden would be the president of the USA than would that deduction be eliminated.

    The limited availability of data prior to 1929 makes it hard to quantify the role of housing in the monetary policy transmission mechanism during the early twentieth century. Comparisons are also complicated by great differences between then and now in monetary policy frameworks and tools. Still, then as now, periods of tight money were reflected in higher interest rates and a greater reluctance of banks to lend, which affected conditions in mortgage markets. Moreover, students of the business cycle, such as Arthur Burns and Wesley Mitchell, have observed that residential construction was highly cyclical and contributed significantly to fluctuations in the overall economy (Burns and Mitchell, 1946). Indeed, if we take the somewhat less reliable data for 1901 to 1929 at face value, real housing investment was about three times as volatile during that era as it has been over the past half-century.

    ***I suspect as we proceed backwards in time from the 1920s to the more ancient, the effects of monetary policy on housing would likely begin to approach zero. Monetary policy probably grew in effectiveness regarding housing continuously from the 1930s into the mid-1980s or a bit later, and has probably dropped precipitously from about 1995 until the present. Sorry, but I’ve preempted Mr. Bernanke’s speech a wee tad here, but you should forgive me and… read on:

    During the past century we have seen two great sea changes in the market for housing finance. The first of these was the product of the New Deal. The second arose from financial innovation and a series of crises from the 1960s to the mid-1980s in depository funding of mortgages. I will turn first to the New Deal period.

    ***No comments.

    The New Deal and the Housing Market

    The housing sector, like the rest of the economy, was profoundly affected by the Great Depression. When Franklin Roosevelt took office in 1933, almost 10 percent of all homes were in foreclosure (Green and Wachter, 2005), construction employment had fallen by half from its late 1920s peak, and a banking system near collapse was providing little new credit. As in other sectors, New Deal reforms in housing and housing finance aimed to foster economic revival through government programs that either provided financing directly or strengthened the institutional and regulatory structure of private credit markets.

    ***Great Crash – boom over and housing is in the tank, but now we’re a much more industrialized, urbanized and labor specialized economy than before the Roaring Twenties, and the housing industry and its allies have begun to represent maybe 25-40% of all jobs. Therefore a recovery in housing will be almost directly proportional to a recovery in GDP.

    Actually, one of the first steps in this direction was taken not by Roosevelt but by his predecessor, Herbert Hoover, who oversaw the creation of the Federal Home Loan Banking System in 1932. This measure reorganized the thrift industry (savings and loans and mutual savings banks) under federally chartered associations and established a credit reserve system modeled after the Federal Reserve. The Roosevelt administration pushed this and other programs affecting housing finance much further. In 1934, his administration oversaw the creation of the Federal Housing Administration (FHA). By providing a federally backed insurance system for mortgage lenders, the FHA was designed to encourage lenders to offer mortgages on more attractive terms. This intervention appears to have worked in that, by the 1950s, most new mortgages were for thirty years at fixed rates, and down payment requirements had fallen to about 20 percent. In 1938, the Congress chartered the Federal National Mortgage Association, or Fannie Mae, as it came to be known. The new institution was authorized to issue bonds and use the proceeds to purchase FHA mortgages from lenders, with the objectives of increasing the supply of mortgage credit and reducing variations in the terms and supply of credit across regions.4

    ***Seeds sown for a very effective mortgage securitizations industry, although not fully shaped at this early time.

    Shaped to a considerable extent by New Deal reforms and regulations, the postwar mortgage market took on the form that would last for several decades. The market had two main sectors. One, the descendant of the pre-Depression market sector, consisted of savings and loan associations, mutual savings banks, and, to a lesser extent, commercial banks. With financing from short-term deposits, these institutions made conventional fixed-rate long-term loans to homebuyers. Notably, federal and state regulations limited geographical diversification for these lenders, restricting interstate banking and obliging thrifts to make mortgage loans in small local areas–within 50 miles of the home office until 1964, and within 100 miles after that. In the other sector, the product of New Deal programs, private mortgage brokers and other lenders originated standardized loans backed by the FHA and the Veterans’ Administration (VA). These guaranteed loans could be held in portfolio or sold to institutional investors through a nationwide secondary market.

    ***Seeds (part II.)

    No discussion of the New Deal’s effect on the housing market and the monetary transmission mechanism would be complete without reference to Regulation Q–which was eventually to exemplify the law of unintended consequences. The Banking Acts of 1933 and 1935 gave the Federal Reserve the authority to impose deposit-rate ceilings on banks, an authority that was later expanded to cover thrift institutions. The Fed used this authority in establishing its Regulation Q. The so-called Reg Q ceilings remained in place in one form or another until the mid-1980s.5

    ***I can’t contribute an excellent understanding of Reg Q for you, because it alone would be worthy of many academic papers much longer than this Bernanke speech. Too, the various forms in which it operated are extremely complex and a little beyond the scope of this review. Let’s hit the high points, and even then I’ll take some risk of my understanding being later supplanted by a better source (which I certainly would invite). I believe that when Bernanke says, “…eventually to exemplify the law of unintended consequences,” that he means that Reg Q was initially intended to prevent depository disintermediation because of banking competition for demand deposits only, not saving or time deposits, but rather cash and checking accounts. It was favorable to the economy to maintain stability in the practiced observation of reserve requirements to satisfy good federal funds demands. It worked, but it needed conditions in which rates were relatively low, inflation quite controlled and alternative forms of competition for bank demand deposits also low. The “unintended” consequence spoken about by Bernanke was that it actually encouraged disintermediation after those conditions I just listed changed dramatically with the onset of higher rates, higher inflation and a plethora of competitive products aimed at leaching away bank deposits. All this changed rapidly in the mid-1980s. Banks and thrifts suffered disintermediation because they were constrained against competing by offering depositors higher rates. It should be easy to understand that this effectively killed the traditional bank- and thrift-based mortgage industry, since mortgage rates were rising, deposit bases were volatile and banks and thrifts could not borrow sufficient funds to offer mortgage loans. Also, Reg Q is the reason you (depending on your age), your parents or your grandparents got a bunch of toasters from their banks and S&Ls!

    The original rationale for deposit ceilings was to reduce “excessive” competition for bank deposits, which some blamed as a cause of bank failures in the early 1930s. In retrospect, of course, this was a dubious bit of economic analysis. In any case, the principal effects of the ceilings were not on bank competition but on the supply of credit. With the ceilings in place, banks and thrifts experienced what came to be known as disintermediation–an outflow of funds from depositories that occurred whenever short-term money-market rates rose above the maximum that these institutions could pay. In the absence of alternative funding sources, the loss of deposits prevented banks and thrifts from extending mortgage credit to new customers.

    ***Did I Bingo?… If not, this may help:
    http://www.afponline.org/pub/gr/test/house_subcommittee_hearing_tes.html

    The Transmission Mechanism and the New Deal Reforms

    Under the New Deal system, housing construction soared after World War II, driven by the removal of wartime building restrictions, the need to replace an aging housing stock, rapid family formation that accompanied the beginning of the baby boom, and large-scale internal migration. The stock of housing units grew 20 percent between 1940 and 1950, with most of the new construction occurring after 1945.

    ***Speaks for itself.

    In 1951, the Treasury-Federal Reserve Accord freed the Fed from the obligation to support Treasury bond prices. Monetary policy began to focus on influencing short-term money markets as a means of affecting economic activity and inflation, foreshadowing the Federal Reserve’s current use of the federal funds rate as a policy instrument. Over the next few decades, housing assumed a leading role in the monetary transmission mechanism, largely for two reasons: Reg Q and the advent of high inflation.

    ***The seeds of diminished Fed monetary policy effectiveness were being sown even then, although marginally and with unrecognized ultimate consequences. Those consequences were the exponential growth of the securitizations industry culminating in a final spurt over this last approximate 5-10 years. Monetary policy effectiveness remained effective because there still remained a high correlation between GDP and housing. Later you’ll see how Bernanke explains how that correlation has dissipated.

    The Reg Q ceilings were seldom binding before the mid-1960s, but disintermediation induced by the ceilings occurred episodically from the mid-1960s until Reg Q began to be phased out aggressively in the early 1980s. The impact of disintermediation on the housing market could be quite significant; for example, a moderate tightening of monetary policy in 1966 contributed to a 23 percent decline in residential construction between the first quarter of 1966 and the first quarter of 1967. State usury laws and branching restrictions worsened the episodes of disintermediation by placing ceilings on lending rates and limiting the flow of funds between local markets. For the period 1960 to 1982, when Reg Q assumed its greatest importance, statistical analysis shows a high correlation between single-family housing starts and the growth of small time deposits at thrifts, suggesting that disintermediation effects were powerful; in contrast, since 1983 this correlation is essentially zero.6

    ***We’ve already introduced this understanding of disintermediation regarding the thrifts, and he makes it another point of discussion.

    Economists at the time were well aware of the importance of the disintermediation phenomenon for monetary policy. Frank de Leeuw and Edward Gramlich highlighted this particular channel in their description of an early version of the MPS macroeconometric model, a joint product of researchers at the Federal Reserve, MIT, and the University of Pennsylvania (de Leeuw and Gramlich, 1969). The model attributed almost one-half of the direct first-year effects of monetary policy on the real economy–which were estimated to be substantial–to disintermediation and other housing-related factors, despite the fact that residential construction accounted for only 4 percent of nominal gross domestic product (GDP) at the time.

    ***Yeah, yeah, yeah… beat us with an ugly stick.

    As time went on, however, monetary policy mistakes and weaknesses in the structure of the mortgage market combined to create deeper economic problems. For reasons that have been much analyzed, in the late 1960s and the 1970s the Federal Reserve allowed inflation to rise, which led to corresponding increases in nominal interest rates. Increases in short-term nominal rates not matched by contractually set rates on existing mortgages exposed a fundamental weakness in the system of housing finance, namely, the maturity mismatch between long-term mortgage credit and the short-term deposits that commercial banks and thrifts used to finance mortgage lending.

    ***I have a sense of : http://en.wikipedia.org/wiki/D%C3%A9j%C3%A0_vu I can not imagine how anyone could have stayed awake through that droning. However, “Federal Reserve allowed inflation to rise” is probably worth the whole paragraph.

    This mismatch led to a series of liquidity crises and, ultimately, to a rash of insolvencies among mortgage lenders. High inflation was also ultimately reflected in high nominal long-term rates on new mortgages, which had the effect of “front loading” the real payments made by holders of long-term, fixed-rate mortgages. This front-loading reduced affordability and further limited the extension of mortgage credit, thereby restraining construction activity. Reflecting these factors, housing construction experienced a series of pronounced boom and bust cycles from the early 1960s through the mid-1980s, which contributed in turn to substantial swings in overall economic growth.

    ***Yeah, yeah, yeah… blind man could’ve seen it coming.

    The Emergence of Capital Markets as a Source of Housing Finance

    The manifest problems associated with relying on short-term deposits to fund long-term mortgage lending set in train major changes in financial markets and financial instruments, which collectively served to link mortgage lending more closely to the broader capital markets. The shift from reliance on specialized portfolio lenders financed by deposits to a greater use of capital markets represented the second great sea change in mortgage finance, equaled in importance only by the events of the New Deal.

    ***Please, God!… have some mercy. Was anybody snoring?

    Government actions had considerable influence in shaping this second revolution. In 1968, Fannie Mae was split into two agencies: the Government National Mortgage Association (Ginnie Mae) and the re-chartered Fannie Mae, which became a privately owned government-sponsored enterprise (GSE), authorized to operate in the secondary market for conventional as well as guaranteed mortgage loans. In 1970, to compete with Fannie Mae in the secondary market, another GSE was created–the Federal Home Loan Mortgage Corporation, or Freddie Mac. Also in 1970, Ginnie Mae issued the first mortgage pass-through security, followed soon after by Freddie Mac. In the early 1980s, Freddie Mac introduced collateralized mortgage obligations (CMOs), which separated the payments from a pooled set of mortgages into “strips” carrying different effective maturities and credit risks. Since 1980, the outstanding volume of GSE mortgage-backed securities has risen from less than $200 billion to more than $4 trillion today. Alongside these developments came the establishment of private mortgage insurers, which competed with the FHA, and private mortgage pools, which bundled loans not handled by the GSEs, including loans that did not meet GSE eligibility criteria–so-called nonconforming loans. Today, these private pools account for around $2 trillion in residential mortgage debt.

    ***And God said it was good – “Go ye forth and multiply.”

    These developments did not occur in time to prevent a large fraction of the thrift industry from becoming effectively insolvent by the early 1980s in the wake of the late-1970s surge in inflation.7 In this instance, the government abandoned attempts to patch up the system and instead undertook sweeping deregulation. Reg Q was phased out during the 1980s; state usury laws capping mortgage rates were abolished; restrictions on interstate banking were lifted by the mid-1990s; and lenders were permitted to offer adjustable-rate mortgages as well as mortgages that did not fully amortize and which therefore involved balloon payments at the end of the loan period. Critically, the savings and loan crisis of the late 1980s ended the dominance of deposit-taking portfolio lenders in the mortgage market. By the 1990s, increased reliance on securitization led to a greater separation between mortgage lending and mortgage investing even as the mortgage and capital markets became more closely integrated. About 56 percent of the home mortgage market is now securitized, compared with only 10 percent in 1980 and less than 1 percent in 1970.

    ***Conferees are abandoning ship to watch a dump truck’s tires get changed.

    In some ways, the new mortgage market came to look more like a textbook financial market, with fewer institutional “frictions” to impede trading and pricing of event-contingent securities. Securitization and the development of deep and liquid derivatives markets eased the spreading and trading of risk. New types of mortgage products were created. Recent developments notwithstanding, mortgages became more liquid instruments, for both lenders and borrowers. Technological advances facilitated these changes; for example, computerization and innovations such as credit scores reduced the costs of making loans and led to a “commoditization” of mortgages. Access to mortgage credit also widened; notably, loans to subprime borrowers accounted for about 13 percent of outstanding mortgages in 2006.

    ***Ah, “frictions!” Remember that word from earlier. It means “constraints” and they’re often absent in unrestrained free-market capitalism. If capitalism has a flaw, that is it!… Things will get lively now… Wake up, we’ve gotten into pay dirt for this speech.

    I suggested that the mortgage market has become more like the frictionless financial market of the textbook, with fewer institutional or regulatory barriers to efficient operation. In one important respect, however, that characterization is not entirely accurate. A key function of efficient capital markets is to overcome problems of information and incentives in the extension of credit.

    ***In other words, a frictionless market is a good thing, but only when that frictionless condition doesn’t result in a breakdown of the mechanism that self-regulates it. That self-regulating mechanism is entirely lost when investors surrender their responsibility to monitor the risk of their investments, either through their own ignorance or the ignorance of their proxies.

    The traditional model of mortgage markets, based on portfolio lending, solved these problems in a straightforward way: Because banks and thrifts kept the loans they made on their own books, they had strong incentives to underwrite carefully and to invest in gathering information about borrowers and communities.

    ***In a general sense the period in which the traditional model worked well and solved all these problems in a “straightforward” way might be thought of as being a sort of period in which the mortgage industry operated in pristine conditions. These pristine conditions were essentially these: 1)- relatively low and stable interest rates, 2)- low inflation, 3)- little incentive for disintermediation: that is, depositors and savers were contented, 4)- careful observation of underwriting standards, and 5)- retention of credit risk by mortgage lenders.

    In contrast, when most loans are securitized and originators have little financial or reputational capital at risk, the danger exists that the originators of loans will be less diligent. In securitization markets, therefore, monitoring the originators and ensuring that they have incentives to make good loans is critical. I have argued [elsewhere](*) that, in some cases, the failure of investors to provide adequate oversight of originators and to ensure that originators’ incentives were properly aligned was a major cause of the problems that we see today in the subprime mortgage market (Bernanke, 2007).

    ***(*)[bracket] My addition; he’s argued this in one or more speech and I believe in Congressional testimony as well in 2007. The reader can easily source and confirm this at the Federal Reserve’s Website: http://www.federalreserve.gov/boarddocs/speeches/2007/
    http://www.federalreserve.gov/boarddocs/testimony/2007/

    *** Unfortunately, the failure of investors to provide adequate oversight of originators extends right down and into the class of individuals who have little knowledge or capacity to provide this oversight, and yet they are apt to suffer and lose money in the event of mortgage delinquencies no differently than if they’d simply been irresponsible lending institutions with maximum capability for evaluating risk.

    In recent months we have seen a reassessment of the problems of maintaining adequate monitoring and incentives in the lending process, with investors insisting on tighter underwriting standards and some large lenders pulling back from the use of brokers and other agents. We will not return to the days in which all mortgage lending was portfolio lending, but clearly the originate-to-distribute model will be modified–is already being modified–to provide stronger protection for investors and better incentives for originators to underwrite prudently.

    ***It’s a good thing. It’s never been that securitization itself presented the problem, but merely that failure in internal or external supervision of the process did. The system will never return to what I’ve defined as “pristine” but the observance of responsible underwriting standards in future securitizations must return there or that industry won’t survive.

    The Monetary Transmission Mechanism Since the Mid-1980s

    The dramatic changes in mortgage finance that I have described appear to have significantly affected the role of housing in the monetary transmission mechanism. Importantly, the easing of some traditional institutional and regulatory frictions seems to have reduced the sensitivity of residential construction to monetary policy, so that housing is no longer so central to monetary transmission as it was.8 In particular, in the absence of Reg Q ceilings on deposit rates and with a much-reduced role for deposits as a source of housing finance, the availability of mortgage credit today is generally less dependent on conditions in short-term money markets, where the central bank operates most directly.

    ***I’m sure he wouldn’t argue with the word “exponential” being substituted for “dramatic,” because the growth of the securitizations industry has been almost meteoric in the last few years of this approximate 1985-2007 period. By his reference to “frictions,” he really means “constraints.” Thus he means that there have been fewer regulatory constraints on the industry. Absent investor constraints, the industry has grown to a size that has become its own form of monetary policy involving the capital markets, obviating much of the Fed’s capacity to effect monetary policy because it attempts to accomplish this in short-term credit markets. Thus, Mr. Bernanke is explaining that the housing market’s response to Fed monetary policy has lost some of its previous sensitivity. I’ll leave it to his expert estimate of that amount in his next paragraph immediately below:

    Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past.9 These results are embodied in the Federal Reserve’s large econometric model of the economy, which implies that only about 14 percent of the overall response of output to monetary policy is now attributable to movements in residential investment, in contrast to the model’s estimate of 25 percent or so under what I have called the New Deal system.

    ***Basically he’s saying to us all, including Senators Schumer and Dodd, and to Wall Street and the White House, that since much of the economy of the USA is dependent on the residential construction industry and allied industries, and further since, as explained above, monetary policy has less effect now on residential housing than it did under the New Deal system that operated long before the securitizations industry developed, that we’re viewing potential changes in the Fed Funds rate as having relatively more effect than they likely can have in the current environment. Thus expectations for a Fed Funds cut are possibly overwrought.

    The econometric findings seem consistent with the reduced synchronization of the housing cycle and the business cycle during the present decade. In all but one recession during the period from 1960 to 1999, declines in residential investment accounted for at least 40 percent of the decline in overall real GDP, and the sole exception–the 1970 recession–was preceded by a substantial decline in housing activity before the official start of the downturn. In contrast, residential investment boosted overall real GDP growth during the 2001 recession. More recently, the sharp slowdown in housing has been accompanied, at least thus far, by relatively good performance in other sectors. That said, the current episode demonstrates that pronounced housing cycles are not a thing of the past.

    ***I don’t know if this will reproduce, but in his written remarks from his speech, the word “boosted” is in italics, I suppose to emphasize his observation of something of an anomaly regarding past recessions and their relationships to housing. Generally, past overall economic recessions have had high correlation with housing downturns, but this relationship has sort of de-linked in the present decade, lending more credence to his observation of the loss of effectiveness of Fed monetary policy to effect the very issue of today – the housing construction and financing industry.

    My discussion so far has focused primarily on the role of variations in housing finance and residential construction in monetary transmission. But, of course, housing may have indirect effects on economic activity, most notably by influencing consumer spending. With regard to household consumption, perhaps the most significant effect of recent developments in mortgage finance is that home equity, which was once a highly illiquid asset, has become instead quite liquid, the result of the development of home equity lines of credit and the relatively low cost of cash-out refinancing. Economic theory suggests that the greater liquidity of home equity should allow households to better smooth consumption over time. This smoothing in turn should reduce the dependence of their spending on current income, which, by limiting the power of conventional multiplier effects, should tend to increase macroeconomic stability and reduce the effects of a given change in the short-term interest rate. These inferences are supported by some empirical evidence.10

    ***Basically he’s saying that it may still be possible to depend on home equity extraction (MEW) to continue to smooth consumer spending for some time, thus making consumer spending itself less dependent on income… and less dependent on changes in short-term interest rates. This is another justification for possibly bypassing a Fed Funds rate cut, at least now. He seems to still possibly rely on sufficient health in the overall economy so that a cut might not be needed. His final paragraph below before his concluding remarks represents the almost obligatory statement of all economists. It’s the famous “On the other hand…” statement.

    On the other hand, the increased liquidity of home equity may lead consumer spending to respond more than in past years to changes in the values of their homes; some evidence does suggest that the correlation of consumption and house prices is higher in countries, like the United States, that have more sophisticated mortgage markets (Calza, Monacelli, and Stracca, 2007). Whether the development of home equity loans and easier mortgage refinancing has increased the magnitude of the real estate wealth effect–and if so, by how much–is a much-debated question that I will leave to another occasion.

    ***It’s been said: “A bird in the hand is worth two in the bush.” I suppose that in this environment it’s still possible that what Mr. Bernanke may have in his “other hand is worth two from Bush.” Well, time will tell, but for now Mr. Bernanke isn’t going to tell us, or doesn’t yet know what to tell.

    Conclusion

    I hope this exploration of the history of housing finance has persuaded you that institutional factors can matter quite a bit in determining the influence of monetary policy on housing and the role of housing in the business cycle. Certainly, recent developments have added yet further evidence in support of that proposition. The interaction of housing, housing finance, and economic activity has for years been of central importance for understanding the behavior of the economy, and it will continue to be central to our thinking as we try to anticipate economic and financial developments.

    ***Simply a reiteration of the core elements of his speech. He’s told us in the speech that the development of the syndicated mortgage finance industry is an institutional factor that now matters a great deal in the Fed’s effectiveness for implementing monetary policy to address the housing element of the business cycle. Both Mr. Greenspan’s “conundrum” and the recent liquidity crisis brought on by subprime woes have only reinforced his conclusion to this speech.

  19. Winston Munn commented on Sep 2

    Eclectic:

    Nice job but I think the whole speech can be reduced to this one paragraph, and maybe even to one word: but…

    “It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy. In a statement issued simultaneously with the discount window announcement, the FOMC indicated that the deterioration in financial market conditions and the tightening of credit since its August 7 meeting had appreciably increased the downside risks to growth. In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.”

    Instead of a statement that the Fed should not bail out poor financial decisions, it reads to me as a statemate concerning motivation for doing just that – he may have well said “although we don’t DIRECTLY want to bail them out, we will if CONSUMER SPENDING IS DISRUPTED.”

    This is the Bernanke Put. He will bail out anyone and everyone if necessary to keep credit flowing and consumers spending.

    The Federal Reserve only has one goal, and it is not about controlling inflation or managing the economy – it is about ensuring the consumer has access to increasing debt in order to “smooth spending” which is simply another way to say “continue to spend beyond his means”.

    He may have just as well said, “We have created a debt-based enconomy, dependent on the continued expansion of debt to survive, and without this continued expansion We’re freakin’ doomed!!! So get off my back cause that ain’t gonna happen!!!”

    But you probably can’t say that in polite circles….

  20. Eclectic commented on Sep 2

    Winston,

    I think you’re more convinced that the FOMC could make a difference now with a Fed Funds rate cut than either Bernanke or the other members of the FOMC are.

    If you offer something here to refute what he’s concluded in his speech, you may have some influence on them to analyze that effectiveness in a different way.

    Larry Kudlow – You got some empirical evidence to contradict his conclusion?… say?… a favorite verse you’d like to quote from I or II Kudlownians?… Spin a yarn from the G.S.N.T.?…

    It’s like when my drill instructor used to give the guys a smoke break, saying lastly just before he dismissed them:

    “If you got ’em, smoke ’em.”

  21. Winston Munn commented on Sep 2

    Eclectic:

    Here are the two most compelling statements relevant to my conclusions.

    “It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions. But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.”

    My paraphrase is this: The Fed isn’t in business of bailing out idiots, but if their idiot behavior overflows and affects the general economy, we have no choice but to try to bail them out to avoid a general economic demise.

    “In a statement issued simultaneously with the discount window announcement, the FOMC indicated that the deterioration in financial market conditions and the tightening of credit since its August 7 meeting had appreciably increased the downside risks to growth. In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.”

    My take: The tightening of credit…increased the downside risk to growth (i.e., debt growth) Further tightening of credit…with possible adverse effects on consumer spending….” (Without credit expansion, we’re freakin’ doomed!!!)

    If this isn’t tacit admission that we are completely dependent upon expansion of credit, I don’t see how much plainer a quasi-politician can put it.

    The whole concept of “wealth creation” in housing is illusion. There are only two ways to extract this so-called “wealth”: borrow against the asset, which immediately negates any wealth effect, or sell the asset, in which case all you can do is purchase a substitute asset that is equal to the one sold – how can there be wealth creation with no gain in purchasing ability?

    The only “wealth creation” is on the balance sheets of the lenders and in the coffers of governments through increasing tax revenues, the hidden taxing effect and wealth redistribution effects of inflation.

    For interest, let’s look at money in its “pristine state”. Money is nothing more than an exchangeable unit of labor. It can take two forms: current labor (income) or past labor(savings). What it cannot ever be is future labor (debt).

    It is simple to show why this is so. Again in a pristine state, I can trade my labor of today to you for a meal and a place to sleep tonight and both of us are rewarded; I can instead pay you for this service from my past unspent labor (savings), and again we are both rewarded; however, if I try to use debt to pay for this service, promising tomorrow’s labor for today’s service, and during the night I have a coronary event and expire, one-half of the arrangement has not and will not be fulfilled – meaning there was not a money exchange. If there is no money exchange, there cannot be a monetary transaction. Yet we continue to explain this debt-for-services arrangement as consumption when in reality one cannot consume what one has not earned by productivity; in truth, this arrangement is the consumption of productivity, facilitated by the expediency of debt. It is of its nature inflationary as today’s service cost is in actuality tomorrow’s productivity plus interest.

    The Fed Chairman did not create this system but he has inherited the reigns – and he seems totally aware of it basic need to feed its beast, inflation through credit expansion, while avoiding at all costs its nemesis, deflation of contracting credit.

    The only way a bailout can be avoided is if the credit squeeze and deflation in housing does not spill over into tightened consumer credit for productivity consumption. As long as the proletariat can be convinced that eating their young is in their best interest, the illusion of growth can be sustained.

    It really is basic Austrian school thought versus quasi-Keynesian; and Austrian school better adheres to Occam’s Razor; the only problem is the time elelment in Austrian thought – by the time it is proven right, it will be too late to do anyting about it.

    And finally there is this: in 1970, before the introduction of pure fiat, the U.S. national debt was $270 Billion. Now, it is over $8300 Billion. If debt-based consumption truly equated to increased output, one might logically expect the U.S. economy to be somewhere near 30 times as large now as then.

    With a per capita average of $50 odd thousand, the national debt, including off-balance sheet items of medicare and social security obligations, is the equivalent of every person in the U.S. working for free for 3 years at that per capita average.

    Consumption debt as growth – what a concept. If you want to know who benefits, all you have to do is “follow the debt” and see who holds the rights to all that future productivity. I’ll give you a hint – it’s not the average American.

  22. RM commented on Sep 3

    This is a lot simpler than it seems:

    -Bush hears the bailout drum beat from the Democrats.

    -Bush doesn’t want a bailout (because contrary to popular belief, he does have a brain, and understands that it would be a terrible idea).

    -Bush understands that something must be done before they rally the country behind a policy of rewarding bad decisions.

    -Bush coordinates his plan before a long weekend to garner maximum press coverage, and because most politicians are already on the beach, he avoids a Democrat response that he “isn’t doing enough for the starving masses”.

    Give the guy some credit. He will keep the Democrats from rallying public support for a massive bailout, while not doing very much bailing out in the meantime. Brilliant political move. It shows that this guy isn’t entirely reliant on Karl Rove.

  23. Eclectic commented on Sep 3

    I’ve looked extensively this weekend through the media coverage of the Bernanke speech in Jackson Hole on Friday.

    Until I found this piece of coverage:

    http://tinyurl.com/28b58c

    …nobody in media had gotten close to the spirit of a complete understanding of what he said. This author got pretty close.

    But close only counts in horseshoes and hand grenades, and still my own analysis of the speech presented above in this topic stands as the only true accurate conceptualization of what he actually s-a-i-d.

    I’ll go an additional step and explain how there is a misunderstanding inherent in what several, including Greg Ip at the Wall Street Journal (also close, before the speech) and Alister Bull at Reuters (after the speech) have reported.

    So far the supposed change in Mr. Bernanke’s tone is assumed to be a p-h-i-l-o-s-o-p-h-i-c-a-l break with Greenspan’s philosophy about the use of monetary policy. It’s not that at all, except that I expect Mr. Bernanke would not object to eventually putting to sleep the notion that he’d offer any entity a put.

    It might not even be that Greenspan himself ever intended to offer market participants a put, but only that the circumstances surrounding his efforts to stave off various financial breakdowns may have just made it seem so. Several ex-Fed types have appeared on Kudlow and told us that the theory of the Long Term Capital crisis having resulted in a Fed bailout was simply mythology.

    The financial media in the USA is a fertile breeding ground for mythology. Sometimes when reading it I’m reminded of psychological experiments I’ve conducted before. One is to sit quietly and observe the conduct and ruminations about referee calls among fans on one side of the field for the first half of a football game, and then to do the same on the opposite side for the second half. That alone will prove to any reasonable observer than humanity for the most part has almost zero capacity for objectivity. It’s winning or losing an argument that’s important to most people – not what the truth is.

    In dialog with Einstein, Freud lamented to Einstein that this was the fundamental and unalterable reason that wars would forever plague mankind. Funny, but Freud also explained that it was actually a helpful motive for humanity, since it kept them herded up with a sense of community and safety that is necessary for sheep to be sheep and a herd of cattle to herd. I’m paraphrasing Freud’s discussions with Einstein, but not by much.

    No, it’s not the philosophy of Bernanke that’s suddenly departed from what we assumed was Greenspan’s philosophy. Had not the other element (that I’ll explain), that is my current focus, changed, he might have been as preemptive by now as we’d imagined that Greenspan would have been upon the worsening liquidity crisis of recent weeks.

    That element I’m speaking about is Bernanke’s view of the effectiveness of monetary policy in current times. That is what has changed – It’s not his philosophy about using monetary policy when it is effective, it’s his newly-evolved understanding that it’s not effective with this type of problem. Why?

    Because the medicine that many want him to apply… has little marginal effect on the disease they want him to treat with it.

    He’s discovered in research that the application of monetary policy that the FOMC conducts primarily in short-term markets has LOST its effectiveness (at least on some marginal basis) in dealing with issues of housing and housing finance which are precipitated in CAPITAL MARKETS. Further, the magnitude of those problems have taken on a new dynamic of monetary transmission that has, temporarily at least, overwhelmed the FOMC’s capacity to do much about it. Why?… It’s because of the relative size of CMO industry (GSEs and non-GSE private lenders) portfolios when compared to securities controlled by the Federal Reserve.

    It’s the conundrum explained.

    Knock – Knock! Hello! Bernanke has e-x-p-l-a-i-n-e-d the conundrum in that Jackson Hole speech, when Greenspan only mystified over it publicly, but couldn’t explain it.

    That’s what the speech was about.

  24. Winston Munn commented on Sep 3

    Eclectic:

    I agree with your assessment of Bernanke’s speech as an explantion of the conundrum.

    Here is another explanation.

    Martin Meyer quoted from his book “The Fed”:

    “The truth is that liquidity, the only significant weapon remaining in the central bank’s arsenal as decision making moves to the markets, will not necessarily go where you want it to go when you need it to go there.”

    The problem with Federal monetizing is that the new money will invariably end up in currect active bubbles and therefore will not act as support for declining bubbles.

    However, along with the explanation of the conundrum came the implicit promise to monetize if c-o-n-s-u-m-p-t-i-o-n slows.

    We have to remember where Bernanke places the blame for the Great Depression, and that is on tightened credit. It looks to me that in Bernanke’s eyes, a credit squeeze is the greatest of all economic risks.

    However, at present there is no way to target credit easing without creating a new bubble or sustaining an existing bubble. And that seems to be the real conundrum.

  25. Eclectic commented on Sep 3

    Winston,

    You’re an unfailing “Contra-Monetinista”

    You’re like a frog at threat of being boiled that hops excitedly into the pot, and later when indeed boiled exclaims loudly “See, I told you they’d boil me!”

    That view by Mayer seems reasonable, but it’s because, as I’ve said, the Fed has imposed on it multiple mandates that can and often do oppose each other as contradicting objectives.

    Free it from everything but responsibility for the integrity of the currency and financial system (s-y-s-t-e-m not asset prices) and at least one half of Mayer’s observation would unravel rather quickly. And, no, the Fed should never have a responsibility for m-a-k-i-n-g liquidity go anywhere… not making it that is, because they shouldn’t make it and can’t anyway*… anywhere except across the counter to settle a business transaction, or through the teller’s window when demanded, or rushing to clear a check presented to the Federal Reserve… all when those funds are the credits of the payees.

    Thanks for the recognition that my analysis regarding Bernanke’s view of the conundrum was correct. Notice that not one single source in media (that I can find) has correctly identified this as the theme of his speech.

    *according to my theory of inflation: “simply an unrecognized reorganization of currency unit value erroneously attributed to profit.” However, I am not opposed to rational and responsible fractional reserve banking. I’m not that much of a Contra-Monetinista. Haha.

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