I know you understand how the (mis)pricing of risk — specifically, the underpricing of risk due to the Federal Reserve’s interest rate manipulations — causes investors move further out on the risk curve and into more speculative investments…and that this spurs the creation of ever-more speculative and risky products because of the increasing demand for these products.
If some of these speculative investments (derivatives, in this case) are also presented as lowering risks even further, it’s easy to see how underwriting standards on certain types of related securities would be lowered as a result. It is all related.[/quote]
The bolded part is the logical fallacy of begging the question.
Let’s work through exactly what the Fed did and did not do prior to the financial crisis in 2008.
It does set the federal funds rate, which is the rate that member banks pay and receive for over-night borrowing/lending. The quantity of member bank borrowing is limited by capital requirements set by the Fed. Member banks do NOT have unlimited access to funds.
It does buy and sell US government securities to keep the prices of those securities stable, but it does not, per se, set the rates on US govt securities at auction. This is an open market function.
It doesn’t set market interest rates which member banks pay on deposits or charge on collateralized or un-collateralized loans.
It doesn’t set the prime rate.
It doesn’t set nor regulate lending standards.
At least since Paul Volker, the Fed has used the federal funds rate to either heat up or cool off inflation, typically setting the interest rate at a level somewhere around 1% above the nominal GPD growth rate. Variations from this target (which as far as I know, they have never set as an official target), have, for at least the last 15 years have served to either stimulate the economy (less than 1% over nominal GDP growth), or slow the economy (more than 1% over nominal GDP growth).
Now what I’d like to know, is which of these functions specifically encouraged lower lending standards, and exactly what the mechanism was to make it happen.
It was a very simple supply/demand equation. Investors wanted more high quality securitized debt at interest rates higher than banks were paying on CD’s, and that was higher than open market US government backed securities yielded. What the market provided instead, was lower quality securitized debt. The market (in this case, Wall Street investment banks) did this by buying everything that direct lenders could supply. The suppliers (the direct lenders which includes banks, and private lenders like Countrywide), gave the market what they wanted by lowering their standards. The Fed had absolutely nothing to do with this piece of the puzzle. It didn’t set the interest rates. It didn’t set the lending standards. It didn’t set the standards used by rating agencies to rate the securities which included these higher risk loans.
Ultimately the investors were not looking for higher risk investments. They were looking for higher yield. They bought higher yield which was marketed as low risk securities, but in fact, were much higher risk securities. The Fed was not involved in that slight of hand.
The Fed’s historical record has never been perfect in hind sight. It can’t be. They don’t base their decisions on what has already happened. They base them on what they expect to happen, and that will always be an unknown. But their direct involvement in the RE bubble is a canard.
They were never parties to the transactions which caused the crisis. They weren’t primary lenders nor did they regulate any piece of that process. They weren’t packagers, nor did they regulate any piece of that process. They weren’t investors, nor did they regulate any piece of that process.
There was simply never a direct (or even much of an indirect) nexus between their function and the credit crisis. They were never a party to the mis-pricing of risk. And that really is the key to assigning culpability in the crisis. I could certainly be convinced otherwise. But you’ll have to show me exactly where in the process the Fed was involved in mis-pricing risk.
