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.[/quote]
It doesn’t have to officially or “directly” set interest rates. It most certainly DOES influence interest rates on deposits, loans, etc. The Fed, itself, admits as much.
Copying this over from the St. Louis Fed’s site:
“The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. (1) The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate.(2) The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.(2)
The Federal Open Market Committee (FOMC) meets eight times a year to determine the federal funds target rate. As previously stated, this rate influences the effective federal funds rate through open market operations or by buying and selling of government bonds (government debt).(2) More specifically, the Federal Reserve decreases liquidity by selling government bonds, thereby raising the federal funds rate because banks have less liquidity to trade with other banks. Similarly, the Federal Reserve can increase liquidity by buying government bonds, decreasing the federal funds rate because banks have excess liquidity for trade. Whether the Federal Reserve wants to buy or sell bonds depends on the state of the economy. If the FOMC believes the economy is growing too fast and inflation pressures are inconsistent with the dual mandate of the Federal Reserve, the Committee may set a higher federal funds rate target to temper economic activity. In the opposing scenario, the FOMC may set a lower federal funds rate target to spur greater economic activity. Therefore, the FOMC must observe the current state of the economy to determine the best course of monetary policy that will maximize economic growth while adhering to the dual mandate set forth by Congress. In making its monetary policy decisions, the FOMC considers a wealth of economic data, such as: trends in prices and wages, employment, consumer spending and income, business investments, and foreign exchange markets.
The federal funds rate is the central interest rate in the U.S. financial market. It influences other interest rates such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly influences longer- term interest rates such as mortgages, loans, and savings, all of which are very important to consumer wealth and confidence.(2)”
Additionally, by keeping rates at such low levels, it caused lenders to shift the interest rate risk to borrowers by encouraging short-term loans over the more traditional, long-term mortgages. That’s why we saw such a proliferation of ARM and “teaser rate” loans.
At the same time, these low rates encouraged people to bid up housing prices, as prices will almost always rise to offset any benefit of lower rates (and vice-versa) if those lower rates are available to a large enough pool of buyers.
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Finally, as far as the Federal Reserve’s ability to regulate the mortgage market, they most certainly DO have the authority to do so. Note how they made changes AFTER the damage was already done. If they had done the following BEFORE the housing bubble began, or at least in the earliest stages (when many of us were already questioning the existence of a housing/credit bubble), much of the damage could have been avoided, IMHO.
“The final rule, which amends Regulation Z (Truth in Lending) and was adopted under the Home Ownership and Equity Protection Act (HOEPA), largely follows a proposal released by the Board in December 2007, with enhancements that address ensuing public comments, consumer testing, and further analysis.
“The proposed final rules are intended to protect consumers from unfair or deceptive acts and practices in mortgage lending, while keeping credit available to qualified borrowers and supporting sustainable homeownership,” said Federal Reserve Chairman Ben S. Bernanke. “Importantly, the new rules will apply to all mortgage lenders, not just those supervised and examined by the Federal Reserve. Besides offering broader protection for consumers, a uniform set of rules will level the playing field for lenders and increase competition in the mortgage market, to the ultimate benefit of borrowers,” the Chairman said.
The final rule adds four key protections for a newly defined category of “higher-priced mortgage loans” secured by a consumer’s principal dwelling. For loans in this category, these protections will:
Prohibit a lender from making a loan without regard to borrowers’ ability to repay the loan from income and assets other than the home’s value. A lender complies, in part, by assessing repayment ability based on the highest scheduled payment in the first seven years of the loan. To show that a lender violated this prohibition, a borrower does not need to demonstrate that it is part of a “pattern or practice.” Require creditors to verify the income and assets they rely upon to determine repayment ability.
Ban any prepayment penalty if the payment can change in the initial four years. For other higher-priced loans, a prepayment penalty period cannot last for more than two years. This rule is substantially more restrictive than originally proposed.
Require creditors to establish escrow accounts for property taxes and homeowner’s insurance for all first-lien mortgage loans.
“These changes have made for better rules that will go far in protecting consumers from unfair practices and restoring confidence in our mortgage system,” said Governor Randall S. Kroszner.
In addition to the rules governing higher-priced loans, the rules adopt the following protections for loans secured by a consumer’s principal dwelling, regardless of whether the loan is higher-priced:
Creditors and mortgage brokers are prohibited from coercing a real estate appraiser to misstate a home’s value.
Companies that service mortgage loans are prohibited from engaging in certain practices, such as pyramiding late fees. In addition, servicers are required to credit consumers’ loan payments as of the date of receipt and provide a payoff statement within a reasonable time of request. Creditors must provide a good faith estimate of the loan costs, including a schedule of payments, within three days after a consumer applies for any mortgage loan secured by a consumer’s principal dwelling, such as a home improvement loan or a loan to refinance an existing loan. Currently, early cost estimates are only required for home-purchase loans. Consumers cannot be charged any fee until after they receive the early disclosures, except a reasonable fee for obtaining the consumer’s credit history.
For all mortgages, the rule also sets additional advertising standards. Advertising rules now require additional information about rates, monthly payments, and other loan features. The final rule bans seven deceptive or misleading advertising practices, including representing that a rate or payment is “fixed” when it can change.”
