No taper

[SK in CV]

[quote=barnaby33]First of all, from the Fed does all money flow. The Fed sets interest rates and bank reserve requirements. It could have easily said, no you can’t make these risky loans, by raising reserve requirements. SK you obviously don’t remember the Fed issuing exemptions to the big banks allowing them to loan more than 10% of assets to their pet investment funds in 2008. Previously that was verboten but the Fed allowed it, to buy more time. Essentially to deepen the crisis that already had to happen.

True it didn’t loosen credit quality, but it certainly didn’t object to Congress doing so either. It had a choice, to uphold the legal/credit nexus that you say they had no part in creating, or along with the Treasury they could print to inflate to allow all the bad actors in the system off the hook, also known as changing the rule book when the game moves against your customers, the large banks. Where do you think the money came from to buy all that Phony/Fraudie debt? Taxes collected? The Fed printed it.
Josh[/quote]

No, the Fed can’t say “you can’t make risky loans”. Other governmental agencies can. The only interest rate the Fed sets is the discount rate. Not prime. Not CD rates. Not Fed debt rates. Not mortgage rates.

The reserve requirement essentially applies to checking accounts, not savings or CDs. It’s really a non-issue. I don’t recall the Fed easing any investing requirements that they don’t have the authority over.

The Fed rarely gets involved in politics. The most recent statements by Bernanke (and similar warnings he’s made before Congress) are about as much control over congress as he has.

You’ll have to point out where Congress loosened credit quality during the run-up to the crisis. I’m not claiming now, nor have I, that the Fed had no part, or couldn’t have done something different that would have changed things. But they simply do not have either the charge nor the authority to have changed things much. Other federal agencies certainly did (the SEC for instance). But ultimately, it was not a regulation driven crisis, more so driven by repeal of regulations and driven by the market itself.

[paramount]

[quote=FlyerInHi]

Sure, it’s not the same as 2006 but we are slowly but surely on the road back. The Fed had a strong hand in engineering a comeback.[/quote]

Spoken like a true metals investor??

[SD Realtor]

Just let us all know how the Fed plans to unwind all the debt it is carrying.

[dumbrenter]

[quote=SK in CV]
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.
[/quote]

SK, that was a pretty good tutorial on how Fed works. Thanks for taking time to write it.

The way I understand this is: By buying US government securities, the Fed actions ended up lowering the yields on them (as a stated policy). This low yield forced banks (and others) to look for higher yield elsewhere, i.e. mortgages etc.

Assuming the above to be correct, you are right that the Fed was not a party to mispricing the risk, but their actions definitely contributed to it.
It is not like they did not see this happening; question is what motivated them to keep the yields so low with their actions?

[SK in CV]

[quote=dumbrenter]
SK, that was a pretty good tutorial on how Fed works. Thanks for taking time to write it.

The way I understand this is: By buying US government securities, the Fed actions ended up lowering the yields on them (as a stated policy). This low yield forced banks (and others) to look for higher yield elsewhere, i.e. mortgages etc.

Assuming the above to be correct, you are right that the Fed was not a party to mispricing the risk, but their actions definitely contributed to it.
It is not like they did not see this happening; question is what motivated them to keep the yields so low with their actions?[/quote]

Quantitative easing, (QE, QE 2, and QE 3) didn’t start until after the credit crisis. They didn’t use the buying of government debt to manipulate interest rates to any great extent before that. One of their charges is to maintain a stable market. I believe they did buy/sell treasuries to that end prior to the crisis, but they currently hold about 2 1/2 times in US Government debt than they held before the crisis. The Fed has also purchased over $1.2 trillion in mortgage backed securities, up from zero before the crisis.

The Fed is owned by banks. Banks own debt. That’s how they make money, by lending money.What banks fear more than anything other than bad debt is inflation. Inflation kills the value of debt. Higher interest rates curb inflation. So their motivation has always been to keep the discount rate (which is the only rate they set) as low as possible without encouraging high inflation.

[CA renter]

[quote=SK in CV][quote=CA renter]

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)”

http://research.stlouisfed.org/fred2/series/FEDFUNDS

—————————

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.

————–

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.”

http://www.federalreserve.gov/newsevents/press/bcreg/20080714a.htm

[CA renter]

New post, because that last one was so long (sorry)…

And while the Fed might not have “direct” regulatory control over certain markets, they have more of an effect on markets than almost any other entity in the U.S. If a Fed official, especially the chairman of the Fed, says that a particular asset is getting dangerously overpriced and that they will begin to take action to offset the misallocation of capital, trust me, the world will listen.

I’m sure you also understand that while they might not have “official” control in certain areas of finance, they definitely meet with and confer with other regulators behind closed doors. They have a lot more power than what is “officially” granted to them, and you know this.

And here are some charts to show the correlation between the Fed Funds Rate and other interest rates:

Fed Funds:

http://seekingalpha.com/article/62673-long-term-chart-of-federal-funds-rate

10-Year Treasury:

http://finance.yahoo.com/echarts?s=^TNX+Interactive#symbol=^tnx;range=1y;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

…………….

And something unrelated to this that I’ve always considered was the fact that the 30-Year Treasury was discontinued in 2002 and reintroduced in 2006. IMO, the possibility exists that investors who traditionally buy longer-term securities (like pension funds) were forced into larger positions in the mortgage market by this move. Just conjecture on my part, but I think it certainly didn’t help. Not the Fed, but just another issue to consider.

—————-

And here’s a snippet about how pension funds were trying to juice their yields with various schemes sold to them by Wall Street. They did this because of the investment losses resulting from the dot-com/stock market crash, and because of the low yields on bonds at the very time that they needed higher yields to help make up for some of those earlier losses. One can even go further back and suggest that if Greenspan had sounded the alarm in full during the stock market bubble of the late 90s, as opposed to remarking about a little “froth,” much of the damage from that bubble could have been avoided as well.

Let’s not forget that the pension benefit enhancements during the stock market bubble has also contributed to the current underfunding in the pension plans. If not for the stock market bubble, I believe these enhancements would never have happened.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aW5vEJn3LpVw

[FlyerInHi]

[quote=CA renter]Let’s not forget that the pension benefit enhancements during the stock market bubble has also contributed to the current underfunding in the pension plans. If not for the stock market bubble, I believe these enhancements would never have happened.

[/quote]

It’s like saying that if it weren’t for the stock market, I would have saved more for retirement. I didn’t; so it’s the financial industry’s fault.

[CA renter]

[quote=FlyerInHi][quote=CA renter]Let’s not forget that the pension benefit enhancements during the stock market bubble has also contributed to the current underfunding in the pension plans. If not for the stock market bubble, I believe these enhancements would never have happened.

[/quote]

It’s like saying that if it weren’t for the stock market, I would have saved more for retirement. I didn’t; so it’s the financial industry’s fault.[/quote]

No, that’s not it at all. SK knows what I’m talking about.

[SK in CV]

[quote=CA renter][quote=FlyerInHi][quote=CA renter]Let’s not forget that the pension benefit enhancements during the stock market bubble has also contributed to the current underfunding in the pension plans. If not for the stock market bubble, I believe these enhancements would never have happened.

[/quote]

It’s like saying that if it weren’t for the stock market, I would have saved more for retirement. I didn’t; so it’s the financial industry’s fault.[/quote]

No, that’s not it at all. SK knows what I’m talking about.[/quote]

I’m not sure exactly which stock market bubble you’re referring to. I don’t think there was a stock market bubble before the crash in ’08. I think a bubble would imply an over-valuation. There were some segments, and clearly some companies that were over-valued, but for the most part, the market was fairly valued based on earnings. Earnings went down (way down in some cases), valuation went down. I don’t think that’s a bubble. The dot-com bubble in the late ’90’s was a real bubble. Companies valued based solely on future earnings. Kinda like Amazon, Facebook and Tesla now. But it was then much of the market.

But to your other point, it’s probably true with regard to public pensions, particularly in California. The RE bubble unreasonably inflated tax revenues. Good investment returns over more than a 15 year period ending in 2008 made it seem the funding for DB plans was sufficient. Why? Because public employee pension funds had been investing in higher risk investments. Even when the Fed funds rate was NOT kept artificially low. But then when those higher risk investments failed, it became time to blame the Fed for “forcing” them into higher risk investments.

[CA renter]

Yes, I’m referring to the stock market bubble in the late 90s (and would also argue that most asset classes were overvalued as a result of the *credit* bubble that was caused by the Fed’s response to the dot-com bubble, as well…we’ve been relying on asset price bubbles for some time now). As you know, that internet/stock market bubble made the pension funds look over-funded, which is why they were able to pass the pension benefit enhancements “without any additional costs to taxpayers.”

The pension funds have NOT been doing well over the past 15 years. They were UNDER-funded after the stock market bubble burst in the early 2000s, so the funds started investing more and more of their money in real estate, mortgages (and related derivatives), and other “alternative” investments, like hedge funds. They were forced into these riskier positions because of the losses from the internet bubble (which I think the Fed had a hand in), and because the yields on bonds were so low. The losses incurred on these investments hit the pension funds even harder than the bursting of the internet/stock market bubble. It was this confluence of events (all of which can be blamed directly or indirectly on the Fed) that caused the pension “crisis.”

[SK in CV]

[quote=CA renter]Yes, I’m referring to the stock market bubble in the late 90s. As you know, that bubble made the pension funds look over-funded, which is why they were able to pass the pension benefit enhancements “without any additional costs to taxpayers.”

The pension funds have NOT been doing well over the past 15 years. They were UNDER-funded after the stock market bubble burst, so the funds started investing more and more of their money in real estate, mortgages (and related derivatives), and other “alternative” investments, like hedge funds. It was this confluence of events (all of which can be blamed directly or indirectly on the Fed) that caused the pension “crisis.”[/quote]

Pension funds have been investing in RE and mortgages for decades, maybe longer. You might remember the San Diego connection to the organized crime syndicate in Las Vegas in the mid 70’s when the Teamsters pension fund lent San Diegan Alan Glick millions to become the 2nd largest hotelier in Vegas behind Howard Hughes. That’s where they put their money. That was the conservative investment.

During the 15 years through 2007 (prior to the crash), CalPers average rate of return was almost 11%. Average. That included the dot com bubble burst. It was fully funded through 2007. They had two years in the ’90’s where their return was over 20%. They couldn’t have made that kind of return in low risk investments. The assertion that they only started making higher risk investments after interest rates fell is unsupportable by the evidence.

[livinincali]

[quote=SK in CV]
During the 15 years through 2007 (prior to the crash), CalPers average rate of return was almost 11%. Average. That included the dot com bubble burst. It was fully funded through 2007. They had two years in the ’90’s where their return was over 20%. They couldn’t have made that kind of return in low risk investments. The assertion that they only started making higher risk investments after interest rates fell is unsupportable by the evidence.[/quote]

The S&P was around 350 in 1992. It was around 1650 in 1997. Guess what that’s compound interest rate of 11%. Surprise, Surprise, CalPers managed to match the S&P over the same time period. Although one that was pretty incredible run for stocks and will likely never be repeated again.

[SK in CV]

[quote=livinincali]
The S&P was around 350 in 1992. It was around 1650 in 1997. Guess what that’s compound interest rate of 11%. Surprise, Surprise, CalPers managed to match the S&P over the same time period. Although one that was pretty incredible run for stocks and will likely never be repeated again.[/quote]

Right. Which means they weren’t investing solely in low risk stuff during that period. They probably did have a pretty significant chunk of their assets in low risk investments like treasuries and mortgages. Which means they must have earned substantially more than 11% on the rest of the portfolio. Which also means they weren’t suddenly “forced” to seek higher yields when the Fed lowered the discount rate after the dot-com crash. They were seeking those higher yields well before that.

[CA renter]

[quote=SK in CV][quote=CA renter]Yes, I’m referring to the stock market bubble in the late 90s. As you know, that bubble made the pension funds look over-funded, which is why they were able to pass the pension benefit enhancements “without any additional costs to taxpayers.”

The pension funds have NOT been doing well over the past 15 years. They were UNDER-funded after the stock market bubble burst, so the funds started investing more and more of their money in real estate, mortgages (and related derivatives), and other “alternative” investments, like hedge funds. It was this confluence of events (all of which can be blamed directly or indirectly on the Fed) that caused the pension “crisis.”[/quote]

Pension funds have been investing in RE and mortgages for decades, maybe longer. You might remember the San Diego connection to the organized crime syndicate in Las Vegas in the mid 70’s when the Teamsters pension fund lent San Diegan Alan Glick millions to become the 2nd largest hotelier in Vegas behind Howard Hughes. That’s where they put their money. That was the conservative investment.

During the 15 years through 2007 (prior to the crash), CalPers average rate of return was almost 11%. Average. That included the dot com bubble burst. It was fully funded through 2007. They had two years in the ’90’s where their return was over 20%. They couldn’t have made that kind of return in low risk investments. The assertion that they only started making higher risk investments after interest rates fell is unsupportable by the evidence.[/quote]

CalPERS was UNDER-funded after the bursting of the internet/stock market crash. It was NOT fully funded for the past 15 years. I’m trying to find the financial statements to show this, but am having a difficult time trying to find the 2002-2004 data, but know that they were not fully funded.

As for the additional risks taken by the pension funds after the stock market crash (causing the under-funded status) and the need to “catch up” with riskier investments at a time when the Fed was holding rates at artificial lows:

“Years of bad bets catch up

Most of Calpers investment losses came from its largely passive investments in baskets of equities, which still account for about half of the system’s assets. But the retirement system also got into trouble by adding leverage, reducing oversight and by chasing other hot markets.

After maintaining a low-risk real estate strategy for decades, studies commissioned by Calpers show that it switched gears in 2002, embracing higher levels of risk even as the real estate market began to top out in 2005. By mid-2009, Calpers had a one-year loss of 48.8% in its real estate portfolio and was reporting among the lowest returns of any large pension funds in the country.

In early 2006, it said it would invest $6 billion in commodities, particularly through index futures, news that caused Grants’ Interest Rate Observer to respond: “On the timing of this demarche, we hand Calpers the gold medal for Being Late.”

Calpers showed even worse timing in the mortgage market. Just before the market tanked, it invested approximately $140 million in unrated collateralized debt obligations (CDOs) and $1.3 billion in complex buckets of loans and debts called structured investment vehicles (SIV). A Calpers lawsuit puts the SIV losses at “perhaps more than $1 billion.”‘

http://money.cnn.com/2010/06/30/news/companies/calpers_pension_risks.fortune/index.htm

[Author]

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