January 27, 2016


Subprime Reasoning on Housing (DAVID BECKWORTH and RAMESH PONNURU, JAN. 27, 2016, NY Times)

In 2006 and 2007, construction employment fell, but overall employment continued to grow, as did the economy generally. Money and labor merely shifted from housing to other sectors of the economy.

This housing decline caused financial stress by sowing uncertainty about the value of bonds backed by subprime mortgages. These bonds served as collateral for institutional investors who parked their money overnight with financial firms on Wall Street in the "shadow banking" system. As their concerns about the bonds grew, investors began to pull money out of this system.

In retrospect, economists have concluded that a recession began in December 2007. But this recession started very mildly. Through early 2008, even as investors kept pulling money out of the shadow banks, key economic indicators such as inflation and nominal spending -- the total amount of dollars being spent throughout the economy -- barely budged. It looked as if the economy would be relatively unscathed, as many forecasters were saying at the time. The problem was manageable: According to Gary Gorton, an economist at Yale, roughly 6 percent of banking assets were tied to subprime mortgages in 2007.

It took a bigger shock to the economy to bring the financial system down. That shock was tighter money. Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy. This point is easy to miss because the Fed lowered interest rates between September 2007 and April 2008. But raising rates is not the only route to tighter money.

Between late April and early October, the Fed kept the interest rate over which it has most direct control, the federal funds rate, at 2 percent. But when the economy weakens, the "natural" interest rate -- the rate that keeps the economy on an even keel -- falls. By staying in place, the Fed's target interest rate was rising relative to that natural rate. The gap between expected interest rates and the natural rate was rising even more. Fed officials spent the late spring and summer of 2008 warning that rates would have to rise to combat inflation. Futures markets showed a sharp increase in expected interest rates.

Market indicators of expected inflation fell sharply that summer, a sign that the economy was getting weaker and monetary policy tighter. Nominal spending showed the change. After growing for years at a relatively steady rate, it began to drop.

In their early August meeting, some Fed policy makers nonetheless anticipated that they would raise rates soon. Inflation expectations and nominal spending kept falling. In mid-September, shortly after the collapse of Lehman Brothers, the Fed refused to cut interest rates further, citing the risk of inflation. (To his credit, Chairman Ben Bernanke subsequently admitted that not cutting rates then was a mistake.) It did not cut rates until weeks after the crisis had become undeniable.

It was against this backdrop of tighter money that the financial stress of 2007 turned into something far worse in 2008. With nominal spending falling at the fastest rate since the Depression, households, businesses and banks all had incomes lower than they had expected. That made servicing debts and paying wages harder than expected. It also lowered asset values, since those were premised on expected streams of future income.

The first folks to suffer from rate hikes are the marginal borrowers and their increased failure rates exposed the fraud behind derivatives.

Posted by at January 27, 2016 3:31 PM