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Boom and Bust Banking
The Causes and Cures of the Great Recession
By David M. Beckworth
The Independent InstituteCopyright © 2012 The Independent Institute
All rights reserved.
Monetary Policy and the Financial Crisis
Lawrence H. White
THE U.S. HOUSING BOOM of 2001–06 and the subsequent bust were not the results of laissez-faire or deregulation in the monetary and financial system. The boom and bust were the results of the interaction of an unanchored government fiat monetary system with a perversely regulated financial system. Overly expansionary monetary policy fueled imprudent lending that was incentivized by "too-big-to-fail" and other regulatory distortions.
President George W. Bush famously explained the boom and bust by analogy (off the record, but someone in the room made a cell phone recording): "Wall Street got drunk! It got drunk and now it's got a hangover." To extend the metaphor, it was the Federal Reserve's cheap credit policy that spiked the punchbowl. The housing boom-and-bust cycle of 2001–07 was driven by Federal Reserve credit expansion.
To use a much-repeated phrase, the Fed in 2001–06 kept interest rates "too low for too long" by injecting too much credit. From 2002 to 2005, the overnight federal funds (interbank lending) rate was below 2 percent. In 2004, it was 1 percent. In an environment of increasing federal subsidies and mandates for widening home ownership through relaxed creditworthiness standards, the credit flowed disproportionately into housing. Real estate lending grew by 10–15 percent per year for several years, an unsustainable path. Low interest rates and easy terms meant that house buyers could afford larger mortgages and therefore pricier houses, driving house prices up dramatically. Federal Reserve Chairman Alan Greenspan in 2004 and his successor Ben Bernanke in 2005 assured observers that there was no national bubble in housing prices.
Rising prices and extended low interest rates made "creative" lending seem to pay off: for a time, default rates were low, even on "nonprime" mortgages that by contrast with traditional standards had low down payments, high loan-to-income ratios, poorly documented income, and monthly payments that would rise once market interest rates rose. The temporary success of creative mortgages encouraged further expansion of real estate lending to non-creditworthy borrowers. Lenders offered "nonprime" mortgages secured not by 20 percent down, but essentially by the hope that the trend in prices would give the borrower 20 percent equity soon. With rising interest rates beginning in 2005 and the reversal in real estate prices beginning in 2006, the bubble burst. Mortgage defaults rose, first on nonprime mortgages and eventually even on conventional mortgages.
The bursting of the housing bubble brought down a surprisingly large array of financial institutions. Fannie Mae and Freddie Mac, the nation's two largest mortgage financiers, became insolvent. They remain in federal "conservatorship" with losses ever mounting by the hundreds of billions. Investment house Bear Stearns failed and was sold to JPMorgan Chase only after the Federal Reserve Bank of New York injected capital by overpaying for the worst assets. Lehman Brothers failed and was resolved. The insurance giant AIG failed and was placed on federal life support. Wachovia Bank, Washington Mutual, and Merrill Lynch had to be absorbed by other institutions. Goldman Sachs, Morgan Stanley, Bank of America, Citibank, and other large institutions lined up for federal capital injections under the Troubled Asset Relief Program, and (we later learned) received quiet capital injections from the Federal Reserve in the form of loans at below-market interest rates.
Causes of the Housing Boom and Bust
In the recession of 2001, the Federal Reserve System, under Chairman Alan Greenspan, began aggressively easing U.S. monetary policy. There is more than one method for judging whether monetary policy is too tight or too easy, but all indicators point toward excessive ease beginning in 2001. Year-over-year growth in the M2 monetary aggregate rose briefly above 10 percent and remained above 8 percent entering the second half of 2003. The Fed repeatedly lowered its target for the federal funds interest rate until it reached a record low. The rate began 2001 at 6.25 percent and ended the year at 1.75 percent. It was reduced further in 2002 and 2003; in mid-2003, it reached a then-record low of 1 percent, where it stayed for one year. The real Fed funds rate was negative — meaning that nominal rates were lower than the contemporary rate of inflation — for more than three years. In purchasing power terms, during that period a borrower was not paying, but rather gaining, in proportion to what he borrowed.
The "Taylor Rule" — a formula devised by economist John Taylor of Stanford University — provides a now-standard method of estimating what level of the current nominal federal funds rate (the overnight interbank borrowing rate that the Federal Reserve uses as its operating instrument) would be consistent, conditional on current inflation and the "output gap" between the economy's estimated potential real output and current real output, while keeping the inflation rate to a chosen target rate. Figure 1.1 contrasts the federal funds rate target path indicated by the Taylor Rule, assuming a 2-percent inflation target, with the actual federal funds rate path. The figure shows that the Fed pushed the actual federal funds rate below the Taylor Rule — estimated target rate starting in the late 1990s, and that this gap had become especially large — 200 basis points or more — between mid-2003 and mid-2005.
The real federal funds rate (adjusted for contemporaneous inflation) shows a similar pattern. Figure 1.2 indicates that the ex post real federal funds rate (measured by the federal funds rate minus the CPI inflation rate) was persistently negative for more than three years between 2002 and 2005, getting as low as — 1.77 percent. This figure also shows that during this time the real federal funds rate was more than 300 basis points below the "neutral" real federal funds rate level as estimated by Thomas Laubach and John C. Williams. By either measure, then, monetary policy was overly loose.
By pursuing a monetary policy so expansionary as to hold the real federal funds rate too low, the Fed drove nominal spending above its established path. Figure 1.3 shows that the final sales of domestic product grew at a fairly stable rate between 1987 and 1998. In mid-1998, however, the Fed deviated and lowered the federal funds rates even though the economy was experiencing robust economic growth. The demand bubble it created set the stage for the recession of 2001. The Fed acted similarly from mid-2002 to mid-2004 by lowering the federal funds rate even after the recovery was underway. The second period of easy money set the stage for the recession of 2007–09. The Fed's policy, in the words of economist Steve Hanke, "set off the mother of all liquidity cycles and yet another massive demand bubble."
This new demand bubble went heavily into real estate. From mid-2003 to mid-2007, while the dollar volume of final sales of goods and services was growing at 5 percent to 7.5 percent annually, real estate loans at commercial banks were growing at 10–17 percent. Figure 1.4 shows how mortgage lending grew from $541 billion in January 2001 to a peak of $1,647 billion in April 2006. The rapidly growing volume of mortgage lending pushed up the inflation-adjusted sales prices of existing houses and encouraged the construction of new housing on undeveloped land, in both cases absorbing the increased dollar volume of mortgages. Because real estate is an especially long-lived asset, its market value is especially boosted by low interest rates. The Federal Housing Finance Agency (FHFA) housing price index exhibited annual nominal growth rates of 7–12 percent and annual real growth rates of 5–7 percent over the 2001–2006 period.
Can the rapid appreciation in house prices be explained simply by the economic fundamentals that normally drive home prices? No, it cannot. Figure 1.5 shows that the FHFA housing price index grew 73 percent more than personal income per capita over the 2001–2006 period. The figure also shows that housing prices grew about 30 percent more than owners' equivalent rent over that same time. Housing prices, therefore, were growing faster than warranted by the growth in the ordinary fundamentals. Monetary policy helps to explain the housing bubble.
Figure 1.6 provides further evidence that the Fed's low interest rate policy was an important contributor to the housing boom. The figure shows that over the Greenspan Fed period (1987–2006) a large amount of the non-fundamentals-driven movement in house prices, measured alternatively as the ratio of house prices to rents and as the ratio of house prices to personal income per capita, can be explained by prior deviations of the federal funds rate from the Taylor Rule federal fund rate target. Much of the extraordinary rise of house prices during the boom thus traces to the period of too-low path movement of the federal funds rate in 2002–2005. Other evidence similarly links much of the housing boom to the Federal Reserve's too-low federal funds rate targets.
The Fed's policy of lowering short-term interest rates not only fueled growth in the dollar volume of mortgage lending, but also had unintended consequences for the type of mortgages written. By pushing the federal funds rate down so dramatically between 2001 and 2004, the Fed lowered all short-term interest rates relative to longer-term rates. Adjustable-rate mortgages (ARMs), typically based on a one-year interest rate, became increasingly cheap relative to thirty-year fixed- rate mortgages. Figure 1.7 shows the Fed's influence on ARM interest rates by charting the federal funds rate target together with and the average one-year ARM interest rate. Back in 2001, the one-year ARM interest rate on average was about 0.90 percent lower than the average thirty-year fixed mortgage interest rate (7.05 percent versus 7.97 percent). By 2004, as a result of the low federal funds rate target, the average gap had more than doubled, growing to 2.08 percent (3.72 percent vs. 5.80 percent). The Fed not only created the gap, but also created the expectation that it would persist by explicitly committing itself in 2003 to keep the federal funds rate low for a "considerable period."
Not surprisingly, increasing numbers of new mortgage borrowers were drawn away from mortgages with thirty-year rates into ARMs. Studies have shown that households deciding whether to take out an ARM mortgage or a fixed-rate mortgage consider the expected path of interest rates. By creating the expectation that the gap between the ARM interest rate and the thirty-year fixed-rate mortgage interest rates would persist for a "considerable period," the Fed made ARMs more attractive to borrowers. Figure 1.8 shows the percent of all mortgages that were ARMs, along with a measure of the mortgage interest rate gap. The gap measure shows the difference between current rates on thirty-year fixed-rate mortgages and the expected one-year ARM rate, as measured by the average one-year ARM rate over the past three years. The greater the gap, the more attractive the ARM will be. Figure 1.8 indicates changes in this gap are an important contributor to changes in the ARM share of mortgage originations.
Figure 1.8 shows that during the housing boom period the market share of ARMs went from around 11 percent (in the first half of 2001) to a high of 40 percent (in mid-2004). Unsurprisingly, the surge in ARM originations coincided with the Fed-induced rise in the mortgage interest rate gap. The Fed's monetary policy was thus the key reason for the sharp rise in ARMs. The rise in ARMs is an important part of the story of how mortgage defaults became such a problem. An adjustable-rate mortgage shifts the risk of refinancing at higher rates from the lender to the borrower. Many borrowers who took out ARMs implicitly (and imprudently) counted on the Fed to keep short-term rates low indefinitely. These borrowers faced severe problems as their monthly payments adjusted upward. Default rates have been much higher on ARMs than on fixed-rate mortgages. The shift toward ARMs thus compounded the mortgage-quality problems arising from regulatory mandates and subsidies.
The riskiness of loans to less creditworthy borrowers was hidden for several years by the upward trend in housing prices. When the bubble burst, borrowers could no longer make mortgage payments by cash-out refinancing or home-equity borrowing.
The Financial System Amplifies the Monetary Stimulus
The Fed's monetary ease set off a housing boom in a financial system distorted by housing mandates and moral hazard problems. Creditors to Fannie Mae and Freddie Mac, Citibank, Bank of America, and the large investment banks believed that they were protected by government backing, whether guarantees were explicitly stated or not.
The U.S. banking system has received ever-increasing protection through its history, amplifying — rather than mitigating — the problems of weak banks and unsound banking. Each attempt to patch the system, to make it less prone to crisis, has unintentionally sown the seeds of a later crisis. In the early republic, restrictions against branch banking, intended to secure local monopoly privileges, left banks under-diversified and undercapitalized. Partly to fix the resulting problem of insecure and heterogeneous banknotes, the National Currency Acts passed during the Civil War required banks to hold federal bonds as collateral against notes (which also served to compel them to buy federal war bonds). The unintended result was a currency so "inelastic" that peak seasonal demands for currency set off financial panics like the Panic of 1907. To address the problem of panics, Congress, in 1913, created the Federal Reserve System, rather than undoing legal restrictions to move toward a system more like the panic-free Canadian banking system.
The Federal Reserve System was supposed to remedy panics by providing an elastic currency and by acting as a lender of last resort. In the 1920s, the Fed experimented with its new powers by engaging in expansionary monetary policy, unintentionally inflating an asset price boom that went bust in 1929. The Fed failed to alleviate the multiple banking panics of 1930–33 and failed to offset the resulting sharp contraction in the money stock. A new patch was added in 1933 with the creation of federal deposit guarantees administered by the FDIC. As is now widely recognized, deposit guarantees have unintentionally bred moral hazard. In adapting to deposit insurance, U.S. banks have lowered their capital ratios and learned to take on greater portfolio risk.
To patch the problem of the incentive to hold inadequate capital, the Basel agreements among central bankers have imposed required capital ratios that are arbitrarily risk-weighted. The unintended result has been that banks have hidden high-risk assets off the balance sheet in "structured investment vehicles," and in other ways have made their risk-taking more opaque. Reported balance-sheet capital ratios have become almost completely uninformative, remaining at the mandated level even for banks whose market-valued capital (share price times number of shares) — which reflects informed estimates of the actual market values of the bank's assets and liabilities — has declined toward zero.
In the recent crisis, it became clear that moral hazard problems have been amplified greatly by implicit guarantees to all creditors and counterparties of even non-bank institutions considered "too big to fail" (TBTF). Moral hazard grows under TBTF because even creditors and counterparties not officially covered by the FDIC consider their claims guaranteed. They therefore have little reason to put a price on risk-taking by requiring a riskier bank to pay higher interest rates before they will lend to it. Money-center banks have adapted to the bigness requirement for this implicit coverage by growing large not for efficiency reasons, but to maximize the credit subsidy.
Excerpted from Boom and Bust Banking by David M. Beckworth. Copyright © 2012 The Independent Institute. Excerpted by permission of The Independent Institute.
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