Interest Rate Roundup

Thursday, January 10, 2008

Bernanke weighs in on just about everything; suggests imminent rate cuts are coming

Here's the Bernanke speech, which is now online. Some excerpts (with my emphasis added):

EXCERPT #1 on the big picture:

"Since late last summer, the financial markets in the United States and in a number of other industrialized countries have been under considerable strain. The turmoil has affected the prospects for the broader economy, principally through its effects on the availability and terms of credit to households and businesses. Financial market conditions, in turn, have been sensitive to the evolving economic outlook, as investors have tried to assess the implications of incoming economic information for future earnings and asset values. These interactions have produced a volatile situation that has made forecasting the course of the economy even more difficult than usual."

EXCERPT #2 on higher-risk mortgages:

"Since early 2007, financial market participants have been focused on the high and rising delinquency rates of subprime mortgages, especially those with adjustable interest rates (subprime ARMs). Currently, about 21 percent of subprime ARMs are ninety days or more delinquent, and foreclosure rates are rising sharply.

"Although poor underwriting and, in some cases, fraud and abusive practices contributed to the high rates of delinquency that we are now seeing in the subprime ARM market, the more fundamental reason for the sharp deterioration in credit quality was the flawed premise on which much subprime ARM lending was based: that house prices would continue to rise rapidly. When house prices were increasing at double-digit rates, subprime ARM borrowers were able to build equity in their homes during the period in which they paid a (relatively) low introductory (or “teaser”) rate on their mortgages. Once sufficient equity had been accumulated, borrowers were often able to refinance, avoiding the increased payments associated with the reset in the rate on the original mortgages. However, when declining affordability finally began to take its toll on the demand for homes and thus on house prices, borrowers could no longer rely on home-price appreciation to build equity; they were accordingly unable to refinance and found themselves locked into their subprime ARM contracts. Many of these borrowers found it difficult to make payments at even the introductory rate, much less at the higher post-adjustment rate. The result, as I have already noted, has been rising delinquencies and foreclosures, which will have adverse effects for communities and the broader economy as well as for the borrowers themselves.

"One of the many unfortunate consequences of these events, which may be with us for some time, is on the availability of credit for nonprime borrowers. Ample evidence suggests that responsible nonprime lending can be beneficial and safe for the borrower as well as profitable for the lender. For example, even as delinquencies on subprime ARMs have soared, loss rates on subprime mortgages with fixed interest rates, though somewhat higher recently, remain in their historical range. Some lenders, including some who have worked closely with nonprofit groups with strong roots in low-to-moderate-income communities, have been able to foster homeownership in those communities while experiencing exceptionally low rates of default. Unfortunately, at this point, the market is not discriminating to any significant degree between good and bad nonprime loans, and few new loans are being made.

"Although subprime borrowers and the investors who hold these mortgages are the parties most directly affected by the collapse of this market, the consequences have been felt much more broadly. I have already referred to the role that the subprime crisis has played in the housing correction. On the way up, expansive subprime lending increased the effective demand for housing, pushing up prices and stimulating construction activity. On the way down, the withdrawal of this source of demand for housing has exacerbated the downturn, adding to the sharp decline in new homebuilding and putting downward pressure on house prices. The addition of foreclosed properties to the inventories of unsold homes is further weakening the market."

EXCERPT #3 on financial engineering and structured credit:

"As you know, the losses in the subprime mortgage market also triggered a substantial reaction in other financial markets. At some level, the magnitude of that reaction might be deemed surprising, given the small size of the U.S. subprime market relative to world financial markets. Part of the explanation for the outsized effect may be that, following a period of more-aggressive risk-taking, the subprime crisis led investors to reassess credit risks more broadly and, perhaps, to become less willing to take on risks of any type. Investors have also been concerned that, by further weakening the housing sector, the problems in the subprime mortgage market may lead overall economic growth to slow.

"However, part of the explanation for the far-reaching financial impact of the subprime shock is that it has contributed to a considerable increase in investor uncertainty about the appropriate valuations of a broader range of financial assets, not just subprime mortgages. For example, subprime mortgages were often combined with other types of loans in so-called structured credit products. These investment products, sometimes packaged with various credit and liquidity guarantees obtained from banks or through derivative contracts, were divided into portions, or tranches, of varying seniority and credit quality. Thus, through financial engineering, a diverse combination of underlying credits became the raw material for a new set of financial assets, many of them garnering high ratings from credit agencies, which could be matched to the needs of ultimate investors."

EXCERPT #4 on jumbo mortgage loans and credit market tightness:

"Importantly, investors’ loss of confidence was not restricted to securities related to subprime mortgages but extended to other key asset classes. Notably, the secondary market for private-label securities backed by prime jumbo mortgages has also contracted, and issuance of such securities has dwindled. Even though default rates on prime jumbo mortgages have remained very low, the experience with subprime mortgages has evidently made investors more sensitive to the risks associated with other housing-related assets as well. Other types of assets that have seen a cooling of investor interest include loans for commercial real estate projects and so-called leveraged loans, which are used to finance mergers and leveraged buyouts."

EXCERPT #5 on the banking system:

"Although structured credit products and special-purpose investment vehicles may be viewed as providing direct channels between the ultimate borrowers and the broader capital markets, thereby circumventing the need for traditional bank financing, banks nevertheless played important roles in this mode of finance. Large money-center banks and other major financial institutions (which I will call “banks,” for short) underwrote many of the loans and created many of the structured credit products that were sold into the market. Banks also supported the various investment vehicles in many ways, for example, by serving as advisers and by providing standby liquidity facilities and various credit enhancements. As the problems with these facilities multiplied, banks came under increasing pressure to rescue the investment vehicles they sponsored--either by providing liquidity or other support or, as has become increasingly the norm, by taking the assets of the off-balance-sheet vehicles onto their own balance sheets. Banks’ balance sheets were swelled further by non-conforming mortgages, leveraged loans, and other credits that the banks had extended but for which well-functioning secondary markets no longer existed.

"Even as their balance sheets expanded, banks began to report large losses, reflecting the sharp declines in the values of mortgages and other assets. Thus, banks too became subject to valuation uncertainty, as could be seen in their share prices and other market indicators such as quotes on credit default swaps. The combination of larger balance sheets and unexpected losses also resulted in a decline in the capital ratios of a number of institutions. Several have chosen to raise new capital in response, and the banking system retains substantial levels of capital. However, on balance, these developments have prompted banks to become protective of their liquidity and balance sheet capacity and thus to become less willing to provide funding to other market participants, including other banks. As a result, both overnight and term interbank funding markets have periodically come under considerable pressure, with spreads on interbank lending rates over various benchmark rates rising notably. We also see considerable evidence that banks have become more restrictive in their lending to firms and households. More-expensive and less-available credit seems likely to impose a measure of financial restraint on economic growth."

EXCERPT #6 on the "TAF" system:

"Based on our initial experience, it appears that the TAF may have overcome the two drawbacks of the discount window, in that there appears to have been little if any stigma associated with participation in the auction, and--because the Fed was able to set the amounts to be auctioned in advance--the open market desk faced minimal uncertainty about the effects of the operation on bank reserves. The TAF may thus become a useful permanent addition to the Fed’s toolbox. TAF auctions will continue as long as necessary to address elevated pressures in short-term funding markets, and we will continue to work closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives."

EXCERPT #7 on the economy:

"Although economic growth slowed in the fourth quarter of last year from the third quarter’s rapid clip, it seems nonetheless, as best we can tell, to have continued at a moderate pace. Recently, however, incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced. Notably, the demand for housing seems to have weakened further, in part reflecting the ongoing problems in mortgage markets. In addition, a number of factors, including higher oil prices, lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008.

"Financial conditions continue to pose a downside risk to the outlook for growth. Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future. On the whole, despite improvements in some areas, the financial situation remains fragile, and many funding markets remain impaired. Adverse economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses. I expect that financial-market participants--and, of course, the Committee--will be paying particular attention to developments in the housing market, in part because of the potential for spillovers from housing to other sectors of the economy."

EXCERPT #8 on the Fed's possible interest rate response:

"Monetary policy has responded proactively to evolving conditions. As you know, the Committee cut its target for the federal funds rate by 50 basis points at its September meeting and by 25 basis points each at the October and December meetings. In total, therefore, we have brought the funds rate down by a percentage point from its level just before financial strains emerged. The Federal Reserve took these actions to help offset the restraint imposed by the tightening of credit conditions and the weakening of the housing market. However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary. The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

"Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability."

Fed Chairman Ben Bernanke's speech illustrates that he "gets" what is behind the problems in the economy and the financial markets. That's good -- for the longest time, this Fed has been underestimating the housing market problems, underestimating the mortgage market problems, and underestimating the threat of economic weakness. His comments strongly imply that an interest rate cut is imminent, and that the Fed will even act between scheduled meetings if necessary. I wouldn't be surprised to see a half-point cut before the January 29-30 gathering if financial markets fail to stabilize.

A reasonable question to ask, though, is: "Why didn't you just go ahead and cut rates if you believe conditions are deteriorating?" Another one worth posing is: "Will Fed rate cuts be enough to 'solve' the financial market's problems?" They certainly won't hurt, in my view. But they can't fix everything.

They can't prevent home prices from declining further, given the massive supply overhang in both the new and existing home market. They won't inspire banks and investors to go crazy with credit again, because they're still nursing their wounds from higher-risk real estate and leveraged finance loans. And they probably can't prevent the U.S. economy from sliding into recession, or getting darn close, in 2008.

In short, we've just experienced an extraordinary housing and credit bubble. It will take time to repair the damage and sleep off the hangover.

UPDATE on the Q&A:

Bernanke took a pass on a question regarding legislation that would allow bankruptcy judges to restructure mortgages in the court system.

Asked about whether we were going to have a recession, he talked about how dating/forecasting a recession is tough. Then he said the Fed is not currently forecasting a recession, but stands ready to cut rates if necessary.

He said politics won't affect decision making in this election year.

Then he said that fiscal stimulus is being discussed, but that those discussions are in the early stages, and that he wanted to see what emerges from that.

Finally, he talked a bit about the proposals the Fed has out for comment pertaining to mortgage advertising. And he pointed out that the Fed and other regulators have issued revised guidance about how to do subprime lending right.

UPDATE on market reaction:

Stocks surged initially, but the Dow has since dipped slightly into negative territory. Long bonds are down pretty sharply, -26/32 on the futures recently. The yield curve has steepened -- 30-year rates have risen by about 6 basis points, while 2-year yields have dropped more than 6 bps. The dollar is getting spanked, with the Dollar Index off about 51 ticks. And gold is up sharply -- about $13.


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