Interest Rate Roundup

Monday, September 17, 2007

Monday morning bits

* Northern Rock Plc, the British mortgage lender mentioned in this blog post from late last week, continues to slide. The stock was recently off another 38%, after falling 31% on Friday, on news depositors are lined up all over the U.K. to take their money out of the firm. The BBC reports that savers have yanked more than 2 billion pounds (about $4 billion), or 8% of Northern Rock's deposit base, in just the past three days.

* British-pound based LIBOR rates are rising on the Northern Rock news, though U.S. LIBOR rates have come down in the past couple of days. Only time will tell if another U.S. financial system time bomb is ticking, and ready to go off a la Northern Rock. But if and when that does happen, you can expect risk premiums to make a quick re-appearance here in the U.S. money markets.

* Alan Greenspan is doing a whirlwind media tour for his new book. You can find all kinds of opinions about the memoir, entitled "The Age of Turbulence: Adventures in a New World." And you can check out his 60 Minutes interview if you want here.

But to focus on his comments about housing and mortgages, Greenspan warned that we're going to see declines in house prices that will be "larger than most people expect," according to the Financial Times. His take is that prices will fall by the high single-digits from the peak to the trough, and that the decline could easily be in the double-digit range.

In other interviews, he has defended himself against charges that the Fed aided and abetted the inflation of the housing bubble. His general stance: That the Fed raised rates to cool things off, but because long-term mortgage rates didn't rise along with the federal fund rate, things got out of control. These excerpts from the Wall Street Journal's website give more detail (The questions are from WSJ reporter Greg Ip):

"Q: At the Fed you said housing was in a froth, but you avoided calling it a bubble. From the vantage point of 2007, can you say now that it was in a bubble?

A: Oh yeah. Lots of froths are equal to a bubble… What was driving prices higher was essentially the aftermath of the decline of the Soviet Union and the fall in real long term interest rates which drove up residential prices all over the world. And indeed, the U.S. was not at the top of the list by any means. It drove them up sooner in Britain and Australia as I recall. I find this issue that the Federal Reserve created the housing bubble just utterly devoid of any awareness of who created all the other bubbles. And they all look alike. Long-term real interest rates moved [in] parallel all over the world and the results were what you always get: a fall in equity [risk] premiums, a rise in price:earnings ratios, huge increases in liquidity, and large increases in the market values of assets.

Q: Many people, including some former colleagues of yours from that period, believe the Fed kept interest rates too low for too long, thereby contributing to the housing bubble and problems in subprime mortgages. Do you agree?

A: We kept them too low for too long because we were effectively creating an insurance against [deflation]. The problem in making choices is that you recognize that if you miss, you can end up with interest rates too low, too long. The question is, what did that have to do with the housing boom? Remember that long term Treasury rates and mortgage rates stayed flat from early 2004 through the summer of 2005 [while the Fed raised the federal-funds rate from 1% to 3.5% in 0.25 percentage-point steps]. We tried effectively to get mortgage rates up as part of our incremental 25 basis point operation and we failed… If we were dealing with an inflationary environment, we would have had no trouble getting the 10-year [Treasury yield] up… Had we [raised rates] earlier, do you think we wouldn’t have gone through exactly the same phenomenon?"

My take: The Fed raised interest rates in a clearly telegraphed, 25-basis points-at-a-time manner. It also spread the rate-hiking cycle out over a long period of time. This contrasted sharply with the fast, severe rate cuts in the down part of the interest rate cycle. As a result, the bond market was able to price out all uncertainty about the future path of interest rates, effectively neutering the impact of fed funds rate hikes.

In addition, Fed officials refused to characterize the bubble for what it was several times over the span of two to three years. And they refused to aggressively use the "bully pulpit" to criticize lenders making all the higher-risk mortgage loans. Meanwhile, on the regulatory front, the Fed and the other agencies merely issued toothless "guidances," rather than new rules, to tame high-risk lending. So I think it's a clear case of revisionist history for Greenspan to say "we did all we could." Under his watch, the Fed simply replaced one boom-bust in the tech world for another in housing.


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