Interest Rate Roundup

Tuesday, January 13, 2009

Ben Bernanke on the economy, lending, and more

Federal Reserve Chairman Ben Bernanke just released some comments on the economy, the lending industry, and the credit markets.

The first portion of his comments is a recap of his view on the credit bubble ...

"The proximate cause of the crisis was the turn of the housing cycle in the United States and the associated rise in delinquencies on subprime mortgages, which imposed substantial losses on many financial institutions and shook investor confidence in credit markets. However, although the subprime debacle triggered the crisis, the developments in the U.S. mortgage market were only one aspect of a much larger and more encompassing credit boom whose impact transcended the mortgage market to affect many other forms of credit. Aspects of this broader credit boom included widespread declines in underwriting standards, breakdowns in lending oversight by investors and rating agencies, increased reliance on complex and opaque credit instruments that proved fragile under stress, and unusually low compensation for risk-taking."

He then briefly talks about the fallout from the bust, including the following passage:

"Heightened systemic risks, falling asset values, and tightening credit have in turn taken a heavy toll on business and consumer confidence and precipitated a sharp slowing in global economic activity. The damage, in terms of lost output, lost jobs, and lost wealth, is already substantial."

He later cites the Fed's aggressive interest rate cuts, and explains why they haven't been as successful as in the past:

"The Fed's monetary easing has been reflected in significant declines in a number of lending rates, especially shorter-term rates, thus offsetting to some degree the effects of the financial turmoil on financial conditions. However, that offset has been incomplete, as widening credit spreads, more restrictive lending standards, and credit market dysfunction have worked against the monetary easing and led to tighter financial conditions overall. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed."

Then, there is a long discussion about the various types of unconventional policy measures the Fed has taken -- including efforts to feed liquidity to the financial sector, enter into swap arrangements with foreign central banks, buy commercial paper and backstop money market funds. The Fed also discusses how it will be manipulating the asset backed securities market -- and hints that the Fed may expand that program to any and all markets as it sees fit:

"In contrast, our forthcoming asset-backed securities program, a joint effort with the Treasury, is not purely for liquidity provision. This facility will provide three-year term loans to investors against AAA-rated securities backed by recently originated consumer and small-business loans. Unlike our other lending programs, this facility combines Federal Reserve liquidity with capital provided by the Treasury, which allows it to accept some credit risk. By providing a combination of capital and liquidity, this facility will effectively substitute public for private balance sheet capacity, in a period of sharp deleveraging and risk aversion in which such capacity appears very short. If the program works as planned, it should lead to lower rates and greater availability of consumer and small business credit. Over time, by increasing market liquidity and stimulating market activity, this facility should also help to revive private lending. Importantly, if the facility for asset-backed securities proves successful, its basic framework can be expanded to accommodate higher volumes or additional classes of securities as circumstances warrant."

Bernanke then compares and contrasts what the Fed is doing with what the Bank of Japan did during the 1990s -- addressing the question of whether or not the Fed is pursuing a policy of quantitative easing:

"The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental. Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally."

Bernanke then tries to address the questions over exit strategy -- how the heck the Fed pulls back once the markets and economy recover. An excerpt:

"However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize. In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy."

Later, Bernanke discusses ways the TARP money could be used to fulfill its originally stated purpose -- removing bad assets from bank balance sheets:

"A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. Should the Treasury decide to supplement injections of capital by removing troubled assets from institutions' balance sheets, as was initially proposed for the U.S. financial rescue plan, several approaches might be considered. Public purchases of troubled assets are one possibility. Another is to provide asset guarantees, under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks. Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank. These methods are similar from an economic perspective, though they would have somewhat different operational and accounting implications. In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability."

Bernanke then explains to people that if you don't like the way the government is aggressively supporting the financial industry, but not other types of businesses, you can go pound sand (in more polite terms):

"The public in many countries is understandably concerned by the commitment of substantial government resources to aid the financial industry when other industries receive little or no assistance. This disparate treatment, unappealing as it is, appears unavoidable. Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt. Indeed, the destructive effects of financial instability on jobs and growth are already evident worldwide. Responsible policymakers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest."

And finally, before his conclusion, Bernanke states that something needs to be done about the "too big to fail" conundrum:

"Particularly pressing is the need to address the problem of financial institutions that are deemed "too big to fail." It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period. The existence of too-big-to-fail firms also violates the presumption of a level playing field among financial institutions. In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking."


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