Friday, August 31, 2007

The Fed, The Fed, The Fed ...

Today's Bernanke speech on the housing market.

Meanwhile, the Fed couldn't have gotten a better set of economic numbers this morning, eh? Growth is solid and inflation is under control. Rock 'n Roll.

The Gory Details

The big banks need to be pushed to use their reserves. Also, they should cut the Prime rate, now. To wit:

Diminished demand for loans and bonds to finance highly leveraged transactions has increased some banks' concerns that they may have to bring significant quantities of these instruments onto their balance sheets. These banks, as well as those that have committed to serve as back-up facilities to commercial paper programs, have become more protective of their liquidity and balance-sheet capacity.
The evil side of technological change - too much shorthand? On the other hand, face-to-face lending, in the USA, has a nasty way of getting discriminatory in the wrong ways ...

In some ways, the new mortgage market came to look more like a textbook financial market, with fewer institutional "frictions" to impede trading and pricing of event-contingent securities. Securitization and the development of deep and liquid derivatives markets eased the spreading and trading of risk. New types of mortgage products were created. Recent developments notwithstanding, mortgages became more liquid instruments, for both lenders and borrowers. Technological advances facilitated these changes; for example, computerization and innovations such as credit scores reduced the costs of making loans and led to a "commoditization" of mortgages. Access to mortgage credit also widened; notably, loans to subprime borrowers accounted for about 13 percent of outstanding mortgages in 2006.
Who will bear the costs of transition away from mistakes? It depends on how big they are, basically. If they derail the economy, yes; otherwise, no. That's a knife's edge to walk in a fully data-dependent way. [One has to laugh at "investors providing oversight", however ...]

I have argued elsewhere that, in some cases, the failure of investors to provide adequate oversight of originators and to ensure that originators' incentives were properly aligned was a major cause of the problems that we see today in the subprime mortgage market (Bernanke, 2007). In recent months we have seen a reassessment of the problems of maintaining adequate monitoring and incentives in the lending process, with investors insisting on tighter underwriting standards and some large lenders pulling back from the use of brokers and other agents. We will not return to the days in which all mortgage lending was portfolio lending, but clearly the originate-to-distribute model will be modified--is already being modified--to provide stronger protection for investors and better incentives for originators to underwrite prudently.
A general truth that didn't work out in this particular bust. As we've discovered, a number of lenders have been caught with far too many short-term liabilities on their balance sheet. It is true, however, that it appears that fees and penalties have played a significant role, rather than rate levels, just as they did during the junk-bond, S&L boom-bust of the early 1990s.

In particular, in the absence of Reg Q ceilings on deposit rates and with a much-reduced role for deposits as a source of housing finance, the availability of mortgage credit today is generally less dependent on conditions in short-term money markets, where the central bank operates most directly.

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