August 27, 2007

 

Editor
Donald R. Byrne, Ph.D.
dbyrne5628@aol.com

Associate Editor
Edward T. Derbin, MA, MBA
edtitan@aol.com

 

August 2007

Excessive Subprime Lending; or Misguided Monetary Policy – A Reasoned Critique

 

What has been the major problem(s) with monetary policy, increasingly over the last decade or two?

1) As we have cited numerous times in recent newsletters, the central bank does not understand the gradual, but profound changes that have occurred in the U.S. economy and to a lesser extent, the world economy.  Despite some declines in competition, especially in oil, the American economy has become increasingly competitive since the end of the Second World War.  The traditional macroeconomic models with impressive econometric studies, still dominates the Federal Reserve’s (FOMC – Federal Open-Market Committee) mindset.  Even Dr. Bernanke, the new chairman of the Fed has cited these studies in a laudatory manner, but clearly admits monetary policy is as much an art than a science. 

What the Fed has failed to understand is that this gradual but significant landscape change in the economy has made meaningful economic analysis more dependent upon microeconomic, not macroeconomic factors.  Cyclical inflationary and recessionary volatility has been replaced with a smoother trending economic trajectory. 

Witness the fact that the moderate behavior of the core rate of inflation did not justify the massive intervention with contractionary monetary policy of the last three years.  Only when energy is included in the full PPI and CPI do inflation rates appear to pose a more serious problem – why is this so?  The oil industry has become more cartelized, whereas the over all economy, absent oil, has become more competitive (witness the auto industry).  This focus on market structure and the resultant competition is a microeconomic issue, not macroeconomic.  The inflation emanating from the oil industry is a form of cost-push inflation as opposed to demand-pull inflation.   

 

2) There seems to be a lack of understanding by the market in general and it seems at times, by Federal Reserve policy makers, that monetary policy affects the economy by causing collateral damage.  The case in point is the current collapse of the residential housing market.  While a few misguided analysts and the media in general want to blame the entirety of the problem on so-called subprime lending (less and less qualified borrowers), the problem is far broader than that single issue.  The subject of adjustable rate mortgages (ARMs) or variable interest rate mortgages extends from highly qualified borrowers to the mass of borrowers who are normally qualified, not just the subprime category.  Qualified borrowers suffer as much or in a very real sense more than the so-called subprime borrowers from rising short-term rates which are clearly a result of constrictive policies deliberately being carried out for the last three years by the Fed. 

 

Background:  Defining the Problem with the Mortgage Industry

The Role of Variable Interest Rates – Balancing mortgage financing risk

With the rampant inflation of the 1970s, there was a significant movement toward the widening use of variable interest rate loans.  This was brought on by the collapse of the savings and loan industry and the consequent failure of the Federal Savings and Loan Insurance Corporation (FSLIC), which relied heavily on fixed rate, long-term mortgages.  The problem was that the financial institutions relied upon short-term funds to finance their long-term mortgages.  This resulted in the cost of their funds rising significantly and continually, while the interest income on their long-term loans rose very slowly.  The result was a precipitous drop in their interest rate margin (difference between interest rate received on funds loaned and funds borrowed) and consequent net profit margins.  In effect, since their rise in popularity in the 1970s, variable interest rate mortgages have become an integral part of the mortgage industry, serving to provide a more balanced sharing of inflation risk between lender and borrower. 

Read more from on the Role of Variable Interest Rates in Letter to the Editor http://byrned.faculty.udmercy.edu/2007Vol/LettersVol2007Issue1.htm

When inflation is taking place and fixed interest rates are used, the inflation risk lies with the lender/saver/investor.  This arises from the fact that as inflation occurs, the real interest rate on fixed rate loans is driven downward.  If the lender wishes for the “borrower” to share some of the risk of inflation, some reward must be offered to the borrower.  The reward is in the form of a lower variable interest rate at the outset.  As inflation occurs, via the fisher effect, market or nominal interest rates begin to rise.  A rise in the variable interest rate on the loan is triggered, thus preventing the real interest rate from falling. 

 

Foreclosure Effect brought on by the long duration of the Fed policy of Constraint

Recent Fed policy has significantly altered the intended linkage of inflation to changes in ARMs.  The Fed’s use of short-term interest rates to carry out this policy of monetary constraint has resulted in those short-term interest rates rising far more than the rate of inflation.  The repricing upward of ARMs is not the consequence of accelerating inflation, but rather the Fed’s persistent increases in the short-term Federal Funds Rate.  In the first half of 2004, the CPI registered 2.3% on an annualized basis and for the first half of 2007 the CPI was at 2.5%. While the Fed might claim victory over inflation, the problem with energy remains.  After all, a barrel of oil is still in the $70 plus dollar range and when they began their ill-advised policy a barrel of crude oil was selling for around $35 a barrel. 

 

 

After more than three years with a heightened fed funds rate, an increasing number of mortgages have been reset (repriced upward), resulting in significantly increased foreclosure rates.  This has now presented the market with a foreclosure effect, which offsets some of the value of sharing the inflation risk.  This foreclosure risk hurts not only borrower, but also the lender as well (Bear Stearns, BNP Paribas, Countrywide (KKR), etc.).  Some evidence of this dampening effect on the use of variable rates is in the narrowed spread between 30-year fixed rate and ARM dropping to 22 basis points in 2007 from a 106 basis point differential in 2004. 

 

Federal Housing Finance Board
http://www.fhfb.gov/GetFile.aspx?FileID=3308

May 2004
Average Fixed-Rate Mortgage 6.10 percent; Average Adjustable-Rate Mortgages (ARMs) 5.04 percent, for a 106 basis point differential

 

Federal Housing Finance Board
http://www.fhfb.gov/GetFile.aspx?FileID=6508

June 2007
Average Fixed-Rate Mortgage 6.57 percent; Average Adjustable-Rate Mortgages (ARMs) 6.35 percent, for a 22 basis point differential

 

 

CURRENT U.S. MONETARY POLICY ON THE VERGE OF CHAOSA FINANCIAL CHERNOBYL IN THE MAKING

 

In June 2004 the Fed, fearing a return of inflation caused by rising oil prices, as was experienced in the 1970s, began a policy of constraint which drove the federal funds rate from 1.00% to its current targeted rate of 5.25%.  What it was not able to do (fortunately) was to drive the intermediate and longer-term rates significantly higher.  This led to a flattening, and at times, an inversion of the yield curve – where short term rates were equal to or higher than long term rates.  This was the cause of former Fed Chairman, Alan Greenspan’s “conundrum”.  What the Fed was able to do (unfortunately) was to cause the resetting of variable rate mortgages as they passed through their short fixed rate term – usually two or three years.  This was the case since three major referenced rates, the 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR) used in determining the changes in Adjustable Rate Mortgages (ARMs) are closely related to the Federal Funds Rate – the rate at which depository institutions borrow and lend reserves with one another.  This led to rising monthly payments for homeowners and increasing financial distress as evidenced by a 20% increase in foreclosures in 4th quarter 2006.  This also resulted in a substantial increase in the supply of homes on the market.  The gradual, rising rates put a damper on the demand for housing, resulting in a surplus, thereby driving home prices downward as recently reported.  The ripple-effects include a 20% fall-off in new homes being built since July 2006 and a decline of existing home prices making it difficult for even for those with fixed rate mortgages to sell or refinance their homes.  

 

Despite the impact to at least a million homeowners, the Fed and its supporters believe that this has kept us from the OPEC induced inflation of the 1970s. 

 

The Meltdown

This view of Fed policy of constraint resulting in rising short-term rates abruptly changed when the largest French bank, BNP Paribas announced that it was unable to estimate the value of mortgage related asset backed securities of its investment companies.  The Fed reacted very quickly, supplying funds to the financial markets through repurchase agreements, cutting the effective Federal Funds rate from an elevated 5.41% on August 9 to 4.54% on August 14, 2007.  On August 15, Countrywide Mortgage, the largest U.S. mortgage lender, recently purchased by private equity firm KKR, followed BNP Paribas’ lead, announcing that they had similar problems in valuing their assets.  As of Thursday afternoon, August 16, 2007, not only had the effective Federal Funds rate fallen, but the 10-year U.S. Treasury constant maturity bond had also fallen to 4.66, or 7 basis points below what it was when the Fed began its credit crunch in 2004.

 

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In a nutshell

On the one hand, prospects for rising variable mortgage rates significantly increased the cash flow for investors.  On the other hand, the rising mortgage payments raised the level of delinquency and foreclosure rates.  Investors like Bear Sterns, BNP Paribas, Countrywide, etc., anticipating significantly higher cash flows from their mortgage portfolios, have instead been left with falling cash flows and a shrinking asset base. 

The Fed and other central banks have been quick to come to the aid of those financial institutions who knowingly stepped into what they imagined were lucrative investments, but what of those people who have lost or will lose their homes due to this resetting process.  Will the Fed intervene on their behalf? 

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The error of the Fed policy stems from their inability to understand that most of the American economy has become increasingly competitive since the Second World War.  As these markets, such as the auto industry, became more competitive, prices become more flexible downward.  This in turn leads to the gradual elimination of the bias the economy has to frequent and severe episodes of inflation and recession.  A factor helping to cause the Fed’s confusion was the reduction of the competition of the American oil industry as the sector was recartelized in the 1990s.  When the Producer Price Index PPI and Consumer Price Index CPI are examined in a total sense, they reflect greater inflationary pressure than when the core rate (taking out energy and food) is examined alone.  This is the classical case of inflationary pressures coming from a narrow source, leading to what is referred to as cost-push inflation. 

 

 

 

>>>>Notable US oil mergers of the last ten years<<<<

1997      Ashland Oil combines most assets with Marathon Oil

1998      British Petroleum (BP) acquires Amoco

1998      Pennzoil merges with Quaker State Oil

1999      Exxon and Mobil join to form Exxon Mobil

2000      British Petroleum (BP) acquires ARCO (Atlantic Richfield)

2001      Chevron acquires Texaco to form Chevron Texaco

2002      Conoco merges with Phillips

2002      Royal Dutch Shell acquires Pennzoil-Quaker State

 

 

The collateral damage, resulting from the Fed combating cost-push inflation is always substantially greater than if the problem came from what is technically called demand-pull inflation.  The more efficient solution in addressing these cost-push inflationary pressures would have been to reverse the FTC’s policy and force a break up of the newly cartelized US oil industry. 

 

 

The Fed’s Challenge in Dealing with Inflation: Demand-Pull versus Cost-Push

Problems in the Fed’s monetary policy: 2004 – 2007 

In the presence of competition, demand-pull inflation is much less likely to occur than in the past (general rise in Aggregate Demand, due mostly to inflation)

Primarily from the oil industry, or a cost-push variety of inflationary pressure (increase in specific sector in economy --- e.g., wage rates; raw materials)

The Fed has never successfully tamed cost-push inflation

1) Two oil shocks in the 1970s

2) Engineered collapse of the economy in 1980 – 1982 

3) A job better suited for the Anti-Trust Division of the Justice Department or Federal Trade Commission


 

 

Please note that despite the Fed’s effort and its significant collateral damage to the residential housing industry, a barrel of oil is still in the $65-70 dollar range (Crude Oil Futures have been in the $70+ range for much of the summer) and when they began their ill-advised policy a barrel of crude oil was selling for around $35 a barrel.

 

 

The Problem: The Heart of the issue is variable in nature, not subprime

Contrary to the popular press, the residential housing malady is result of the upward resetting (repricing) of all ARMs and not just the subprime portion of the market.  The solution to this dilemma is for the Fed to reverse its policy and allow the short-term rates to fall so that the yield curve returns to its more normal configuration – upward sloping.  ARMs would reset downward; monthly payments would fall; foreclosures would diminish; housing prices would rise; and the current distress of mortgage holders would gradually dissipate. 

Once again, it should be clear that variable rate mortgages or ARMs are very useful in enabling lenders to shift some of the inflationary risks to the borrowers by offering them an initially lower rate than they would otherwise receive with a fixed rate mortgage.  A subprime loan, is a loan made by a lender to a less credit-worthy borrower (a crude rule of thumb points to a credit score below 620), enabling the lender to receive a higher yield by adding on a significant risk premium to the mortgage rate.  These subprime loans can be made on a fixed or adjustable rate basis.  Variable rate mortgages can be made to subprime borrowers, but at least 80% of recent ARMs have been made to fully qualified borrowers. 

Will the Fed in its September meeting choose to alleviate the anxiety and suffering of the multitude of households with variable rate mortgages, or will they leave the short-term rates high and continue to bail-out the financial firms considered too big to fail. 

Dr. Bernanke – let my people go!

 

 

THE SMOKESCREEN OF SUBPRIME LOANS

Those borrowers, who chose variable interest rate loans (ARMs), were not substandard credit risks.  These were rational people who calculated that the lower initial rate, more than offset the risk of significant inflation occurring – and they were right!

 

++++++++++++++++++++++++++++++++++++++++++++++++

ARMS (from low credit risk to high credit risk --- best credit to subprime)

Christopher L. Cagan, Ph.D.
Director of Research and Analytics

http://www.csupomona.edu/~rerc/RERCSC%20Chris%20Cagan%205.30.07.pdf

This recent study identified three categories of ARMs and their likelihood for default:

1.  Higher Quality Credit Risk (teaser loans) with an initial rate of 1.0% to 4.0%
            32% of teaser loans may default due to reset

 

2.  Standard Credit Risk Borrower with an initial rate from 4.0% to 6.5%
            7% of market-rate adjustable loans may default due to reset

 

3.  Subprime Borrower with an initial rate starting at 6.5%
            12% of sub-prime loans may default due to reset

 

+++++++++++++++++++++++++++++++++++++++++++++++++

 

 

 

…Basic Facts of Subprime Mortgage Lending

Subprime lending can be defined simply as lending that involves elevated credit risk. Whereas prime loans are typically made to borrowers who have a strong credit history and can demonstrate a capacity to repay their loans, subprime loans are typically made to borrowers who are perceived as deficient on either or both of these grounds. Obviously, lenders take a borrower's credit history into account when determining whether a loan is subprime; however, they also take into account the mortgage characteristics, such as loan-to-value ratio, or attributes of the property that cause the loan to carry elevated credit risk.

A borrower's credit history is usually summarized by a Fair Isaac and Company (FICO) credit score. Everything else being the same, borrowers with FICO scores below 620 are viewed as higher risk and generally ineligible for prime loans unless they make significant down payments. But it is noteworthy that about half of subprime mortgage borrowers have FICO scores above this threshold, indicating that a good credit history alone does not guarantee prime status.

Federal Reserve Board of Governors
Remarks by Governor Edward M. Gramlich
May 21, 2004
http://www.federalreserve.gov/boarddocs/Speeches/2004/20040521/default.htm

 

 

From PBS on credit scores

http://www.pbs.org/wgbh/pages/frontline/shows/credit/more/scores.html

“The best credit rates are given to people with scores above 770, but a score of 700 -- out of a possible 850 -- is considered good, according to Fair Isaac. The median score is about 725. Generic interest rate calculations on the myfico.com Web site show that when the score dips below the mid-600s, those consumers generally qualify only for "subprime" lending and the interest rate starts to climb significantly.” 

 

 

Summary

This continuous increase in monthly mortgage payments eventually resulted in rising delinquency and foreclosure rates on home mortgages.  As pointed out before, the public was of the mindset that short-term interest rates would not stay high over the next several years.  Expectations theory argues, the average of those short-term rates over the next ten years (or so), gave us ten-year US security rates that were at times, the same or less than the shorter term treasury security rates resulting in a flattened and often inverted treasury security yield curve.    As we pointed out in several issues of this newsletter, restrictive Federal Reserve monetary policy works by causing collateral damage.  In this case, it victimized households who had financed their homes with variable interest rate mortgages – and were rational in doing as such. 

These households, along with other households, were also bearing the burden of high energy prices, as witnessed in the oil prices which have topped $77 per barrel in the summer of 2007.  Victims of the recartelization of the oil industry and the misguided Federal Reserve policy have left many households hanging from the yardarm.  While so-called hedge funds and private equity funds have been favored with bailouts by the Federal Reserve authorities, no such mercy has been extended to the suffering household sector – facing ever-higher mortgage payments and energy bills. 

To label this housing disaster a result of lenders making numerous subprime loans in the form variable rate loans, is a misstatement of facts and/or a lack of understanding of the rationale underlying variable rate mortgages (ARMS – Adjustable Rate Mortgages). 

 

R

   E

     A

       D

         ON

 

MORE ABOUT THE FED…A POLICY SHIFT IN THE MAKING (?)    

The truth of the matter is that the effect of ARMs will be felt most strongly in states such as Michigan, suffering from severe losses in manufacturing jobs – auto in particular, this additional factor of foreclosures has aggravated a precipitous decline in housing prices.  In many cases, the assessed/appraised value on properties significantly exceeds their market prices.  Not long ago, the former chairman of the Federal Reserve indicated that the Fed might have a legitimate role in influencing a broader spectrum of asset values than that traditionally associated with its role in the financial markets.  Is the implosion of home prices in various parts of the country, a mere coincidence or a result of a much broader initiative by the Fed? 

“Our forecasts and hence policy are becoming increasingly driven by asset price changes.  The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.”

Remarks by Chairman Alan Greenspan
Reflections on central banking

At a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming

August 26, 2005
http://www.federalreserve.gov/Boarddocs/Speeches/2005/20050826/default.htm

 

In a market known for asset value determination characterized as ‘ location, location, location’, we now have a central bank hell-bent on replacing that tradition with their with some yet-to-be-announced valuation principle.   

Is the Fed now concerned about asset values in the sense of home values stock portfolios?  In addition to Greenspan’s comments from Jackson Hole, he has repeatedly referred to terms such as the wealth effect and irrational exuberance in describing consumer behavior.  Is this representative of a policy shift for the Fed, or simply musings by the outgoing chairman? 

 

 

The FED and its influence on the financial markets as it conducts monetary policy…a changing MO (modus operandi)

 

The Fed conducts its monetary policy by targeting short-term interest rates such as the Federal Funds rate.

This has not always been the case. 

As inflation roared in the latter half of the 1970s, the Federal Reserve Open Market Committee FOMC announced its shift to the targeting of the monetary aggregates and their control with within a narrow band.  Monetarism had a rebirth under the leadership of Milton Friedman…

From a previous edition of the newsletter
http://byrned.faculty.udmercy.edu/2004%20Volume,%20Issue%201/Newsletter%20Vol%202004%20Issue%201.htm    

This focus on the monetary aggregates, was abandoned in recent years when the financial markets experienced an explosion of changes which caused the linkage between the monetary aggregates and nominal GDP to become increasingly de-linked; the so-called velocity of M1 money and other aggregates was no longer predictable.  The Fed moved back toward targeting interest rates.  This can be seen in the Fed’s most recent policy directed at constraining the economy.  It influenced the short-term Federal Funds rate, through the Federal Reserve Open Market Committee FOMC from 1.00% in May 2004 to its current stated target rate of 5.25%.

 

Federal Reserve Board of Governors: Historical background

The FED was created by Congressional legislation in the Second Decade of the 1900’s.  Prior to the Fed’s establishment, the American economy would periodically suffer from a collapse in the banking system.  In those days, most of what we call M-1 today was in the form of bank notes issued by federally chartered privately owned banks, referred to as National Banks.  Prior to the Civil War, banks were chartered by the states.  A tax on the bank notes issued by those state chartered banks eliminated them from circulation.  The newly chartered national banks had the monopoly of issuing band notes.  Much of the change was due in large part to the necessity for the Federal Government to find a way to finance the Civil War. 

Demand deposits were championed by the state chartered banks as a result of the loss of their ability to issue bank notes.  In the 1930’s, the federally chartered national banks had their bank notes issuing privilege revoked.  Only Federal Reserve (bank) notes and some paper money issued by the Treasury, along with coins, constituted what is referred to as the medium of exchange.

 

The Changing Definition of Money

The farther back we go, the greater the percentage of medium of exchange money (now called M-1) was in the form of bank notes.  As we come forward in time, demand deposits, now part of what are called checkable deposits became increasingly of more relative importance.  They are liabilities or debts of the formerly called thrifts (credit unions, savings banks, and savings and loan associations) and commercial banks.  Currently, checkable deposits are a little under half of M-1 money and currency a little over half of M-1 money.  This is somewhat misleading as a good portion of the currency is used in place of domestic currencies in many other countries.  In addition, the medium of exchange of the underground economy is currency.  The vast majority of the domestic, above ground – legitimate economy, is facilitated with the checkable deposit version of M-1 money. 

When the banks collapsed in past times, including the 1930s, much of the medium of exchange, in the form of bank notes, lost their value.  Notes were in circulation that had zero value.  It was a mess.  Congress eliminated bank notes of commercial banks from the supply of medium of exchange money.  They were replaced with Federal Reserve notes which are non-interest bearing bank notes or liabilities of the 12 Federal Reserve District Banks.

Only after the Second World War did The American financial markets became the dominant markets they are today.  As these markets matured, the modus operandi of the Fed in its attempt to control the supply of money and credit changed gradually.  With the Great Depression and the Second World War, the Federal Government’s outstanding rose to a very significant size.  This is the base of U.S. financial markets.  The so-called nation debt has two parts, the non-marketable debt and the marketable debt.  The marketable debt consists of Treasury bills, Treasury Notes, and Treasury Bonds.  They are issued new at auctions and traded in secondary markets.  As time passed and new securities were issued, as well as new processes such as stripping coupon bonds, new risks hammered investors such as inflation and floating exchange rates.  Process such as securitization and derivative markets in which hedging risks can occur rose in importance.

 

Supplying Reserves…Discount Window

Now we have the unrivaled markets of the world.  Why is this important to the FED?  It enabled them to change from lending reserves through the Discount Window facility and gradually replace that modus operandi with open market operations.

From its inception, the FED has been mandated to control with varying degrees of success the creation of money and credit by commercial banks and then later, all depositories including the former thrift institutions.  During the FED/s early years, there was virtually no federal debt.  To carry out is legislated mandate of such control; the FED used the Discount Window facility.  It provided reserves to the commercial banking system by buying eligible loans made by the commercial banks      as they created money and credit.  Their way of doing this was explained in Chapter 3 of my text, Financial Economics.

Most of the loans in those days were of the discount type.  The borrower discounted its note with the bank and received the discounted present value of the face value of the note.  In effect, the interest was prepaid.  The bank’s required reserved increased as it created M-1 money and lent it out.  As the banks required reserves approached its total legal reserves and it was nearing a “fully loaned up” status, it would seek additional legal reserves by rediscounting or selling its loans t the FED.  In fact, the rate the FED charged for supplying reserves in this manner was called the discount rate.  Later the Fed changed its practice and simply lent the reserves at the Window in the form of advances.  The practice of banks rediscounting the loans it made to borrowers gradually disappeared.  The name for the interest rate charged banks for advances (supplying additional reserves) became known as the Discount Rate.

Thrift institutions clamored for the ability to create M-1 money and lend it out.  They also wanted to pay interest on such checkable deposits.  Remember that both Federal Reserve Notes and Demand Deposits bore a zero nominal interest rate.  The thrift institutions eventually received this power and within a short while became subject t the same regulatory restrictions to which commercial were subject.  NOW accounts, Share Drafts at credit unions and ATS accounts were authorized.  There were interest bearing checkable deposits, which accomplished the same as Demand Deposits at commercial banks.

Now the medium of exchange definition of money or M-1 includes currency (coins and Federal Reserve Notes and technically U.S. Notes so rare they are seldom seen) checkable deposits (Demand Deposits, Now accounts, Share Drafts, and ATS accounts) as well as a relatively very small amount of non-bank Travelers Checks.  Gone are the private bank notes of commercial banks.  Also gone are gold coins and gold certificates as well as the backing of currency by silver and gold.  Gold, as Keynes finally said, is but a “barbarous relic”.

 

To Supplying Reserves through Open Market Operations
Federal Open Market Committee (FOMC)

Since the initiative for requesting loans of reserves and the Discount Window was that of the member institutions (originally only commercial banks and now all depository institutions, i.e. the former thrifts), it forced the Fed into a reactive role.  This was gradually phased out as the open market operation replaced loans at the Discount Window.  Currently the Feds makes loans at the Discount Window for seasonal purposes and emergency purposes.  The former is to ease the peak loads of banks having a few months of heavy activity for agriculture or recreation related borrowers and then for slow times the rest of the year.  The latter is to quell a modern day run on a bank.

As the U.S. financial markets became increasing broad, deep and resilient and the Federal debt became large, the FED moved from the reliance on the discount window to control the reserves of depository institutions to open market operations for controlling reserves and thus controlling the growth of money and credit.  The Fed buys and sells mostly U.S. Government securities as well as some Federal Agency securities.  The Discount Window facility is relegated to offsetting seasonal peak load demands at some commercial banks and in the event of clearing house runs at some depository institutions, for emergency purposes. 

When the FED decides on a restrictive policy as they did in the very late 1990’s and again in 2004-2006, it slows its rate of buying securities in the open market with the resulting increase in the scarcity of legal reserves of depository institutions.  The first area in which this growing tightness shows up is the Federal Funds market.  This is the market in which depositories borrow and lend reserves with one another.  Those depositories having excess reserves lend them, often overnight, to others seeking to avoid a deficiency for a settlement period.  As the availability of Fed Funds decreases, upward pressure on the Fed Funds rate causes some depositories to seek additional legal reserves thru third parties. 

 

Tools of the Fed – Repurchase Agreements

One of these markets is the Repurchase Agreement market.  Commonly called RP’s or Repos, repurchase agreements are sold to the buyer with the agreement to repurchase (usually) U.S. Government securities – this is a Repo.  The other side of the transaction is a Reverse Repo.  Here the buyer agrees to resell the securities back to the seller.  It can be for any length, but in the context of depositories, it is usually for a very short time.

This Repo market is also used by security dealers to finance their inventories.  Dealers buy for resale and hence have an inventory to finance that brokers do not have.  In this case, the Repos can have longer maturities, often in months depending upon the dealer needs.

The FED also uses Repos and Reverse Repos for temporary offsets; reversing changes in the legal reserves of depository institutions.  When a date nears for the settlement of a tax liability with the Federal Government, checks flow to the Treasury and drain the legal reserves of depositories and the Treasury deposits at the FED increase.  In past times, the Treasury would deposit the receipts in Tax and Loan Accounts at depositories to avoid this problem.  The practice was criticized and replaced by the Treasury keeping its tax proceeds on deposit at the FED.  This required the FED to take temporary actions to offset the loss of reserves by depositories.  The FED  buys securities under Repurchase  Agreements and lets them mature or ceases rolling them over since the Federal Government will soon spend the funds as time passes.

A recurring problem having the opposite of the legal reserves of depository institutions is that of the float.  When a depository is asked to collect checks of its depositors, it does through the clearing house system.  There is a schedule by which the Fed increases the legal reserves of the depositories collecting such checks.  While it has changed over time, currently the depository presenting the check for payment to the clearing house system will receive an increase in it s reserves in no more that 2 days.  However, the depository upon whom the check was drawn will not haves its legal reserves decreased until such checks are presented for collection at that institution’s local clearing house.  This takes a few days if the check must travel across the country.  There is always a float but when the weather turns bad, it takes longer for checks on distant banks to clear.  This increases the float and raises the total reserves of the depository institution system.  The FED will offset this by selling securities and agree to buy them back under a Reverse Repo Agreement.  As the float decreases with time, the Fed will unwind the Reverse RP’s.

The upward pressure on the Federal Funds rate is transmitted quickly in this manner to the Repo rate.  But the upward pressure on short term interest rates does not stop there.  Other markets and the rates in those markets are also impacted by the FED’s restrictive policy including the Eurodollar market and the large CD market.

The Eurodollar market is the market in which dollar denominated deposits are made in banks outside the U.S.  They are part of what is more generally terms the external currency markets.  Of the term offshore is used for such transactions.  The Eurobanks also make loans denominated in U.S. dollars.  The usual structure of interest rates in the Eurodollar market

Under current practices of the FOMC, short-term interest rates, including the Federal funds rate are dominated by the Fed through open market operations; controlling longer term rates, such as 10 AND 30 YEAR U.S. Government bond rates is much more problematic.  In fact the former Chairman of the FED referred to the relationship as a “conundrum”.  Of course that relationship has been well researched and is embodied in the much respected Expectations Theory of the Term Structures of Interest Rates.

Excerpt from Dr. Byrne’s New Paradigm in Economics: 

The Expectations Hypothesis Analysis of the Term Structure of Interest Rates argues that the current long-term interest rates are heavily influenced by the expected future short-term interest rates.  In the absence of liquidity bias, long-term (really all rates except the very shortest) interest rates are the geometric average of expected future short-term interest rates.  For example, the geometric average of 3, 4, and 6 is the cube root of their product or the cube root of 72 = 4.16.  Simply put, if the market consensus believes that short-term interest rates will rise in the future, the current long-term interest rates should be higher than the current short-term interest rates and the yield curve should slope up and to the right.  Conversely, if the market consensus believes that short-term interest rates will fall in the future, the yield curve should slope down and to the right and short-term interest rates should be higher than long-term interest rates.

 

Letters to the Editor Volume 2005: Issue 2
http://byrned.faculty.udmercy.edu/2005%20Volume,%20Issue%202/Letters%20Volume%202005%20Issue%202.htm

To Russ…
The
Expectations Theory of the Term Structure of Interest Rates best explains the link between short-term interest rates and long-term interest rates, or the term structure of interest rates, the graph of which is the yield curve.    It argues the long-term interest rates (e.g. 5-year, 10-year, 20-year and 30-year U.S. Government Bonds) is the geometric average of expected yields on short-term government securities over that period of time (5-30 years, for example).  

Therefore, if the market expects short-term rates to rise over the next five years, the current 5-year interest rate on the U.S. government security is going to be higher than the current short-term rate (on similar risk levels of securities).  If, on the other hand, the market expects short-term rates to fall over the next five years, the current 5-year interest rate on the U.S. government security should be less than the current short-term U.S. government rate. 

 

 

In summary, while the FED has enormous power to influence the short-term interest rates, under its current modus operandi, that is not so for the longer term interest rates, as the actual data abundantly shows. 

The Fed, in forcing the short-term interest rates upward, has caused a flattening and at times an inversion of the yield curve.   The FED’S upward pressure on short-term interest rates has not been reflected in the longer term rates.  Which is the result of the fact that the public/the market, does not believe that the short-term rates will remain high for a sufficiently long enough period of time to translate into higher rates on the longer term maturities.  Again, the result is a flattening, and at times an inversion of the yield curve.

In order to understand how the Fed operates in the current environment, it is necessary to fully understand what an interest rate is and how changes in it can affect the real economy.  The interest rate is a price just as the wage rate and exchange rates are also prices.  In fact all ratios of exchange are prices; even if money is not involved the ratio of exchange is still a price: a standard bag of salt on the American frontier exchanged for shotgun shells is still a price.  Since no money is involved, it is called a barter price.

 

A more formal way of expressing an interest rate of 5% simple interest is:

1.05 t+1 / 1.00 t

In other words, it is the ratio of money to be paid in one year for the use of current money.  It is important to understand this since all prices, including interest rates, are determined by supply and demand.

 

It is equally important to understand that a market rate of interest, the one you see being quoted and at which transactions occur, is a composite of factors.  The first component is the pure interest rate.  It is about 2% plus or minus 1%.  In the market, the pure interest rate can never be observed due to the fact that the market rate of interest is a composite of factors.  The closest thing to the risk-free interest rate is the short–term, U.S Government rate on (for example), Treasury Bills (maturities of one year or less). Even this rate is influenced by expectations of price level changes and a small risk premium as well as changing tax treatment. 

A second factor that is part of the composite market rate of interest is a premium to offset the effects of inflation or a discount to offset the effects of deflation.  Unfortunately, this so called Fisher effect is muted when the behavior pattern in the market is one of compete illusion.  It is partially muted in a behavior pattern of adaptive lag.  The Fisher effect is fully effective when the behavior pattern is rational expectations.

 

The following fleshes out the Fisher Effect http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%203/Fisher%20Effect.htm

 

 

In conclusion, the reader should understand that despite the impact of $75 per barrel of oil (make that $77 per barrel – July 2007), the overall inflation rate remains relatively low – the core rate (absent food and energy), while volatile, is even lower.  The chairman of the Federal Reserve Board, Ben Bernanke, has pointed out how this differs from previous surges in oil prices which drove up the overall inflation rate by a much greater magnitude.  

 

“Likewise, a lower sensitivity of long-run inflation to supply shocks would imply that such shocks are much less likely to generate economic instability today than they would have been several decades ago. Notably, the sharp increases in energy prices over the past few years have not led either to persistent inflation or to a recession, in contrast (for example) to the U.S. experience of the 1970s.”

http://www.federalreserve.gov/boarddocs/speeches/2007/20070710/default.htm

 

This is consistent with the New Paradigm, which this newsletter espouses, since much of the economy has reflected an increasing degree of competition… 

 

INTRODUCTION: WHY ANOTHER NEWSLETTER?

“To restate what we the editors of this newsletter, as well as a growing number of other economists, have been arguing for the past several years: we are embarked on a new era in this country; one where a sea change has occurred – a New Paradigm in Economics that has been evolving since the Second World War.  This is a result of increasingly widespread and significant growth in competition.  We argue that the growing importance of the invisible hand of competition is bringing the United States economy toward the achievement of efficiency and equity in the microeconomy and is also eliminating the biases toward recessions and episodes of inflation that the lack of competition was causing.”

http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%201/Newsletter%20Introduction.htm

 

 

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