Sunday, October 5, 2008

Economy: The Credit Crunch, KC Fed View

Tom Hoenig, president and CEO of the Federal Reserve Bank of Bank City, got the second and heavy half of the road show last Thursday. The purpose of the gathering—the 2008 New Mexico Economic Forum—was both to share information and perspective and to listen to people and hearing things that might not filter to Kansas City.
Hoenig, speaking from notes, said his comments could not be characterized as the usual economic outlook. Rather, it would and “economic feel sort of speech” because things were too murky.
He opened with what proved a continuing theme of the talk. “We will see our way through this.” Later Hoenig said that “a year from now” the people in the audience would be saying to themselves, wow, that was really rough. Hoenig also said, “We will work to a solution.” He cautioned against “irrational fear.” Ultimately, the issue is confidence, the faith of businesses and individuals that they will get paid for actions undertaken.
The credit crunch today traces to three causes, Hoenig said. The first was the housing bubble, which happened because of “relatively easy financing.”
What Hoenig didn’t say is that the easy money happened in major part because of Clinton administration changes to the rules for the Fannie Mae and Freddie Mac starting in 1993. The idea was to expand homeownership, certainly a worthy objective. I mention this because of the casual and unsubstantiated claims by liberal pundits that the (evil slimeball) Bush administration did it. In a recent op-ed, Terry Jones of Investors Business Daily said, Clinton “turned the two quasi-private, mortgage-funding firms into a semi-nationalized monopoly that dispensed cash to markets, made loans to large Democratic voting blocks and handed favors, jobs and money to political allies. This potent mix inevitably led to corruption and the Fannie-Freddie collapse.” The additional detail (thing moral hazard here) is that Fannie and Freddie probably never should have been created with an implicit government guarantee.
There “used to be a statute” limiting a real estate loan to 80% of the value of the property. The limited was eliminated. Loans went, sometimes, to 120% of value. The rush was on.
Also unmentioned by Hoenig is the claim that the Fed’s easy money policies made things worse.
The second shock came because “people hadn’t been paying much attention” to what was really in the CDOs, the too-clever-by-half securities created to somehow off-load the risk of the mortgages done to finance the increase in homeownership. When people did look at the CDOs, the quickly resulting unhappiness “began to affect a whole host of asset backed securities.” Values plunged.
Finally, commodity price shocks affected goods from corn to oil and copper. The result “affected consumers’ willingness to spend” and “depleted disposable income.”
“A fundamental rethinking of the U.S. economy” is the result of everything hitting the fan.
In response, the Fed has been doing its basic thing—trying to keep liquidity, meaning reasonable access to money, in the system. The Fed lowered the Fed Funds rate from 5.25% to 2%, began to use its lending facility to target distressed banks, introduced something called a term auction facility and cooperated with central banks around the world for more liquidity.
What the Fed can’t do and what is the point of the bailout is put capital into the market. Under the bailout, the treasury will buy bad securities. This “is not part of what the central bank does.”
What the Fed—America’s central bank—does do is use monetary policy to pursue a dual mandate—stability in both prices and economic growth. Hoenig tilts a bit toward price stability, which, he said, in the long run is necessary for growth. Over the 20 years, the price index has doubled. “We have to be mindful of that,” he said.
The most important thing that has to happen, Hoenig said, is that someone (which sounds here a whole lot like the government) has to absorb a lot of losses and then get the bad stuff off the books. When you have losses of this magnitude, the government has to make a decision as to what to do. The final step is to think about how to mitigate the negative effects in the future.
For the U.S. economy, the “feel” is:
• “Consumption in the U.S. will slow” but not stop.
• Business fixed investment should improve in 2009. The balance sheets of most of the corporate world are still in good shape, but companies will hang out through 2008.
• Exports, which have been “growing very strongly,” will slow. Export growth has offset the housing hit on the economy.
• “The government of course does appear to be spending.” Hoenig got a chuckle from the audience with that line.
• Depending on the economy, the bailout “should have some effect on the cost of borrowing. You should see an increase in the cost of capital as a result.”
• The third quarter of 2008, which has just ended, will show “very modest growth,” well below the economy’s long term potential of 2.75%, plus or minus, per year.
• “The economy will improve slowly over time” ad will look better by the second or third quarter of 2009.
• “Right now, for the most part, regional and community banks are still lending.”
We’re coming off “a decade of very extreme growth.” Improvement will take time.
Changing mark to market rules is proposed fix Hoenig doesn’t favor. Mark to market means that financial institutions are support to value securities such as sub-prime loans at what the security could be sold for today, however that can be figures.
“I think backing away from mark to market will cause as much (of a) problem as it is intended to alleviate, “Hoenig said. “It would be chaotic. Mark to market is not the problem. The problem” is the sub-prime mortgages and the easy lending practices that produced the sub-primates.
Hoenig’s response to the argument that U.S. regulation of financial institutions is fragmented and ineffective was, “That’s a red herring. I hope we diagnose the problem correctly. It’s not the regulatory structure.” Hoenig noted that the Fed’s attempt to address banks’ concentration of real estate loans ran into a wall.

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