Welfare for Wall Street, Federal Reserve-Style
The Federal Reserve’s recent surprise decision to lower its short-term interest rate target by three-quarters of a point has received much attention. Most commentary has focused on the idea that the Fed is trying to stimulate spending in the hope of preventing a recession. Over-looked, and equally important, is the fact that lower interest rates raise asset prices, which is something Wall Street desperately needs to prevent a systemic meltdown.
The Federal Reserve is right to play the interest rate card aggressively since the economy-wide costs of a financial meltdown are so large. But let’s not fool ourselves about Wall Street and free markets. The Fed is using its government granted power of fixing interest rates to bailout Wall Street. That is welfare, Federal Reserve-style.
Normally, economists focus on the effect of interest rates on business investment and consumer spending. The thinking is that lower rates cause increased spending, albeit with long and variable lags and the net impact is also highly uncertain and contingent on the state of confidence.
However, another feature of lower interest rates is that they increase the price of fixed income assets. Thus, when interest rates go down, bond prices go up, and that is critical for understanding recent Federal Reserve policy moves.
The U.S. financial system is currently deeply stressed. Growing perceptions of heightened default risk on mortgages and consumer debts have caused large price declines for securities backed by these assets. That in turn has caused massive losses at banks and insurance companies, eroding their capital. This erosion has placed many firms in danger of regulatory insolvency, unable to meet capital requirements. Some are in deeper danger of bankruptcy with the value of liabilities exceeding assets.
The problem is acutely visible among bond insurers, where rising default rates have reduced asset values while simultaneously increasing potential payouts on insured securities. If the bond insurers are downgraded, this could trigger a cascade of losses that could fracture the system. This is because insured bonds would fall in value, thereby wiping out further capital.
This possibility means maintaining asset prices, and preventing further mark-to-market losses is critical. The Fed’s problem is that as quickly as it has been lowering the federal funds rate, default rates on mortgage and consumer debts have been rising. Consequently, rising credit risk has offset the effect of a lower federal funds rate, so that asset prices have remained weak.
Moreover, there are pitfalls in the low interest rate policy. On one hand lower rates increase bond prices and also reduce defaults on adjustable rate mortgages. On the other hand, lower interest rates could trigger a wave of mortgage re-financing by those good risks still capable of re-financing. That would cause pre-payment losses to holders of existing mortgage backed securities, while also concentrating the proportion of remaining bad risks. The net effect is prices of mortgage-backed securities could fall further.
The fact that Wall Street needs this helping hand has important public policy implications. The existing system of regulation by capital requirements helps discipline risk-taking, but it has proven inadequate. The problem is individual firms do not take account of the impact of their risk-taking on others, so that the system takes on too much risk. This problem can only be solved by a system-wide regulator who monitors and limits total risk-taking. Yet, that is exactly what the Federal Reserve has rejected during the last twenty-five years of de-regulation.
Remedying this failing calls for deep regulatory reform that is nothing less than paradigm change. This is something the Fed will resist and Congress will have to push. But until deep regulatory reform is enacted, the “welfare for Wall Street†problem will persist.
Copyright Thomas I. Palley
January 27th, 2008 at 8:31 am
Maybe I am confused but I thought Bond Insurers guaranteed the stream of revenue from these bonds rather than the value of the bonds themselves. So if the debtor defaults then the Insurer steps in and makes the normal payments to the bondholder for the life of the note. So I don’t see what a lower Fed Funds Rate really does for the bond insurers.
January 27th, 2008 at 9:29 pm
Although I agree in sentiment with the title of your essay, I’m not sure you prove it. If lower interest rates support stock prices while also having several other effects (such as leading low risk borrowers to refinance, which may ultimately hurt stock prices), then it’s not clear that it’s actually or intentionally welfare.
Also, would like to hear your views on the stimulous package on the verge of being passed.
January 28th, 2008 at 2:19 pm
Well, this does clarify things! Given that the unemployment rate is only 5%, and the inflation rate is already 4.1%, it seemed rather odd to me that the Fed would reduce interest rates in such an drastic and urgent manner. In fact, it seemed odd that the Fed would reduce interest rates at all, going by the textbook I teach. But propping up bond prices makes more sense, given that everyone is writing that the possible downgrading of the bond insurers would be catastrophic. Now, more on that latter issue would be appreciated.
February 2nd, 2008 at 6:56 pm
Mr. Palley: I read your article on the Fed and the interest rates. I disagree. My view is that the Fed is lost and they just do not know what to do. Lowering interest rates will not pull us out of the depression but the Fed feels they had to do something if it only is for moral support. It was lower interest rates that led to the mess we are in. In my view lower rates will A) discourage savings at a time when we need to increase the saving rate, B) push inflation C) put added pressure on the dollar as the money supply increases and as money flows out of the US seeking higher rates of return abroad. One serious adverse affect of the drop in rates is that a number of US companies will borrow huge amounts to buy back their own stock from the market. This will give the market an artificial short term lift in price but will leave the companies in an over debt to equity situation. I have already sold off a number of my stocks because companies have announced that this is what they intend to do. One example is Home Depot who said they would borrow funds for this purpose if they could not get the price they want from selling off a subsidiary.
February 9th, 2008 at 6:35 am
There is no question that the Fed has lowered rates abruptly to respond to financial system crisis, more so than to real economy crisis. The ‘meltdown’ is due to a systemic failure of risk management. This includes banks and regulators.
The core of the failure has to do with capital requirements for financial institutions. Var and RAROC systems for quantitative assessment of risk and capital have failed completely. They are based on statistical analysis, which makes no allowance for the gaming and evolution of the macro system generating the statistics. In future, the Basle capital system for banks will have been seen to have been a near total failure because of its inadequacy in dealing with derivative credit risk.
The solution for the future is to reject naive statistical models on their own, and increase capital requirements in order to accommodate more sensible approaches to the dangers of systemic leverage. Broader and deeper regulation unfortunately is inevitable. Greenspan’s laissez faire approach as head technology cheerleader and head housing leverage cheerleader has been a failure. The Fed’s ignorance of the risks, including their ignorance of the data, which were evolving in the mortgage markets, has been shocking.
Dealing with the current mess is a massive challenge. The Fed should be lowering rates. Yes, it does constitute a quasi-socialization of losses at the margin, but there is no choice when the best case for losses otherwise is so close to systemic catastrophe. Any inflationary concern must be tempered by the recognition that much of this is required to offset otherwise deflationary forces put in motion by the housing and credit contraction.
The system is painfully cleansing itself via credit contraction and related bank equity destruction. But the current risk management system at micro and macro levels is broken and finished. It requires a fix followed by a systemic overhaul. This unfortunately requires more government intervention at all stages.
February 10th, 2008 at 8:58 am
I too agree with sentiment, but not with your arguments.
Interest rates have been lowered simply to put money in bankers pockets from increased profits from interest margins rather than changes in asset prices.
Mortgage rates, credit cards and even simple deposits have all lagged the fall in rates as there is a real credit problem. Fed lowers rates; Bankers don’t. Mucho money very little risk. A State-sponsored recapitalisation of banks balance sheets.
One is always generous with someone else’s money
February 27th, 2008 at 4:35 pm
I agree with Jeff H:
1) The derative positions at the Bank for International Settlements are so huge, they are just not realistic any longer.
2) The present Basel 1 system is not only deaf for derivatives but in general for lots of other ‘off balance’ items. If my info is correct, in the year 2009 the FED will go to Basel 2 but I cannot comment on that because I need to study Basel 2 further.
3) The climbing of the leverages without proper margin calls (only more leverage on what you have left) is in my view one of the most deadly details in the impending crash of this financial system.
4) After the crash even the FED will go on a regulary tour, likely it will not be Bernanke but some Volckel (I hope I spell his name right) kind of guy. I think that in this fiat money system central bankers need to be feared and not those Alan Greenspan kind of folks.
5) The present speed of bank equity destruction can be anything between 0 and 2 billion a day (under Basel 1), time will tell…