VoxEU Column Financial Markets

A B & B future for subprime borrowers?

A rate cut is unnecessary. Congress will swiftly augment the Bush bail-out, adding a fiscal stimulus worth, say, 0.5% of GDP. The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions.

The two Bs in the title of this Vox column refer not to bed and breakfast, but to the rather less restful and nutritious contributions made on Friday, August 31 by President Bush in the Rose Garden of the White House and by Chairman Bernanke of the Federal Reserve Board, at the annual Jackson Hole Conference in Wyoming.

Both addressed the crisis in the US subprime mortgage market, falling US house prices, the wider turmoil in credit markets and the liquidity problems encountered by a growing number of diverse financial institutions.  Bernanke listed the weapons in the Fed’s armoury and tried to outline the Fed’s contingent reaction function to new developments.  Bush outlined a small bailout for financially distressed low and middle-income homeowners.

Bernanke’s ‘wait and you shall see’

Chairman Bernanke first.  He succeeded completely in what he set out to do: he said nothing at all new, but said it very well indeed. Ignoring the scholarly/historical bits, what is relevant to future Fed policy can be captured by the following quotes and their translations.

“…. if current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. We are following these developments closely.”

Translation: Even though the Fed is in Washington DC, we are not asleep at the wheel.

“The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets”. 

Translation: We can inject additional liquidity through open market purchases or at the discount window; we can cut the discount rate or the Federal Funds target rate, and we can widen the range of eligible assets we will accept as collateral in repos or at the discount window.

“… the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.” 

Translation: An increase in credit risk spreads represents a tightening of monetary conditions, even if the Federal Funds target is unchanged.  The Fed is aware of this.

“… in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.”

Translation: Never mind what we said following the August 7 FOMC meeting.  That was then.  This is now.  HOWEVER, financial kerfuffles influence the setting of the Federal Funds target if and only if (and to the extent that) they have a material impact on our fundamental objectives, employment and price stability, going forward.

What does this mean for the future path of the Federal Funds rate?

Most of the recent real economy data are robust, including the QII GDP growth rate of 4.0% (annualised) and robust personal income and personal spending growth in July.  However, they extend no later than July 2007, and therefore do not capture any negative effect on consumer and investment demand of the August financial turmoil. 

Core PCE rose 0.1% in July 2007, keeping the 12-month rate of core PCE inflation at 1.9% for a second month.  Headline CPI also rose by 0.1% in July, and fell to 2.1% over a 12-month period, down from 2.3% in June.  While both are north of the centre of the Fed’s assumed comfort zone (which ranges from 1.0 to 2.0%), they are low enough not to be a cause for embarrassment were the Fed to decide to cut the Federal Funds target on September 6. 

Although if I were a voting member of the FOMC, I would vote to keep the Federal Funds rate constant, barring exceptional developments between now and September 6, I believe that the most likely outcome is a 25 bps ‘insurance cut’ in the Federal Funds rate.  We shall see.

Bush’s small bail-out

By revealed preference, poverty in the USA is something this Republican Administration and Democratic Congress (like past Republican and Democratic Administrations and Congresses) can live with.  The prospect of a couple of million homeowners being foreclosed upon during the year before a presidential election is, however, more that the body politic can stand – these people might well be voters.  President Bush gave us the homeowners bailout ‘lite’ in his speech.  The Congress will no doubt up the ante and turn this into a homeowners bailout ‘premium’. 

Bush first gave a concise statement of the case against bailing out mortgage lenders, speculative investors in real estate and those who unwisely took on excessive mortgages and then outlined a plan for bailing out the last-mentioned category.

“A federal bailout of lenders would only encourage a recurrence of the problem. It's not the government's job to bail out speculators, or those who made the decision to buy a home they knew they could never afford. Yet there are many American homeowners who could get through this difficult time with a little flexibility from their lenders, or a little help from their government. So I strongly urge lenders to work with homeowners to adjust their mortgages. I believe lenders have a responsibility to help these good people to renegotiate so they can stay in their home. And today I'm going to outline a variety of steps at the federal level to help American families keep their homes.”

There are a number of aspects of these proposals that are interesting from an economic point of view.

(1) It represents a cyclically appropriate, albeit small (especially in the President’s version – the only one formally on the table) fiscal stimulus. That’s what is meant by “…a little help from their government”.

(2) The fiscal stimulus proposed by the President will be implement mainly through quasi-fiscal means.  That means that they will not come in the form of on-budget tax cuts or increases in subsidies or other public spending.  Instead they will be hidden in below-market mortgage interest rates, supported by Federal Guarantees, through subsidised mortgage insurance and other off-budget measures that are functionally equivalent to tax cuts or subsidies.  The full budgetary impacts will be obscured and delayed. 

That is clear from the central role assigned to the Federal Housing Association (FHA), the cornerstone of socialised housing finance in the USA.  The FHA is a government agency that started operations in 1934 and provides mortgage insurance to borrowers through a network of private sector lenders. Bush proposes to expand a proposal he sent to the Congress 16 months ago that enables more homeowners to qualify for this insurance by lowering down-payment requirements, by increasing loan limits and providing more flexibility in pricing.  There are obvious elements of subsidy in this proposal.

Already about to come online is a new FHA program (‘FHA-Secure’) that aims to allow American homeowners who have a good credit history but cannot afford their current mortgage payments to refinance into FHA-insured mortgages.  Again, the unaffordable can only be made affordable through a Federal subsidy.

The President also proposes to change a feature of the US Federal income system that can hit homeowners who no longer can service their mortgages hard.  Debt forgiveness counts as taxable income.  Assume you have $100,000.00 worth of mortgage debt you cannot afford to service. Your house is worth $100,000.00 to the bank.  If the bank were to forgive you your mortgage debt and take your house in exchange, you would still be left with income tax liability on the $100,000.00 of forgiven debt.  That seems a bit rough.  Of course, you could instead sell the house to the bank for $100,000.00 and use the proceeds of the sale to pay off the loan.  No income tax would be due (there could, under certain conditions, be capital gains tax). 

The US Congress is likely to expand on these proposals by letting Fannie May (or Federal National Mortgage Association) and Freddie Mac (or Federal Home Loan Mortgage Corporation), two Government Sponsored Enterprises (GSEs) created by the Congress that are at the heart of the US system of socialised housing finance, expand the scale of their operations, specifically by increasing the upper limit on the size of the mortgages they can extend or guarantee from its current level of $417,000.001

(3) It represents a redistribution of income towards those low and middle-income Americans who had taken on excessive mortgage debt.  The bill is paid mainly by the shareholders of the mortgage lenders (that is what is meant by “… a little flexibility from their lenders,…” and by the American tax payer who will have to foot the bill of the increased subsidies attached to the loan guarantees and subsidised mortgage insurance offered by the FHA.  If the Congress manages to get Fannie May and Freddie Mac involved in the game, the cost to the tax payer could turn out to be significantly higher.

(4) By subsidising excessive and imprudent borrowing, it reinforces the moral hazard faced in the future by low and middle income Americans pondering the size of the mortgage they can enforce (if the market-friendly President Bush is willing to bail us out today, would a more market-sceptical President Barack Obama or President Hilary Clinton not do so again tomorrow?)

(5) By leaning on the lenders to show greater leniency towards delinquent mortgage borrowers than would be required by the mortgage contracts and the dictates of the competitive environment, it will discourage future subprime lending and other higher-risk mortgage lending by banks and other mortgage finance institutions.  This will further increase the role of the FHA, Fannie, Freddie, and the Federal Home Loan Banks, and will further strengthen the role of socialised housing finance in the USA.

(6) There is a reasonable prospect that Federal legislation and Federal regulation and supervision of the housing finance industry will be changed in such a way as to reduce the likelihood of the excesses, the mis-selling and the misrepresentations that became rampant especially during the past 5 years or so.  There has been a serious failure by the regulators to stop the rogue mortgage lending practices that have proliferated, and not just in the subprime market.  The Fed, both under Chairman Greenspan and under Chairman Bernanke is one of the institutions that bears responsibility for this regulatory fiasco. 

It is, unfortunately, quite likely, that the legislative and regulatory changes we will get will amount to a Sarbanes-Oxley-style regulatory overshoot, that is, regulation of the ‘if it moves, stop it’ variety. This will discourage future lending to low-income or credit-impaired would-be homeowners even when such lending is fundamentally sound.

Parochialism in US economic policy.

Both sets of remarks were amazingly parochial.  The President clearly believes that, except for oil and Chinese imports, the US is a closed economy. 

Chairman Bernanke’s text contains a few rather generic references to global matters, but rather less than the topic deserved.  Surely the fact that so much of the subprime exposure ended up in European and Asian financial institutions must have made it easier for the US lending excesses to occur.  One also has to recognise the importance of international regulatory arbitrage as a factor limiting the ability of national regulators to impose even mild disclosure restrictions (let alone more serious regulatory constraints, whether for prudential or consumer protection reasons) on internationally mobile financial institutions. 

Even in a lecture on ‘Housing, Housing Finance, and Monetary Policy’, it is surprising not to find the word ‘exchange rate’ in a section of the lecture titled The Monetary Transmission Mechanism Since the Mid-1980s’.  During the past 20 years, the US economy has become increasingly open, both as regards trade in real goods and services and trade in financial instruments.  Transmission of monetary policy through the exchange rate undoubtedly has become more important, both for prices and for aggregate demand, during this period, and US real interest rates are increasingly influenced by global economic developments, as Governor Bernanke himself has pointed out in a lecture on the global saving glut 

When all is said and done, the entire construction sector in the US is 5 percent of GDP.  The bit that is hurting badly, residential construction is somewhere between 3 and 4% of GDP.  Exports are 12% of GDP and growing in volume terms at an annual rate of over 11%.  Import competing industries are also doing well.  The combination of a sharp nominal and real depreciation of the US dollar and continued rapid growth outside the US accounts for the strength of the externally exposed sectors of the US economy.  It goes a long way towards offsetting the weakness of parts of the nontraded sectors, including housing.  While increased credit risk spreads represent a tightening of monetary conditions, the weaker dollar represents a loosening of monetary conditions.  There is no indication from Chairman Bernanke’s address that the Fed pays any attention to this in its actual policy deliberations.  This is especially surprising in view of Chairman Bernanke’s recognition of these issues ‘in the abstract’, in some recent lectures.

Of course, housing troubles are not limited to the construction sector.  Housing wealth is an important component of total net household financial wealth; real estate assets can be collateralised and thus are a ready source of consumer spending power.  Another Fed Governor, Frederic Mishkin argued at the same Jackson Hole conference that a fall in housing wealth could be a serious drag on consumer spending, assuming that the marginal propensity to spend out of housing wealth was 3.75% (a very precise number indeed). 

Bottom line

A 25 bps cut in the Federal Funds rate on September 6 is unnecessary, likely, but my no means a foregone conclusion.  By the time Congress is done augmenting the Bush mini bail-out of financially stressed mortgage holders, there may be a fiscal stimulus worth about 0.5% of GDP.  With elections looming, this fiscal stimulus could be enacted rather swiftly.  The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions (albeit at spreads closer to long-run historical levels rather than at the anomalously low levels of 2003-mid 2007) and to provide a boost to asset markets.  The US housing market is in structural trouble, with excess capacity in most categories that will take years to work off.  But that is a small enough part of the US economy not to be a serious drag on overall activity in the years to come.


Together, the three mortgage finance GSEs (Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks) have about 4.4 trillion dollars of on-balance sheet assets. Fannie May had about $2.6 trillion, Freddie Mac has about $820bn and the 12 Federal Home Loan Banks just over $ 1.0 trillion. Fannie Mae and Freddie Mac initiated the securitisation of home mortgages.