Don’t blame interest rate policy?

Fed Chairman Ben Bernanke gave a speech to the American Economic Association yesterday.  In it, he argued that the Fed’s interest rate policy circa 2003 played virtually no role in the financial crisis and the causes were due to regulatory failures (Speech here)

What policy implications should we draw? I noted earlier that the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates. Moreover, regulators, supervisors, and the private sector could have more effectively addressed building risk concentrations and inadequate risk-management practices without necessarily having had to make a judgment about the sustainability of house price increases.

Technically, this is correct.  I view the height of the housing bubble as the period from 2005 through 2006 with some residual carryover in the first half of 2007.  The low interest rate environment was less a function of the Fed’s interest rate policy and more a result of increased demand for Treasuries from offshore sources looking to invest excess dollar-denominated reserves (also known as the global savings glut) in U.S. Treasury bonds.  By the time the exotic mortgages were being churned out in record volumes, the Fed’s rate was continuing its upward march to 5.25%, which it reached by the middle of 2006 while the housing boom was running white hot.

However, the problem I have with Bernanke’s speech is that because he establishes no direct link between short-term interest rates and the increasing prevalence of exotic mortgages (presumably at the height of the bubble), the issue is not explored further.  I believe this is a mistake and agree with Barry Ritholtz’s post on this subject:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages (Yes, I laid all this out in the book).

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

Ritholtz’s list is by far the best summary of this issue I have seen.  Not only does he successfully distill the big picture of the financial crisis (no pun intended!) into a list of ten items in very accessible fashion but his list also demonstrates how interwoven these variables were. In light of this list, the Fed’s interest rate policy may not be as large a contributor to the crisis as, say, the idiocy of the ratings agencies; however, we should not ignore the fact that interest rates did play a role in setting the wheels in motion.

As a parting thought, with regard to the Fed having the ability to employ a “surgical approach” to containing bubbles (an exercise in wishful thinking if there ever was one)  I leave you with this excerpt from Mark Thoma:

Greenspan would not allow new regulation to be imposed on the financial sector as those who tried to warn about the problems in housing markets and got nowhere (or were ridiculed) will attest. Bernanke was not among the few who were issuing warnings, but even if he had been the pleas for new regulation would not have been received well by Greenspan. The real problem was not Bernanke’s failure to call for regulation, the problem was the structure of power within the Fed that would not allow those who did see problems to bring their arguments forward and provide the persuasive evidence needed to turn their concerns into action.

But there was another, bigger problem that drove Greenspan’s views on regulation. Again, I don’t want a Fed Chair who is all powerful, a maverick who can take the Fed wherever he or she wants. One of the constraints the Fed operates under, and this includes Greenspan, is that the policies that are enacted must be within the accepted bounds of the economic profession. A maverick that goes outside these bounds may be successful, but the howls from the profession would be loud and it’s unlikely the Fed Chair would survive such an outcry. In any case, for the most part I’d prefer that that the Chair of the Fed follow accepted practices.

Greenspan was a hard-liner on regulation, certainly toward the tail of the distribution, but he was not outside what the profession believed. Economists, for the most part, believed that deregulation was good, that it had produced lots of valuable financial innovations. I can recall holding up a graph in class long ago showing how few bank failures there were the year before, there were hardly any, and asking if this was stifling progress in the financial area. My point is that Greenspan was doing exactly what most of the profession supported. Thus, when Bernanke also adopted a supportive stance toward deregulation, it was not as though there was a big debate within economics on this issue and he chose the wrong side. He simply thought what we all thought — he was part of one big collective mistake the profession made. Had Bernanke been arguing strongly for new regulation, nothing would have changed (except his reputation today). Greenspan would not have welcomed or supported a call for new regulation no matter how hard Bernanke might have argued, and the broader profession would not have supported it either.

To the extent that a lone voice jumping up and down to get the right person’s attention can successfully bring about this sort of change, the one-two punch of lobbying and regulatory capture will do just as much to stifle change as the internal workings of the Fed, which is exactly what happened with the last bubble.