Federal Reserve & Interest Rates

The collapse of the mortgage industry has caused untold havoc on financial systems around the globe.  The breakdown of the originate to distribute model and the failure of secondary markets for securitized mortgages has pretty much ended any hopes for a quick rebound in the housing market.

Federal Reserve Chairman Ben Bernanke spoke at a symposium in Berkeley about the future of mortgage finance in this country.  The private securitization market has all but dried up and the only reason Fannie Mae and Freddie Mac are still doing business is because the government took control of the two GSEs. 

The financial crisis that began in August 2007 has entered its second year.  Its proximate cause was the end of the U.S. housing boom, which revealed serious deficiencies in the underwriting and credit rating of some mortgages, particularly subprime mortgages with adjustable interest rates. 

As subsequent events demonstrated, however, the boom in subprime mortgage lending was only a part of a much broader credit boom characterized by an underpricing of risk, excessive leverage, and the creation of complex and opaque financial instruments that proved fragile under stress.  The unwinding of these developments is the source of the severe financial strain and tight credit that now damp economic growth.

What will the government end up doing with the two companies is anybody’s guess.  There have been calls for the government to privatize the two organizations but that probably isn’t feasible at this time.

So while the mortgage market is running far from smoothly at least it’s still running somewhat.  Only because the government is backing their debt are the two companies able to continue to purchase mortgages and resecuritize them. 

What we are witnessing is the government taking a much more active hand in the financial system in this country and with nearly $2 trillion already spent on the financial crisis, I don’t think that’s going to change anytime soon.  The treasury is already taking on more control in the banking system, exchanging access to capital for equity stakes.

Until conditions return to somewhat normalcy, we may see the expansion of the nationalization which began in the banking sector, extend to all aspects of financial services.  But with the government having to take such an active role in the economy, are we witnessing the breakdown of capitalism?

The Federal Reserve announced it was cutting interest rates today, lowering the federal funds rate to 1% and the discount rate to 1.25%.  The move comes as an effort to jump start a credit market that has been reeling since the collapse of the investment banking sector.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

This quickly follows on the heels of a coordinated rate cut move by global central banks earlier in the month.  The Fed had pretty much frozen rates at 2% in the spring when inflation worries were much higher.

With the price of oil having lost over half it’s value since July, their assessment that a decline in global demand would ease price stability concerns was essentially correct.  Now that stagflation issues have dissipated somewhat, the Fed has moved decisively this month, initiating a number of monetary policy moves as well as recommending additional fiscal spending in a second stimulus package to promote consumer spending.

It is even possible we could see rates fall even further in the upcoming months and not just in this country.  The sharp drop in global economic activity has raised concern is some circles of deflation risk.

Statements released this year from FOMC meetings in the early 2000’s showed that the Fed was prepared to lower rates to as low as 0% if it deflation risk increased.  Whether or not that will become necessary this time around remains to be seen.

The government is hoping that the $250 billion it has earmarked to re-capitalize the banking system will be enough to jump start lending once again.  However the landscape of the banking system far different then it was when this all began.

Leveraged finance saw the explosion of credit in the past two decades, where that $250 billion could have easily become over $5 trillion in credit, if not more.  It would not have been surprising for many financial institutions to have leverage ratios of over 20.

During good economic climates this maximized profit potential but during the current financial collapse the opposite is now true.  Now institution are frantically trying to de-leverage themselves from more potential losses over and above what they have already lost.

Structured finance and the selling of collateralized debt took the credit market to new levels but with the failure of that financial model, there is serious doubts on how quickly banks will start lending again.  Nothing has really changed in the past six months, banks will still want to hoard capital and just because it’s from the government doesn’t change that fact.

The FDIC’s troubled banks list is enormous and more than likely any capital received from the Treasury will be used to stave off collapse.  Until they get their balance sheets in some kind of order, lending and the extension of credit will not be their primary concern.

We could quickly see the government’s involvement grow even further, as some analysts feel that the $250 billion which has been allocated to the banking system so far, is no where near enough what is enough to restart lending.  With another stimulus package in the works, how high will the government’s price tag eventually become.