Posted by: Dirk | June 8, 2009

Asset-backed securities – implications for monetary policy

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‘Government actions and interventions caused, prolonged, and worsened the financial crisis’. So says John Taylor in his book Getting off track. His main argument is that loose monetary policy has led to a housing boom that created the real estate bubble. Its subsequent burst led to the financial crisis we are still fighting with. I do not agree with this line of reasoning, and the reason is quite simple. The rise of asset-backed securities has cut off the traditional link between monetary policy (and hence the Fed’s interest rates) and the sector of housing. Therefore, other factors have been responsible for the rise of the real estate bubble.

Paul Krugman recently pointed out that Reagan did it. Deregulation in the financial sector opened the gates for financial innovation that benefited a few while harming the rest. The financial sector was enabled to play a huge Ponzi scheme, where banks and companies had to increase their debt in order to sustain their profits. Those that did not increase their debt were bought up with the extra credit that was inserted into the economy by the Fed.

So, I would argue that Taylor is wrong in saying that low interest rates caused the housing boom, but would point out that the loose monetary policy caused an increase in overall company debt. This opens the gate for debt-deflation, which has been the main worry of Hyman Minsky. On the other hand, the US financial system got an extra boost from China. The Chinese government – via their central bank – invested heavily into treasury bonds, crowding out private investors. These had to look for alternative investments. After scrambling to find a place to “dump” the foreign capital, Wall Street firms came up with asset-backed securities. Mortgages were one of those assets. This invention changed the rules of the game.

Above you find a graph taken from M.A. Akhtar’s Understanding Open Market Operation, published by the St. Louis Fed. It shows how monetary policy affects the economy. This is the so-called transmission mechanism. Housing is affected by cost and availability of credit, which, according to the graph, are determined by interest rates, among other things. It is this connection that John Taylor highlights. Economists have been saying that for decades, so basically it is nothing new. Low interest rates, especially the long-term one, create incentives to build and buy houses. This is a major transmission channel of monetary policy. Hence, low interest rates lead to more investment via an increase of economic activity in housing.

How does the securitization of mortgage-backed loans fit into the picture? A comparison with the old transmission mechanism should provide some insights. Before securitization, banks gave a loan to somebody and waited until the loan plus interest was paid back in full. The amount of credit available for the bank was reduced by the amount of the loan. The bank had the loan on its own books, and it waited to get the money back and then give another loan. If the loan would not perform – the house owner defaults for some reason – the bank would have to take a loss. The amount of loans taken out depended on the US interest rate, because this is how the banks refinanced.

Asset-backed securities (ABS) changed this. Formerly, banks held on to the loan until it was fully paid back, securitization means that the loan will be sold on. This means that the bank gives away the loan, and then sells the expected income stream to a 3rd party. Often, diverse loans were sliced and mixed to reduce the risk of default. This created a very opaque product. Rating agencies rated the resulting ABSes according to the rating of the origin – the emitting bank. They simply did not have the resources to go through thousands of single loans for each single ABS. Also, conflict of interest might have been an issue.

Through ABSes, banks were able to unload mortgages to 3rd parties. The foundations of this were laid in the 1980s, hence Krugman blaming Reagan. It took until the early 2000s that mortgages would transform themselves into a licence to print money. The Wall Street bank would give the loan (and gain a fee), bundle existing loans and sell them off (and gain a fee). After collecting the fees, no risk was left for the bank. Loans were no in the books anymore since they belong to a 3rd party now. Also, the whole monetary value of the loan was back at the bank. Time to repeat the whole circle. As long as house prices are on the rise, people will take out loans to get their free lunch – buy a house, sell it for a profit, repay the loan, pocket the rest. Teaser rates increased the appetite for loans, and banks and debtors collaborated to get around the lending standards, leading to warnings from the FBI as early as in September 2004.

So, who would buy the resulting financial product, which was opaque and risky, and hence carried a high interest rate? Here we have to take a broader perspective. The US attracted a lot of capital from countries like China, Japan and Germany. All these countries are net exporters versus the US, which means that the US has not enough foreign currency to pay for all their imports. Hence, trade partners have to accept financial assets as payments for part of their exports (the part that exports were higher than imports). This could be anything: dollars, t-bonds, stocks and corporate bonds.

China invested heavily in t-bonds and drove the risk-less interest rate down. Other investors were looking for some other asset to invest in, since the yield from t-bonds was low, eventually even below the level of inflation. Savers did not want to lose purchasing power. They were craving for something with a higher interest rate. A higher interest rate means higher risk. In the early 2000s, Wall Street firms came up with the product to establish a supply of what was demanded – a high-yield but seemingly secure investment. This lead to an explosion of the housing bubble, first with rising prices, and then the second with a steep fall.

Of course, there are other factors that play a role. Fannie Mae and Freddie Mac were involved in the mortgage frenzy, bankers were greedy, regulators sleeping – but all of this was nothing new. Also, the failure of Basel II or the rating agencies were not coming out of the blue. These problems existed for a long time or were known by experts beforehand. However, the consensus of society was let the market work. Politics were pro-business, allowing hedge funds to work without oversight and without significant taxation of their windfall gains. Education was pro-business, with the new neo-classical synthesis ruling and mathematical modelling taking over a more historical and institutional approach.

So, how did we get off the track? It seems that global economic imbalances together with an unregulated financial sector in the US has caused all the trouble. The main international imbalance is that of China and the US, caused by an implicit understanding between a Chinese Communist president and the US administration of George W Bush that China would provide finance for all the fiscal excesses of the US government. Is the purchase of US t-bonds by the People’s Bank of China, which belongs to the Chinese Communist Party, an outcome of free markets?

So I agree with John Taylor saying: ‘Government actions and interventions caused, prolonged, and worsened the financial crisis’ – but for different reasons. Also, I ask myself who determines government actions and interventions.

UPDATE 11/06/2009: According to Martin Wolf from the FT, Goldman Sachs has written (but not published) a paper which takes the same point of view – that the Chinese appetite for t-bonds drove their yields so low that investors were looking for new opportunities with high yields.

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