The US subprime crisis era from 2007 to 2009 posed an unprecedented challenge to the US Federal Reserve (“the Fed”) as well as the outgoing Bush administration and incoming Obama administration. US Subprime Mortgage Crisis Crisis: Policy Reactions (“the Case”) provides us a glimpse of the actions by the Fed, the two administrations, as well as the support and criticisms for those actions. The US as a whole generally disregarded “common sense” leading up to the downturn and crisis. An overheating economy had been ignored for too long, loans were extended to individuals and entities with little to no income and who lacked the sophistication to understand the nuances and ramifications of new financial products created to yield higher returns for investors with voracious investment appetites, and the worst fears of laissez-faire economics were realized due to unregulated business practices with little to no oversight or full understanding of those new financial products.
The Case highlights the tools used by the Fed in monetary policy during the economic downturn and crisis in the housing and commercial real estate markets and can be reflected on in terms of standard utilization as well as non-standard utilization. With respect to standard utilization of monetary policy, the Fed can influence the Fed Funds Rate, which is the rate at which commercial banks and other depositary institutions can borrow money from the Fed. The Fed members meet at the Federal Open Market Committee eight times a year, seven weeks apart to establish the fed funds target rate. To reach this target rate, the Fed conducts open market operations in the buying and selling of government treasuries to influence the money supply. Essentially, when the Fed is looking to inject money into the economy, the Fed purchases the bonds, which in turn raises the bond prices and effectively decreases the interest rate. Alternatively, the Fed may choose to sell treasuries, reduces the amount of funds in the money supply, causing treasury prices to decrease, and interest rates to rise. These actions are utilized primarily to control inflation, slow or chill an overheating economy, or jump start and push an economy forward by either discouraging or incentivizing saving or investment.
When discussing the Fed’s actions, one cannot disregard the Fed’s inaction. The Fed did not begin raising interest rates until June 2004 and continuing the practice reaching 5.25% in June 2006 (pg. 3). Therefore, critics argue that “there never would have been a subprime mortgage crisis if the Fed had been alert” (pg. 3). Almost a year later, after the damage had become more visible with the heightened interest rates creating mortgage defaults on adjustable rate mortgages by those who had now realized they could longer continue to refinance their debt at the previously historically low rates, the Fed began cutting the discount rate. The US economy and the world were now realizing that the rapid increase in housing prices was created by over-leveraging on borrowing, lack of saving, and lack of accountability on complex loans which were now carved up numerous times, repackaged, and sold numerous times across investors. Chairman Bernanke vaguely warned of significant losses before the August 2007 rate cut (Timeline, pg. 8). The rate cut was intended to inject money into the economy as tightening credit pressures mounted. Once again, in August, the Fed issued a vague statement that it would “act as needed” to contain the crisis (pg. 8). As large institutions like Citi, Merrill Lynch, and Countrywide made announcements of impending losses, credit continued to tighten, fears mounted, and the Fed again cut rates in January 2008 followed by another cut in March 2008 (pg. 9). During these cuts, the Fed denied concerns of stagflation (inflationary pressures combined with recessionary pressures). The Fed’s mixed messages of the state of the economy, combined with the expansionary practices of cutting rates to stimulate credit extension and investment simultaneously discouraged saving, after all, with a dropping risk free rate and uncertain health of major financial intermediaries, it is no surprise that a run would begin on the banks and numerous bankruptcies announced.
Thus, we are left with a question, was the Fed’s actions driven by the goal of controlling inflationary pressures, or directed at controlling excessive high housing prices initially, and then at creating liquidity in the system as a whole when housing prices collapsed and credit dried up? Exhibits 9 and 10 show the CPI rising dramatically in the US, Europe, and Canada in 2005, while oil prices continued to rise, as well as housing prices. A reasonable assertion can be made, therefore, that the Fed had not only acted too slowly, but also not as strictly, given the benefit of hindsight now.
However, we must also take into account the Fed’s non-standard monetary policies in action. First, the Fed had now become a “direct credit line for investment banks for the first time in history” (pg. 1). There is much contention if this was the appropriate action to restore investor confidence as this essentially was viewed as a bailout “for financial institutions imprudent lending practices” as well as excusing negligent homeowners of personal accountability in living beyond their means. Also, the Fed was now dictating to investment banks what strategic acquisitions were required to ensure that the economic system did not collapse in its view, for example JP Morgan acquiring Bear Stearns and Bank of America acquiring Countrywide (and later Bank of America acquiring Merrill Lynch, and Barclays buying Lehman assets). The Fed also began purchasing the toxic assets on various investment banks books, essentially now making every taxpayer an investor in the bailout. Compounding the issue is the fact that the SEC and the regulatory agencies lacked the oversight and sophistication to fulfill their responsibilities to monitor the investment banks, hedge funds, and other derivative firms which means the Fed was and still is taking a more active role than many otherwise believe it should. The question is still being asked today if these actions are appropriate by the Fed and the case can be made that the financial system was not only nationalized but that the Fed’s actions promote moral hazard and lack of accountability (pg. 6). I believe the most prudent action should be less of a band aid approach of injecting funds into the money supply and that there is a conflict of interest when the Fed begins dictating what assets will be purchased, what banks should be saved, and when the taxpayer ultimately pays the price.
The recent Federal Reserve Bank (“FRB”) monetary policies of continued Quantitative Easing, MBS/CDO purchases, and manipulation of the medium and long term interest rates through Operation Twist have at the most provided continued liquidity and provided somewhat relief to the credit crunch. Essentially the Fed is just printing money with no backing but a promise. One can argue, and I believe it is evident in the fact that we have also experienced a side-ways moving market for some time now, that these actions have been at most very artificial, a band aid, which has not created long term value. Rather an economic malaise has been the experience. The Quantitative Easing has also been geared to keep interest rates at their historical lows with the hopes of stimulating investment in the financial markets (as investors look for higher returns versus the bond markets, especially where “high yield” is extremely uncharacteristic at 4%-6%) and promote new housing and building construction but as we continue to see in the news in recent years, housing and building recovery is arguably still far in the distance.
With respect to fiscal policy, the Bush administration provided a $150 billion stimulus package which “included tax rebates for households and individuals and tax cuts” (pg. 6). However, we know as the Case points out that it is uncertain whether these actions were appropriately targeted, temporary, and timely. Stephen Roach even pointed out that the idea of the stimulus more than likely promotes the idea of excessive consumption which in all actuality was a contributing factor to the crisis occurring in the first place. Even further, it is falsely assumed that the stimulus funds would be used for investments, rather individuals would choose rather to save the funds or pay down debt instead of spending on consumable goods to jump start the economy. Also, many have advocated that rather than pursue such fiscal policies, that the administrations should focus on “fixing problems in the housing sectors” instead of using low rates to solve the problems, again band aid approaches which do not reach the core problems rooted in excessive practices to seek superficially high returns combined with negligent behavior. I truly believe the stimulus was a band aid and has prolonged the economic pain, rather than the Fed, the administration , and the major financial players “come clean” and acknowledge the gravity of the financial crisis, which in turn, would allow a faster track to “hit bottom” in order to begin rebuilding a damaged, but not destroyed financial system. Ideally, we have learned from our mistakes and will not lose sight of our “common sense” again.