The Fed today unveiled a set of proposed amendments to Regulation Z, the collection of rules intended to ensure "truth in lending." Why is this big news? Mainly because it is the Fed's long-awaited response to the unfolding subprime debacle. Many have been highly critical of the Fed for failing to take proactive steps to curtail abuses in subprime lending. (See this article in today's New York Times.) And many will surely be critical of the Fed's proposed amendments as "too little, too late."
Still, the Fed's document is groundbreaking in at least one respect: it explicitly acknowledges the problem of market failure in the business of loan origination, and it even uses that term repeatedly in giving the background for the proposed changes. Manifestations of these market failures include the "yield spread premiums" paid to mortgage brokers, the failure to escrow tax and insurance payments--and even the coercion of appraisers. This represents a real shift from the Fed's more laissez-faire policy of recent years. Even more remarkable is that the person leading the effort to overhaul Reg Z was governor Randy Kroszner--a University of Chicago professor with ties to the American Enterprise Institute. Economists with Kroszner's background tend to emphasize the power of markets, rather than their limitations. So give the Fed, and Kroszner, credit for recognizing that markets can, and do fail. That's cold comfort to those who have already been burned in the subprime debacle, of course. Let's just hope that, by making markets work better, tinkering with the obscure provisions of Reg Z will help avert the next catastrophe.
Update: another five seconds of fame! Check out my sound bite on this evening's edition of Marketplace.
Tuesday, December 18, 2007
Risky Business
In a recent Wall Street Journal interview, Philadelphia Fed President Charles Plosser expressed concerns about the FOMC's "balance of risks" statement, saying that it can "put the committee in an awkward position. Markets often use our balance of risks to infer something about what they think the path of the funds rate is going to be..."
Plosser makes a good point: ideally, the FOMC's statement should communicate a sense as to how the Fed would respond to new information, rather than drop hints about the next change in the target rate. The FOMC's old "asymmetric directive" with its "woulds and coulds" was abandoned precisely because it was widely believed to provide a good forecast of the next rate change. It was hoped that the "balance of risks" formulation would address Plosser's concerns, but clearly it hasn't: instead, it seems to have become a substitute, at least in the minds of market participants, for the "tilt" in the asymmetric directive.
Probably the only way to deal with the problem is to increase the bandwidth of Fed communication. Fedwatchers will always be in the business of forecasting the FOMC's next move, of course. But so long as the FOMC's announcements are accompanied by brief, formulaic statements, Fedwatchers will interpret even the smallest changes in the wording of those statements as a signal of -- or worse, an implicit commitment to -- future target rate changes.
Plosser makes a good point: ideally, the FOMC's statement should communicate a sense as to how the Fed would respond to new information, rather than drop hints about the next change in the target rate. The FOMC's old "asymmetric directive" with its "woulds and coulds" was abandoned precisely because it was widely believed to provide a good forecast of the next rate change. It was hoped that the "balance of risks" formulation would address Plosser's concerns, but clearly it hasn't: instead, it seems to have become a substitute, at least in the minds of market participants, for the "tilt" in the asymmetric directive.
Probably the only way to deal with the problem is to increase the bandwidth of Fed communication. Fedwatchers will always be in the business of forecasting the FOMC's next move, of course. But so long as the FOMC's announcements are accompanied by brief, formulaic statements, Fedwatchers will interpret even the smallest changes in the wording of those statements as a signal of -- or worse, an implicit commitment to -- future target rate changes.
Wednesday, December 12, 2007
Buzz Cut
Give the Fed credit: today, the central bank announced a new and innovative mechanism of getting more "liquidity" into the banking system, what they're calling a term auction facility. Basically, you can think of this as a new and improved discount window -- another way for the Fed to fulfill its function as "lender of last resort."
This kind of facility can come in handy when fundamentally sound banks experience a liquidity crisis: think of Jimmy Stewart's old Building and Loan in It's a Wonderful Life. Banks, many of which can't liquidate their assets quickly enough because the markets for those assets have dried up, will now be able to use them as collateral for borrowing from the Fed. This will allow them to go about their business as usual, and pay off any nervous depositors. In theory, the discount window already serves this purpose -- but banks have historically been shy about discount window borrowing on the grounds that this sends a bad signal about their underlying strength.
Good idea -- but two questions that come to mind are: (1) What exactly are these assets that are going to be pledged as collateral? Are these going to be exactly the same opaque, impossible-to-value CDOs that landed banks in trouble to begin with? If so, what "haircut" will the Fed take (i.e., how much of the asset's supposed value will the Fed lend against)? The advice from the standard central bank playbook on this matter, Bagehot's Lombard Street, is to lend only against good collateral, and only in situations where liquidity -- not solvency -- is the issue. And (2) why would banks prefer to use the term auction facility instead of the more conventional discount window?
In the end, one has to wonder whether the Fed's liquidity enhancing actions can, innovative as they are, really solve the underlying problem: billions and billions of dollars of nonperforming assets. Clearly, there are some serious credit problems out there, and all the liquidity in the world won't solve them. Just ask the Bank of Japan: in its efforts to counter the effects of the collapse of its banking system in the 1990s, the BoJ progressively expanded the range of assets it would accept as collateral for its lending operations. These measures did little to solve the banking problem, of course; that only came with the workout or liquidation of the nonperforming loans. There's no reason to think the U.S. would be any different.
This kind of facility can come in handy when fundamentally sound banks experience a liquidity crisis: think of Jimmy Stewart's old Building and Loan in It's a Wonderful Life. Banks, many of which can't liquidate their assets quickly enough because the markets for those assets have dried up, will now be able to use them as collateral for borrowing from the Fed. This will allow them to go about their business as usual, and pay off any nervous depositors. In theory, the discount window already serves this purpose -- but banks have historically been shy about discount window borrowing on the grounds that this sends a bad signal about their underlying strength.
Good idea -- but two questions that come to mind are: (1) What exactly are these assets that are going to be pledged as collateral? Are these going to be exactly the same opaque, impossible-to-value CDOs that landed banks in trouble to begin with? If so, what "haircut" will the Fed take (i.e., how much of the asset's supposed value will the Fed lend against)? The advice from the standard central bank playbook on this matter, Bagehot's Lombard Street, is to lend only against good collateral, and only in situations where liquidity -- not solvency -- is the issue. And (2) why would banks prefer to use the term auction facility instead of the more conventional discount window?
In the end, one has to wonder whether the Fed's liquidity enhancing actions can, innovative as they are, really solve the underlying problem: billions and billions of dollars of nonperforming assets. Clearly, there are some serious credit problems out there, and all the liquidity in the world won't solve them. Just ask the Bank of Japan: in its efforts to counter the effects of the collapse of its banking system in the 1990s, the BoJ progressively expanded the range of assets it would accept as collateral for its lending operations. These measures did little to solve the banking problem, of course; that only came with the workout or liquidation of the nonperforming loans. There's no reason to think the U.S. would be any different.
Tuesday, December 11, 2007
Panic is counterproductive
So: the Fed cut rates by 25 basis points, and the market tanked! (DJIA down 200 points or so, half an hour after the announcement.) Why?
The answer seems to be that the markets had priced in a roughly 55% likelihood of a full 50 bp rate cut. The average funds rate implied by the December Fed funds futures contract was 4.255%.
But this represents an average for the whole month of December -- and since we already have 10 days at the old rate of 4.5%, futures market participants apparently thought there was a good chance (55% to be exact) of 50 basis points.
Still, this seems like a disproportionate reaction. In a 2005 paper published in the Journal of Finance, Ben Bernanke and I looked at the stock market's reaction to Fed policy, and found that a 1 percentage point "surprise" policy action was typically associated with a roughly 5% change in the stock market. Today's surprise was quite small in the scheme of things: only 12 basis points or so, which would normally have generated only a 0.6% (82 points on the DJIA) market decline. So today's reaction is unusually large by historical standards. Why?
Good question. Obviously, relationships like the one Bernanke and I fitted, will never fit the data perfectly, and there's no point in trying to come up with an explanation for every outlier. Still, the outsize reaction makes one think: was it something the FOMC said -- or didn't say? (There have been plenty of instances where the Fed's statement, as much as the rate change itself, generated major movements in the market.) Was it the failure to cut the discount rate 50 bp to address mounting liquidity concerns? Maybe. Or perhaps in times of financial stress, Fed actions (particularly unpleasant surprises) simply have larger effects on financial markets than they do during "normal" times. That would be an interesting hypothesis to explore -- but with no more than a handful of observations, any conclusions would be pretty speculative!
The answer seems to be that the markets had priced in a roughly 55% likelihood of a full 50 bp rate cut. The average funds rate implied by the December Fed funds futures contract was 4.255%.
But this represents an average for the whole month of December -- and since we already have 10 days at the old rate of 4.5%, futures market participants apparently thought there was a good chance (55% to be exact) of 50 basis points.Still, this seems like a disproportionate reaction. In a 2005 paper published in the Journal of Finance, Ben Bernanke and I looked at the stock market's reaction to Fed policy, and found that a 1 percentage point "surprise" policy action was typically associated with a roughly 5% change in the stock market. Today's surprise was quite small in the scheme of things: only 12 basis points or so, which would normally have generated only a 0.6% (82 points on the DJIA) market decline. So today's reaction is unusually large by historical standards. Why?
Good question. Obviously, relationships like the one Bernanke and I fitted, will never fit the data perfectly, and there's no point in trying to come up with an explanation for every outlier. Still, the outsize reaction makes one think: was it something the FOMC said -- or didn't say? (There have been plenty of instances where the Fed's statement, as much as the rate change itself, generated major movements in the market.) Was it the failure to cut the discount rate 50 bp to address mounting liquidity concerns? Maybe. Or perhaps in times of financial stress, Fed actions (particularly unpleasant surprises) simply have larger effects on financial markets than they do during "normal" times. That would be an interesting hypothesis to explore -- but with no more than a handful of observations, any conclusions would be pretty speculative!
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