Until very recently banks and other lenders have been aggressively supplying home loans to financially stretched individuals — called sub-prime borrowers. A lot of people without adequate streams of income borrowed 100 per cent of the value of a house. The lenders weren’t much concerned about the quality of borrowers because they bundled loans into what is called mortgage backed securities and sold them to other financial organisations such as Wall Street investment banks. In 2006 lenders bundled $449.2 billion of sub-prime loans against $464.6 billion in 2005. Note that in 2004 lenders bundled $363 billion — an increase of 86 per cent from 2003.
Until mid last year sub-prime mortgages drew little media attention — all that however, has started to change with the fall in house prices. Year-on-year the median price of existing homes fell by 2.1 per cent in May after a fall of 1.3 per cent in April. This was the 10th consecutive monthly decline. A weakening in economic activity coupled with a fall in home prices has lifted mortgage delinquencies. The number of home foreclosures rose 19 per cent in May from April to 176,137. The yearly rate of growth jumped to 89.9 per cent from 62 per cent in April. Sub-prime foreclosures as a percentage of total home loans rose to 5.1 per cent in Q1 from 4.5 per cent in the previous quarter. In Q2 2005 this figure was 3.3 per cent.
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Growing foreclosures are currently causing concern among investors in mortgage backed financial instruments constructed by Wall Street financial engineers. The sub-prime mortgage loans have been packaged by Wall Street financial wizards into attractive investment products - called collateralised debt obligations (CDO’s). A chunk of the CDO’s is constructed to yield high returns and to carry high credit ratings. In short, low quality debts were converted, by means of Wall Street alchemy, into a high quality and supposedly risk free investment, which also offers attractive yield.
But heavy losses incurred at two Bear Sterns Co hedge funds, which were heavily invested in the lower grade parts of the sub-prime backed CDO’s have raised fears that these financial products may be a more risky investment than many investors previously thought. Some experts are of the view that all this raises the likelihood that the value of these CDO’s is likely to come off and this could put pressure on the net worth of many investors.
It is also held that as a result of all this the pressure on banks’ capital will slow down significantly bank lending, which could undermine activities of various financial operators. It is further argued that Wall Street financial engineering is not only applied to sub-prime mortgages but also to various other debts. Hence there is a threat that all this could set in motion a financial accident of a serious dimension.
Many commentators are of the view that the Fed should have imposed controls on the activities of Wall Street wizards. It is argued that on account of Wall Street alchemy investors have under-estimated the risk incurred on the investment in various products generated by Wall Street financial engineers. If a financial accident were to erupt should we blame Wall Street financial engineering for it, which allegedly caused investors to underestimate the risk of mortgage loans? We suggest that should an economic bust occur the prime cause for it will not be financial engineering but the policies of the Fed. The essence of the problem is the financial bubble that the Fed has created.
What is a financial bubble?
We can define a bubble as activities that have emerged on the back of loose monetary policy of the central bank. In the absence of monetary pumping these activities would not have emerged. Since bubble activities are not self-funded, their emergence must come at the expense of various self-funded or productive activities. This means that less real funding is left for real wealth generators, which in turn undermines real wealth formation. (Monetary pumping gives rise to a misallocation of resources, which as a rule manifests itself through a relative increase in non-productive activities against productive activities).
When new money is created, its effect is not felt instantaneously across all market sectors. The effect moves from one individual to another individual and thus from one market to another market. Monetary pumping generates bubble activities across all markets as time goes by.
In similarity to any other businesses, participants in financial markets are trying to “make money”. It is this that gives rise to the creation of various products like CDO’s in order to secure as big a slice possible of the pool of newly created money. (Financial entrepreneurs are basically trying to exploit opportunities created by the Fed’s loose monetary stance and get as much as possible out of the expanded pool of money). So in this sense various financial instruments like CDO’s should be seen as part of a bubble activity.
The housing boom that we have been witnessing and the incentives that it generated for Wall Street financial engineers has come in response to the aggressive lowering of interest rates between December 2000 and June 2004. During that period the federal funds rate target was lowered from 6.5 per cent in December 2000 to 1 per cent by August 2003. As a result the 30-year fixed mortgage rate fell from 7.4 per cent in December 2000 to 5.2 per cent by June 2003.
Between Q3 2001 to Q4 2004 the average yearly rate of growth of our monetary measure AMS stood at 7.5 per cent. This should be contrasted with the rate of growth of 2 per cent in Q2 2001 and 0.9 per cent in Q4 2000.
As long as the Fed kept pushing money into the system to support the low interest rate target various activities that sprang up on the back of the loose stance appeared to be for real. When money is plentiful and interest rates are extremely low investment in various relatively high yielding assets that masquerade as top-notch grade investment becomes very attractive. The prompt payment of interest and a very low rate of defaults further reinforce the attractiveness of financially engineered investment products. Once, however, the central bank tightens its monetary stance, i.e. reduces monetary pumping, this undermines various bubble activities.
(Remember that bubble activities cannot stand on their own feet. They survive through money out of “thin air”, which diverts real funding to them from wealth generating activities).
Since monetary pumping generates bubble activities across all markets, obviously the eventual bursting of the bubble permeates all markets — including the housing market. Hence contrary to popular thinking financial instruments such as CDO’s cannot cause general economic bust. These instruments are just a manifestation of the Fed’s loose monetary stance. The reason for currently observed problems in the housing market is the tighter stance that the Fed adopted from June 2004 — the fed funds rate target was raised from 1 per cent to 5.25 per cent currently. As a result the mortgage interest rate on the 30-year fixed rate rose from 5.6 per cent in May 2005 to 6.8 per cent in July 2006.
In response to the tighter stance the growth momentum of our monetary measure AMS has been in visible downtrend since Q4 2004. The yearly rate of growth fell from 7.1 per cent in Q4 2004 to 0.9 per cent in Q1 2007. The current weakening in economic activity is also in line with the lagged yield curve (the difference between the long-term T-Bond rate and the fed funds rate), which depicts the interest rate stance of the Fed. In short, what is happening in the housing market should be seen as the result of the Fed’s boom-bust monetary policies.
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It remains to be seen whether a fall in the growth momentum of AMS since 2004 will lead to a significant decline in economic activity in the months ahead. For the time being, our monetary analysis, which employs the lagged growth momentum of AMS adjusted for price inflation, points to a mild slowdown. The rate of growth of industrial production is forecast to fall from 4 per cent in 2006 to 2 per cent this year whilst the rate of growth of real GDP is forecast to ease from 3.3 per cent in 2006 to 2 per cent this year.
Obviously all this could change rapidly if the pool of real funding should come under severe pressure. Elsewhere we have suggested that as long as the outside world, and in particular China, is still doing ok this should provide support for the US pool of real funding. Should trouble emerge with this pool we maintain that it will manifest itself through a sharp fall in bank lending and in turn in large declines in money supply and monetary liquidity.
A fall in liquidity in turn exerts strong upward pressure on long-term interest rates and the mortgage rate. (Needless to say this cannot be good news for the housing market). The latest data for commercial bank credit expansion continues to indicate that bank lending is still holding its ground. So far in June the yearly rate of growth stood at 8.2 per cent against 7.7 per cent in May.
(Note that only commercial banks can create credit out of “thin air”. Hence once banks slow down on the expansion of credit out of “thin air” this undermines the rate of growth of money supply and monetary liquidity).
In the week ending June 18 the yearly rate of growth of our liquidity measure has fallen to negative 4.1 per cent from negative 3.8 per cent in May. Despite a decline in the growth momentum the underlying up-trend in the yearly rate of growth, which started in August 2006 is still intact.
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Various experts including Greenspan and Bernanke are of the view that financial instruments such as CDO’s are the manifestation of free market risk management. It is held that these products enable investment risk to be spread and thereby prevent sudden financial disruptions, or financial accidents. However, regardless of how widely the risk is spread this cannot prevent the deflation of the bubble once the Fed tightens its stance. Note that what keeps the financial bubble alive is Fed’s loose monetary policies. Hence it is not possible to prevent the deflation of the bubble once the central bank tightens its monetary stance. In short, the subject of the risk spreading whilst the central bank tampers with financial markets is beside the point.
Summary and conclusion
Heavy losses incurred by the two Bear Stern Co hedge funds which invested in financial instruments backed by a sub-prime mortgages has raised concern among experts that Wall Street financial engineering runs the risk of destabilising the economy. It is held that various financial products created by Wall Street financial engineers causes investors to underestimate the true risk associated with a given investment. Hence it is argued that what is needed is to introduce regulations as far as financial engineering is concerned.
We suggest that various financial products that Wall Street creates are not to blame for a possible financial accident. We have shown that financial instruments cannot create the bubble and that they are in fact the components of the bubble. The main source of the bubble and a possible accident is the Fed’s loose monetary policy. Through monetary pumping the Fed creates an environment for various non-productive activities — the components of the financial bubble. Once the Fed tightens its stance it puts a squeeze on various activities that comprise the bubble.
The best way to prevent the burst of the bubble and the so-called financial accident is not to make the bubble in the first instance. This means that the various sources of money creation out of “thin air”, predominantly Fed’s tampering with financial markets, must be sealed off.
Dr Shostak is a former professor of economics who now works in the private sector
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