If Monetary Policy Can’t Do the Job, Then What?
March 04, 2008
By Richard Berner | New York
Aggressive monetary ease hasn’t thwarted a credit crunch, especially in mortgage lending − at least, not yet. Losses are mounting, some financial markets remain dislocated, and lenders continue to tighten standards and credit availability. It appears that ongoing Term Auction Facility (TAF) auctions are needed to prevent liquidity from drying up again in money markets. And there’s little sign that housing or home prices have bottomed; indeed, incoming data increasingly suggest that tighter financial conditions are affecting the economy at large. If the credit squeeze continues and the economy continues to weaken, proposals to help struggling homeowners will likely continue to multiply. What remedies beyond further monetary ease might actually ease financial conditions? And what are the risks of putting the burden of battling the credit crunch entirely on monetary policy?
Not surprisingly, there are no simple remedies. Lifting the GSEs’ portfolio caps and gradually reducing capital surcharges will take time and offer limited help. Proposals to aid homeowners directly at lender expense could be counterproductive. Good bank-bad bank ‘carve-outs’ are a good solution, but private capital must be found to finance them. Efforts to alleviate balance sheet strains with taxpayer funds are fraught with moral hazard. Nonetheless, patience is wearing thin in Washington and the risk is growing that a rescue plan will gain traction in the Congress. Even if such plans aren’t enacted, the debate will have important consequences for financial markets. And there are significant risks in using monetary policy alone. Here’s why. Mortgage Losses Mounting To assess the scope of the credit squeeze, we need to dimension the potential losses in mortgage lending, the proximate source. We have been working with an assumption that they might reach $200-250 billion, but that appears to be too low. We now estimate that mortgage losses may reach $400 billion over the next two years. The methodology is detailed in a report by David Greenlaw et al., “Leveraged Losses: Lessons from the Mortgage Market Meltdown,” US Monetary Policy Forum Conference, February 29, 2008. The estimates are derived from several models. One extrapolates the loan performance of successive ‘vintages’ of subprime and other mortgage loans, adjusted for declines in home prices. A second model uses market prices to obtain a market-based loss estimate. A third model uses the historical experience of losses in regions in which home prices have declined in the past, such as California, Texas and Massachusetts. This last model provides an estimate of the cumulative ‘excess’ (over a baseline) foreclosures of about 13.5% and then assumes 55-60% repossession and 50% loss severity rates, to arrive at an estimate of overall losses. The striking feature of these three approaches is that they all yield estimates of about $400 billion in losses, about half of which are borne by banks or other institutions for whom losses will erode their capital base. The financial and economic consequences of these significant losses are straightforward. Rising losses will erode lender capital and thus promote further deleveraging of lender balance sheets as capital ratios shrink. Lenders can continue to raise new capital, but I suspect that, as losses mount, the terms on which investors offer it will become increasingly stringent. Moreover, rising losses likely will continue to force banks to bring assets back onto balance sheets that they find difficult to fund off the balance sheet. The combination of capital constraints and ‘reintermediation’ of the banking system will keep financial conditions restrictive. This financial restraint will limit housing demand and extend the ongoing vicious circle of decline in housing activity. Weakening demand boosts the excess in housing supply over demand, manifest in nearly 10 months’ supply of new, 1-family homes. That imbalance is depressing home prices, and would-be buyers are loath to step up while prices are falling. Falling prices, as noted above, intensify the deterioration in mortgage credit quality, increasing lender risk aversion and financial restraint. Real home prices now seem likely to decline by a cumulative 15% by early 2009, restraining household wealth and consumer spending. The spiral won’t last forever; such a price decline should restore housing affordability to levels consistent with a housing recovery. The issue is whether the collateral damage to the economy along that painful path will trigger an ‘adverse feedback loop’ that spills over into the rest of the economy. More Action from the Fed Both Fed Chairman Bernanke and Vice-Chairman Don Kohn have made it abundantly clear that concerns about such a feedback loop dominate any near-term worries about upside inflation risks. As a result, we now expect that the Fed will lower the funds rate by 50bp at the March 18 FOMC meeting, validating market expectations. Previously, we expected the FOMC to reduce the funds rate by 25bp at the March meeting. Moreover, we believe that their three biggest concerns − tightening credit conditions, weakening housing, and a softening labor market − are unlikely to show any notable improvement over the next several months. Thus, we now look for the FOMC to reduce the fed funds rate target to 2% at their meeting on April 30. We expect this to be the last move in the easing cycle. Tax rebate checks will begin to flow shortly after the April FOMC meting. The fiscal stimulus is only a temporary fix, but it may boost the economy by enough to buy some time while economic and market headwinds begin to fade. In addition, we sense that Fed officials are extremely reluctant to reduce rates to the levels they did in 2003. Finally, we continue to look for the Fed to begin to recalibrate policy at the first sign of some stability in the economic climate – a theme that was emphasized in the latest FOMC minutes. Thus, we still expect a tightening toward the end of year, with the funds rate target winding up 2008 at 2.25%. Legislative Policy Risk But even this uncertain and wobbly outlook is subject to downside risks. If the combination of monetary and fiscal stimulus fails to get traction, the adverse feedback loop might intensify, promoting, as Chairman Bernanke noted in testimony this week, bank failures and systemic risk. Thus, it is hardly surprising that both Congressional leaders and thoughtful observers are considering alternative, unconventional tools to help alleviate the crunch and short-circuit that feedback loop. What might some of those tools be? Some have already been enacted. The Mortgage Forgiveness Debt Relief Act of 2007 allows borrowers to exclude from taxable income any mortgage debt that is forgiven through foreclosure or because of loan renegotiation. OFHEO this week lifted the voluntary caps on the GSEs’ portfolios, and intends to reduce gradually the 30% capital surcharge imposed following the revelation of accounting irregularities. Together with the earlier hike in the conforming loan limit from $417,000 to as high as $729,500, these steps will allow the GSEs to expand their purchases of conforming mortgages effective March 1. However, the GSEs’ prospective losses could absorb some of that surplus capital, so they are likely to conserve it, and thus these steps likely will take time to implement and offer limited help (for discussion of the impact of the change in the conforming loan limit, see Janaki Rao, Increase in Conforming Loan Size Limits: How Will it Affect Us?, January 28, 2008). Proposals to aid homeowners directly at lender expense are also under discussion. Some are voluntary, relying on enlightened self-interest. For example, under a voluntary plan organized by the Treasury Department, the Hope Now Alliance, and the American Securitization Forum, participating mortgage servicers would freeze the interest rates of certain categories of subprime ARMs for five years at the introductory or "starter" rate. The non-binding program is designed to give loan servicers greater flexibility and certainty in quickly modifying troubled mortgage loans. Spearheaded by the Treasury Department, "Project Lifeline" involves a commitment by top lenders to reach out to borrowers who are 90 days delinquent and suspend any foreclosure proceedings for 30 days so that a loan modification can be contemplated. Because these are voluntary, these plans may help, but with limited impact. In contrast, plans mandating aid to homeowners at lender expense could be counterproductive because they would add significant risk premiums to new loans. Likewise, proposals that would allow bankruptcy judges to change the principal and interest rate terms of the mortgages of borrowers who declare Chapter 13 bankruptcy protection likely would also be counterproductive because they would add significant risk to new loan contracts. Ideally, private capital would finance a good bank-bad bank or ‘carve-out’ solution to the problem, in which distressed assets are sold at a deep discount to investors with more financial strength than the current holder. The new investor hopes to realize a gain relative to that discount by patiently working out the credit. The burdened institution realizes a loss but is able to focus remaining capital and resources on new business. However, the cost of private capital to finance distressed portfolios is rising, and the current lenders are not yet motivated sufficiently to take haircuts large enough to make carve-outs attractive. Efforts to help homeowners or to alleviate balance sheet strains with taxpayer funds are also appearing. House Financial Services Chair Barney Frank proposes making community development block grants to the states to purchase foreclosed properties and rent them to previous owners. Others that would guarantee loans are fraught with moral hazard. Some would reduce the risk to the taxpayer by offering the guarantor (the taxpayer) an equity participation in the property. For example, Chairman Frank proposes that lenders be required to take a partial loss on troubled loans, and that distressed borrowers refinance the remainder (the fair market value) with a loan guaranteed by the Federal Housing Administration (FHA). The FHA and the lender might share in a warrant that would be redeemed if the house were sold at a higher price. The Office of Thrift Supervision has a similar proposal, further allowing the warrants, called “negative amortization certificates,” to trade publicly. While stress is mounting in financial markets, it probably hasn’t reached the point at which lawmakers on both sides of the aisle are willing to approve such unconventional ways of dealing with the credit crunch. Unlike in the late 1980s when the savings and loan crisis threatened the payments mechanism and broader financial stability, there are no depositors to bail out. Opposition to proposals that would bail out lenders or homebuyers for bad decisions is legitimate, and the Administration’s threat to veto any of these proposals is understandable. However, there is still a risk that even aggressive monetary policy won’t mitigate the adverse feedback loop. And even if monetary policy is up to the task, Fed officials themselves likely are worried about the potential for undesired consequences of such an aggressive policy stance. For example, lowering rates to 1% may create distortions in market pricing, as seemed to occur in 2003 and thereafter. Maintained for too long, such an expansive policy could rekindle inflation expectations. As a result, despite the obvious hurdles, I think investors should pay heed to Congressional efforts to cut the credit crunch Gordian knot. Even if none is implemented, talk of alternative remedies may reduce the markets’ bets on further aggressive Fed ease, and flatten the yield curve. Thus, rate volatility seems likely to increase.
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Review and Preview
March 04, 2008
By Ted Wieseman | New York
Treasuries posted huge front-end-led gains (but with the belly of the curve holding in very well) over the past week after small losses through Wednesday were sharply reversed by a massive flight to safety/spread trade unwind rally Thursday and Friday as various markets moved into increasingly disorderly seeming breakdowns after what had in two recent focus areas − corporate credit and commercial real estate − been decent recent improvements that lasted through the first part of the week. The corporate credit CDX and commercial real estate CMBX indices had been posting decent recoveries through early in the week off the all-time wides hit earlier in the month. But this drastically reversed course in the back half of the week, with big sell-offs Thursday and Friday sending both markets to new all-time wides at Friday’s close, while sending investors in these markets running for Treasuries. Various other markets were also in increasing disarray over the course of the week, further fueling the flight to safety. The already-struggling municipal bond market had deteriorated into just about a freefall by late in the week, providing a particular focus for the Treasury fear trade Friday. The dollar was crushed to new lows as commodity prices surged to new highs, and whatever the longer-term inflationary implications of these moves might be, the initial reaction at least to the increasingly disorderly-seeming developments in these markets was to seek safety in Treasuries. Rising inflation fears, however, were certainly made clear by an extraordinarily strong performance by TIPS on the week. Interbank lending dislocations badly deteriorated, with the spread of 3-month LIBOR over the expected fed funds rate over the next three months surging to the highest level since mid-December, as LIBOR barely budged while an ever-more-dovish Fed path was priced into futures. The Fed repricing − which cut the expected funds rate trough to 1.75% from 2% and significantly scaled back the expected reversal off that low into 2009 − was implicitly given a green light by Fed Chairman Bernanke and Vice Chairman Kohn, who both clearly focused on downside risks to growth and the Fed’s determination to address them while giving little attention to inflation risks. All the disorder across various markets was probably exacerbated by somewhat restrained liquidity as several primary dealers faced quarter-end balance sheet constraints, possibly a preview of what could be much worse dislocations moving through March as a much broader range of banks and brokers reach their quarter-ends. On the week, benchmark Treasury coupon yields plunged 16-35bp, with the gains more than accounted for by huge back-to-back rallies on Thursday and Friday. The 2-year yield fell 35bp to 1.63%, the 5-year 30bp to 2.50%, the 10-year 27bp to 3.52% and the 30-year 16bp to 4.42%. This left 2s-30s at +279bp, at a new high since mid-2004, but with the relatively very strong performance of the 10-year, 2s-10s at +189bp is still a bit below the closing high of +193bp hit February 14. TIPS put in an extremely strong showing, actually managing easily to outperform such a huge rally in nominals as inflation fears were stoked by the surge in commodity prices, the plunge in the dollar and ugly inflation PPI and PCE inflation reports. TIPS strength didn’t seem to come so much from actual buying of TIPS by traditional investors in the area as from the indirect impact of investors focused on other asset classes looking to put on inflation hedges of various sorts in the interest rate space. The 5-year TIPS yield actually turned negative Friday (joining all other TIPS with shorter maturities) after rallying 44bp on the week to -0.02%. The 10-year yield fell 39bp to 1.04% and the 20-year 22bp to 1.73%. Focus during the huge rally Thursday and Friday were major, in many cases disorderly, losses in various markets − both from a powerful flight to safety rally and a more direct impact in some cases as trades gone wrong were unwound. After hitting an at the time all-time closing wide of 157bp on February 21, the 5-year investment grade CDX index improved to 135bp Tuesday, before sharply reversing course to end the week at a new all-time wide of 166bp, 13bp worse on the week. The widening was particularly severe Thursday and Friday, with the market appearing to be suffering badly from negative convexity as the need by investors in certain structured products to buy more protection rose as the index kept widening. The commercial mortgage CMBX market similarly had been extending a recent improvement early in the week before sharply reversing course. On the week, the AAA index widened 26bp to 212bp, the AJ (junior AAA) 61bp to 547bp, and AA 29bp to 676bp. The latter two were all-time wides, while the AAA was holding a bit below its worst close of 228bp hit February 11 after a modest improvement Friday. At the beginning of the year, the AAA index was trading at 65bp, the AJ at 174bp, and the AA at 274bp, so the deterioration in the past two months has been huge and obviously bad news for anyone marking commercial real estate positions to market based on the CMBX. Recent losses in the subprime ABX market haven’t been as abrupt as the recent losses in CDX and CMBX, but downside over the past month has been steady and almost uninterrupted, with all the indices ending February at or very close to all-time lows, the AAA index having fallen more than 10 points for the month to 60.04. Joining the losses in these markets as a major focus late in the week, and the single-biggest area of concern Friday, were major losses in municipal bonds, particularly on a spread basis as Treasuries were surging. One modest positive on the week was some improvement in the leveraged loan LCDX index, which at least through the midday pricing Friday was 22bp tighter on the week at 473bp, though this still represented a 164bp year-to-date widening. The key takeaway from Fed Chairman Bernanke’s testimony and Vice Chairman Kohn’s preceding speech (which actually provided a much more thorough overview of the Fed’s outlook), was that the absence of a stepped-up concern regarding inflation risks could be interpreted as validation of the market’s expectation of a 50bp rate cut at the March 18 FOMC meeting. As a result, we changed our Fed outlook. We now look for the FOMC to cut the funds target to 2.50% on March 18 instead of just 25bp. Moreover, we believe that the three fundamental risks that officials appear to be most closely focused on – the credit crunch, the housing recession and the weakening labor market – are unlikely to show any improvement over the next several months. So, we now look for the FOMC to reduce the fed funds rate target another 50bp to 2% at their meeting on April 30. With the tax rebate checks expected to start arriving shortly thereafter, we expect this to be the last move in the easing cycle. The fiscal stimulus certainly does not represent a permanent fix, but we believe that it will provide a significant short-term boost to the economy and buy some time while the other economic and market headwinds are worked through. In addition, we sense that Fed officials are extremely reluctant to reduce rates to the levels they did in 2003. We continue to look for the Fed to begin to recalibrate policy at the first sign of some stability in the economic climate – a theme that was emphasized in the latest FOMC minutes. Thus, we still expect a tightening towards the end of year, with the funds rate target winding up at 2.25% at end-2008 and 4% at end-2009. After a significant repricing over the past week, the market’s near-term Fed view is somewhat more dovish than our revised outlook, with a 75bp rate cut at the March FOMC meeting now priced in, followed by 25bp cuts in April and June. There is much bigger divergence between our outlook for policy moving into 2009, with the market much more skeptical about the possibility of a meaningful reversal in rates any time soon. On the week, the April fed funds contract gained 16.5bp to 2.33%, the May contract 30bp to 1.985%, July 31bp to 1.82% and the low-rate September 30bp to 1.77%. Eurodollar futures gains were led by a 53.5bp surge by the Sep 09 contract to 2.62% and a 51bp gain in the Dec 09 contract to 2.865%. The low-rate Sep 08 and Dec 08 contracts gained 30.5bp to 2.215% and 35.5bp to 2.21%, respectively. So, the expected increase in rates in 2009 off the lows in the second half of this year was significantly scaled back, with the Sep 08 to Sep 09 spread falling 23bp to 40.5bp and the Dec 08 to Dec 09 spread 15.5bp to 65.5bp. In the face of this big Fed repricing, 3-month LIBOR only managed to fall 2bp on the week to 3.06%, resulting in a big blow-out in LIBOR/OIS spreads. The 3-month LIBOR/3-month OIS spread jumped 25bp on the week to 77bp. Aside from a temporary distortion on the day of the Fed’s intermeeting rate cut, this was the high since December 20. Despite this severe deterioration, the Fed announced Friday that it would not be increasing the size of the TAF program. The upcoming auctions on March 10 and March 24 will again be US$30 billion, merely rolling over the maturing February loans. It was busy week for economic news, but the data were largely ignored. Information pertaining to GDP growth were modestly positive. Fourth quarter growth was held at +0.6% instead of the small upward revision we expected, but the downside surprise was in inventories, pointing to a smaller negative in 1Q. There was also an upside surprise in inventories in the durables report, though capital goods shipments were weak, continuing to point to a decline in investment in 1Q, and we now see inventories as neutral for 1Q growth instead of a small negative. In addition, real consumer spending was flat again in January instead of the small decline we expected, leading us to raise our 1Q consumption forecast to +0.6% from +0.3%. Combining the small inventory and consumption upside, we raised our 1Q GDP forecast to -0.2% from -0.5%. On the negative side, home sales results remained weak and inventories of unsold homes continued to surge higher, the Conference Board’s measure of consumer confidence joined the previously reported collapses in the Michigan and ABC surveys, all the remaining regional manufacturing surveys were weak after the previously reported soft results from the Philly Fed and Empire State, confirming expectations for drop in the ISM, and jobless claims deteriorated again, pointing to another weak employment report. Meanwhile, core inflation posted an elevated monthly gain in January, and though the year-on-year pace held steady, it is set to move significantly higher in coming months as base effects turn much less favorable. And producer price inflation spiked to its highest annual rate since 1981. Real GDP growth in 4Q07 was unrevised at +0.6%, with a larger-than-expected downward adjustment to inventories the surprise. Inventory accumulation was adjusted down to -US$10.2 billon (a -1.5pp contribution to GDP growth) from -US$3.4 billion (-1.3pp), providing an easier comp for 1Q. On top of this, durable goods inventories rose a much higher-than-expected 0.6% in January. As a result, we now see inventories being neutral for 1Q growth instead of a small negative. As expected, final domestic demand growth was revised down slightly in 4Q to +1.2% from +1.4%. We see 1Q final domestic demand on pace for a 1.1% decline, a little better than our previous estimate, thanks to a flat reading for real consumption in January − the third unchanged reading in the past four months − instead of the small decline we anticipated. We expect this stagnation in consumer spending to continue in February and March, leaving 1Q consumption up just 0.6%, which would be the smallest quarterly increase in over 16 years. Meanwhile, non-defense capital goods ex-aircraft shipments ticked up 0.1% and December (+1.7%) was revised lower, leaving 1Q on track for a decline in equipment investment. The absolute shipments numbers have not been that weak, but the issue from the domestic perspective is that capital goods exports are showing strong growth − surging at a 21% annual rate in 2H07 − so shipments for domestic purposes are much weaker than the overall numbers. We see overall investment falling 4% in 1Q, with the equipment and software component down 5.5%. In addition, residential investment in 1Q is on pace to post a near-record 32% plunge. On the positive side, upwardly revised net exports added 0.9pp to 4Q growth (for a full year add of 0.8pp, a high since 1980), and we look for similarly big positive contribution in 1Q. If we do start to see economic recoupling going forward, the US economy is going to be in much worse shape. Falling home sales that worsened an already terrible inventory situation provided support for our expectations of a further intensification of the housing recession in the first part of this year. New home sales fell 2.8% in January to a 588,000 annual rate, a 13-year low. The number of homes available for sale fell a smaller 2.2%, causing the months supply of unsold homes to rise to 9.9 from 9.5, a high since 1981, and way above the 5-6 months that would be consistent with a balanced market. We look for a further 30-35% drop in single-family housing starts − which have already fallen 60% from the January 2006 peak − to bring inventories into line over the next year. Meanwhile, existing home sales dipped 0.4% in January to a 4.98 million unit annual rate. Sales of single-family homes actually rose slightly for the first time in a year, but condo sales fell sharply. The number of homes available for sale rose 5.5%, pushing months supply up to 10.3, just below the recent peak of 10.5 hit in October. This out-of-control inventory situation will continue to pressure home prices, which showed marked further deterioration at the end of last year in both the Case-Shiller and OFHEO reports released the past week. Inflation numbers continued to look ugly. The producer price index is running at levels not seen since the Great Inflation of the 1970s and early 1980s. Annual core consumer inflation has shown a significant recent acceleration as well, though this has been masked in the annual numbers recently by favorable base effects. But these base effects are set to swing sharply in the other direction going forward. The producer price index surged 1.0% in January for a 7.4%Y rise, the biggest annual increase since 1981, on sizable gains in both food (+1.7%) and energy (+1.5%) and the largest increase in the core (+0.4%) in nearly a year. Upside in the core was broadly based, with both capital goods (+0.4%) and core consumer goods (+0.4%) posting elevated gains. News at earlier stages of production was also ugly. Headline readings were boosted by food and energy upside. And both the core intermediate (+0.8%) and core crude materials (+4.0%) gauges also surged, with upside in metals prices key drivers. Meanwhile, the core PCE price index rose an elevated 0.3% in January, though the year-on-year rate held steady at 2.2%. The recent trend has been well above that, however. Over the past three months, core PCE inflation has risen at a 3.0% annual rate, and 2.8% in the past six months. Last year, it rose only at a 1.6% annual rate during the seven-month period from January to August, and that tough year-ago comparison will likely put steady upward pressure on the year-on-year rate of core PCE inflation in the months ahead. We do expect that the slack in the economy, engendered by the recession we see currently unfolding, will eventually lead to a significant moderation from the recent elevated pace going forward, but for now core inflation is likely to continue drifting higher. A number of key data releases are due out in the coming week as the initial round of February data are released − manufacturing ISM and motor vehicle sales Monday, non-manufacturing ISM Wednesday, chain store sales Thursday and employment Friday. Results are likely to be weak across the board. It is also a heavy week for Fed news, with a lot of speakers scheduled, including Chairman Bernanke Tuesday and Vice Chairman Kohn Friday and the Beige Book prepared for the upcoming FOMC meeting released Wednesday. Other data releases due out include construction spending Monday and revised productivity and factory orders Wednesday: * We forecast a February manufacturing ISM reading of 49.0. Based on the regional results, which were soft across the board, we look for a reversal of the surprising uptick that was posted in January. In particular, the production component seems likely to register a pullback. Finally, the price index is expected to remain quite elevated in February. * We expect construction spending to fall 1.3% in January. The recent trend in housing starts points to another sharp drop in the residential category. Meanwhile, commercial construction has been holding up quite well but appears poised for some significant moderation going forward. We look for a dip in the non-residential component to about offset an expected rebound in the government category, following a surprising decline in December. * Based on widespread anecdotal reports of continued deterioration, our autos team looks for sales to fall further to a 15.0 million unit annual rate after plunging last month, which would be the second-worst month since the 1998 GM strike. Activity clearly appears to have fallen significantly further this year after moderating from 16.5 million units in 2006 to 16.1 million in 2007. On top of the broader deterioration in the consumer spending picture, this appears to reflect the fact that automakers have pared excess capacity and are now less anxious to prop sales up with aggressive incentive offerings. * We forecast a 2.0% decline in January factory orders. A good price-supported gain in the non-durables component should provide a decent offset to the plunge in durables, which was concentrated in aircraft, but still leave overall factory orders down sharply. Durable goods shipments, on the other hand, were up sharply in January, which along with the expected upside in non-durables should lead the I/S ratio to fall two-tenths to 1.22. * We look for a 40,000 increase in February non-farm payrolls. Although we believe that the demand for labor is moderating on an underlying basis, payrolls are expected to post a modest rebound in February. In particular, we look for gains in categories − such as government and business services − which may have been artificially depressed in January due to a holiday calendar shift. However, an accelerated pace of decline is likely in some other sectors such as construction. Many parts of the nation experienced significantly milder-than-usual weather conditions around the time of the January survey period, and we could see some payback in the February report. Finally, the jobless rate is expected to reverse the downtick that was registered in January, rising to 5.0%.
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