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United States Fixing the Credit Crunch – The Growing Case for ‘Unconventional’ Tools United States Review and Preview View GEF Archive

		The Global Economics Team

			Richard Berner
Dick Berner is a Managing Director and Chief US Economist.
			Ted Wieseman
Ted Wieseman is a Vice President and an economist focusing on US fixed income markets.
		Read about other GEF team members

The subprime meltdown and its spread to housing generally continues to boost mortgage defaults and foreclosures — despite aggressive Fed ease, provisions of liquidity, the rescue of a significant financial institution, and significant pending fiscal stimulus.  Notwithstanding the recent rally in financial markets, these developments still threaten to intensify the credit crunch in ways that could deepen and prolong the emerging recession.  Other policy responses designed to alleviate the burden on troubled homeowners and forestall (or at least cushion) an economic downturn are now being mooted in the Congress and considered by the Administration, and I think one or more of these is likely to be passed and implemented this year.

Given enough time and aggressive stimulus, the Fed could fix the credit crunch.  The severity of the problem, however, means that the time would be calibrated in years and the stimulus in hundreds of basis points.  We estimate that US losses in mortgage lending will run at least $400 billion over the next two years (see David Greenlaw et al., Leveraged Losses: Lessons from the Mortgage Market Meltdown, US Monetary Policy Forum Conference, February 29, 2008).  A guess at overall credit losses might put them at $750 billion.  Our large-cap banks analyst Betsy Graseck estimates that the yield curve from Fed funds to 10-year Treasury notes would have to persist at 275 bp for two years to increase net interest margins by enough to offset such losses (see Looking for a Bottom in Financials, March 18, 2008). 

But there is no guarantee that lenders will be eager to supply credit quickly, even after policy acts to offset those losses.  Loan losses, reduced liquidity, and the deleveraging of bank and other intermediaries’ balance sheets are still driving an ongoing reduction in credit availability.  The losses have eroded bank capital, the drying up of liquidity has forced a “reintermediation” of the banking system (and of other leveraged lenders), and the resulting reduction in credit availability has spread to creditworthy borrowers (see “Reintermediation and Monetary Policy”, Global Economic Forum, September 17, 2007).  The capital-raising needed to ease the crunch will also take time.

Beyond reducing the availability of credit, the deterioration in credit quality and increase in volatility have also raised its cost.  The Fed’s creative efforts to boost liquidity at term, to distribute it to lenders outside the banking system, and to accept a broad range of collateral through the TAF, the PDCF and the TSLF have gone well beyond what the Fed has attempted in the past (see “Unconventional Policy Options: Footnotes in the Fed’s Playbook”, Global Economic Forum, August 17, 2007). (These are the Term Auction Facility, the Primary Dealer Credit Facility and the Term Securities Lending Facility.) While credit spreads have narrowed significantly in the past week in response to the Fed’s and Treasury’s actions, and there is certainly a lot of bad news in the price, pending losses and volatility likely mean that a further significant narrowing of spreads will require either more time to work through the credit cycle or more aggressive policy actions.  Thus, we think that it will take time and a recapitalization of lenders to offset the resulting credit crunch. 

Reliance on traditional monetary policy alone risks higher inflation and undue pressure on the dollar.  Indeed, the compromise 75 bp reduction in the Federal funds rate at last week’s FOMC meeting, with dissents by two Reserve Bank presidents, and the post-meeting statement — noting that “some indicators of inflation expectations have risen” — all pointed to a Fed reluctant to take interest rates significantly lower.  That statement helpfully reversed 10 bp or more of the recent escalation in distant (5-year, 5-year) forward inflation breakevens (as measured by the Fed’s smoothed-yield curve), but they remain near historical highs at about 3%.  (Note that market-based measures of distant-forward breakevens collapsed last week, from about 315 bp to 215 bp.  The “true” measure may lie somewhere between these extremes.)

Traditional fiscal policy can partly offset the economic fallout from the credit crunch, with potentially less inflation risk.  Indeed, we expect that the $107 billion of personal tax rebates set to be mailed starting in May will give the economy a moderate, if temporary lift (see “A Darker US Outlook”, Global Economic Forum, March 10, 2008).  But such an approach will only indirectly cushion the fallout from the housing downturn and the credit crunch. 

What about other solutions?  Until two weeks ago, the political climate was unfriendly for mitigating the adverse effects of the subprime meltdown/credit crunch and substantive reform.  The initial hostility arose from a crowded election-year calendar, industry resistance, and legitimate objections to bailing out borrowers and lenders who made bad decisions.  That was then; recent events have changed the outlook, as aggressive initiatives to mitigate escalating market turmoil and the Bear Stearns transaction have altered the financial and political landscape.  Fed and Treasury officials, fearing that the collapse of a major securities firm could create a financial market meltdown, orchestrated its sale and a loan to support its assets pending the closure of the deal.  The framers of new initiatives still need to find the balance between moral hazard and risks to the economy.  But having supported Wall Street with taxpayer funds, officials will find it difficult to argue that struggling homeowners don’t merit assistance. 

A growing case for addressing housing distress.  Thus, both the economic and political cases for using more direct tools to address the housing downturn, slow the decline in home prices, and mitigate the credit crunch are growing stronger.  Since we first addressed this issue three weeks ago and catalogued some of the proposals then on the table, the menu of alternatives has grown (see “If Monetary Policy Can’t Do the Job, Then What?” Global Economic Forum, March 3, 2008).  OFHEO last week announced that the 30% capital surcharge imposed on Fannie Mae and Freddie Mac following the revelation of accounting irregularities would be reduced quickly to 20% in exchange for a promise to raise new capital.  Together with the earlier lifting of the caps on their portfolios, this will allow the GSEs to expand their purchases of conforming mortgages.  However, the GSEs’ prospective losses could absorb some of that surplus capital, so they are likely to conserve it, and thus these steps may offer limited help.  This week’s decision to allow the Federal Home Loan Banks to expand their investments in MBS will also help market functioning.

Efforts to help homeowners or to alleviate balance sheet strains with taxpayer funds through agencies like the Federal Housing Administration (FHA) are also appearing.  The most prominent is a draft proposal from House Financial Services Chairman Barney Frank — the FHA Housing Stabilization and Homeownership Retention Act — that would help borrowers refinance into federally insured FHA loans.  Under this proposal, the FHA would provide up to $300 billion in new guarantees that would help at-risk borrowers to refinance with FHA-insured mortgages.  Lenders would be required to take a partial loss on troubled loans, and distressed borrowers could refinance the remainder (the fair market value).  The FHA would also get a warrant or a soft second lien 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.  Chairman Frank also proposes giving $10 billion in community development block grants to the states to purchase foreclosed properties and rent them to previous owners.  Guaranteeing loans carries significant risk to the taxpayer, even with a government equity participation in the property.  In any case, it seems likely that the Congress will pass, and the Administration will sign, legislation containing some of these elements in the next few months.

Still more direct approaches could use the Treasury’s balance sheet instead of the Fed’s to improve market functioning or to offer assistance to homeowners.  The Fed’s new facilities to ease liquidity strains do so by allowing intermediaries to exchange low-quality collateral for higher-quality Treasury debt, with a corresponding, temporary change in the composition of the Fed’s balance sheet.  The Fed will never run out of ammunition to promote such a collateral exchange, but at some point the balance sheet would have to expand, running the risk of an excessively easy monetary policy.  In contrast, as our Morgan Stanley Investment Management colleague Paul O’Brien notes, the Treasury could more easily offer investors the risk-free asset they want by supplying more of its own liabilities in exchange for agency debt or MBS.  Equally, the Treasury has the ability to guarantee a large volume of loans either through the FHA or directly to assist struggling homeowners.  But there are obstacles to such an approach, although recognizing them through the Treasury’s balance sheet and budget makes the process more transparent.  Any of these options puts taxpayer funds at risk and face high political hurdles, given Washington’s desire to hide risk to the taxpayer and the reluctance in Congress to grant too much authority to any one agency.

In addition, policymakers already implicitly offer other insurance policies beyond guarantees for borrowers.  They could consider making them more explicit.  In using the Treasury’s balance sheet to finance impaired assets, officials could invite private investors to participate, offering them equity partnerships as was done with the Resolution Trust Corporation (the agency set up to liquidate the assets of failed savings and loan institutions in the late 1980s and early 1990s).  They could sell high-deductible insurance policies to backstop against market disaster.  Although such options would have the economic advantage of making the risks to the taxpayer explicit, that exposure could prove to be too much of a political liability. 

In sum, there’s no mistaking the moral hazard posed by the various unconventional fiscal proposals and the political hurdles they would face.  Even if implicit insurance becomes more explicit, backstops can set bad precedent, encouraging excessive risk-taking and prompting attempts to ‘game’ the changing rules.  Any such initiative must balance that risk against the real hazard that severe market dislocations pose to market functioning and to economic activity. 

In considering such risks, officials must weigh two economic arguments: First, in a crisis, while monetary policy can be changed instantly, it may be less effective than a direct solution.  Second, once past political and implementation hurdles, direct solutions can take effect quickly, and speed is of the essence to mitigate the ‘adverse feedback loop’ and spillovers to the rest of the economy a crunch will nurture.  Also, such solutions need not be blanket ‘bailouts’ — imposing loss of equity for borrowers and investors reduces moral hazard.

As we noted three weeks ago, the market implications of these developments are critical, and investors should pay heed to proposals to fix the credit crunch.  Even if none is implemented, talk of alternative remedies and the Fed’s own hints that it is reluctant to take interest rates significantly lower have already reduced market bets on further aggressive Fed ease.  Those developments present a risk to our base case for yield-curve steepening, and uncertainty about the economy and about the fate of these new proposals seems likely to increase interest-rate volatility.

Once the crisis is past, what to do?  Wise observers have long noted that our financial regulatory infrastructure is fragmented and has failed to keep pace with financial innovation.  The challenge for regulation is to balance entrepreneurship with the goals of financial stability, investor protection, and market integrity.  The balance is delicate: Deregulation, regulatory arbitrage and a system of capital requirements based on narrow definitions of risk functioned well when the system was free of stress.  But in the classic paradox engendered by stable markets, those developments created excessive complacency and risk-taking, leaving markets with inadequate financial shock absorbers.  In the cruelest irony, innovation that was supposed to disperse risk transparently ended up concentrating it in ways more opaque than ever, thanks to the embedded leverage in complex structured securities.  And the stress exposed thinly capitalized segments of the financial services industry, as risk-management and stress-testing was inadequate to deal with the speed of the shocks that these innovations spread.  Lacking appropriate safeguards, booms and busts can promote the socialization of credit and, ultimately, less-efficient markets and resource allocation. 

Watch for re-regulation.  As has been the case following every financial crisis, re-regulation of financial markets and institutions is coming.  There is, frankly, some good news here: The outcome is likely to be more uniformity of regulation and a safer, better-capitalized financial system that will reward strong market participants.  Intermediaries with little to no regulation will get new oversight, new disclosure responsibilities, and new capital requirements.  And America’s patchwork regulatory system will likely get an overhaul.  Fed Vice-Chairman Kohn summarizes the future regulatory backdrop succinctly: “A number of markets will need to make institutional changes before they are likely to function smoothly again, and regulators will need to adapt their oversight to take account of the lessons learned.  In the end, we will have a safer system, but one with more bank intermediation, less leverage, and higher financing costs for many borrowers” (The U.S. Economy and Monetary Policy, February 26, 2008).

United States
Review and Preview
March 26, 2008

By Ted Wieseman | New York

The Treasury curve saw a huge flattening move over the past holiday-shortened week, as, after some initial jitters Monday in response to the shockingly low buyout price for Bear Stearns, financial system systemic fears eased on the back of the introduction of the Fed’s Primary Dealer Credit Facility (PDCF), certainly the most important yet of the many unconventional policy measures the Fed has adopted, and better-than-expected earnings results from several major broker/dealers.  Judging from huge rallies in short bills and a plunge in Treasury repo rates, there is still major demand for cash, so a significant degree of nervousness does remain in the market.  But along with the sell-off at the shorter end of the Treasury coupon market and flattening of the yield curve, risk markets still rebounded solidly as systemic and counterparty fears eased, with a big narrowing in credit spreads of particular note.  Stocks, commercial real estate, leveraged loans and subprime mortgages also rebounded to varying degrees.  Meanwhile, the recently badly struggling agency MBS market received a major boost from OFHEO’s decision to cut the excess capital requirement on Fannie Mae and Freddie Mac to 20% from 30%, potentially allowing nearly US$200 billion in additional mortgage purchases, according to our interest rate strategy team’s estimates.  As a result, there was broad improvement across other interest rate markets along with the rebounds in risk markets, with swaps tightening significantly further – the drop in mortgage rates should lead to a pick-up in refinancing activity, with narrowing implications for swaps – agency MBS significantly outperforming this good showing by swaps, and straight agency debt also doing very well.  A light week for economic data continued to make clear that we are very likely in a recession as the credit crunch works its way through the economy, with soft claims and regional manufacturing surveys pointing to another round of negative employment and ISM reports in a couple of weeks.  But at least, the potentially huge downside risks of a major systemic financial sector meltdown now appear far less worrisome than they did a week ago after last Friday’s initial Fed intervention to prevent the immediate collapse of Bear Stearns, with the Fed now having provided a crucial backstop to the primary dealer community and the federal government via Fannie and Freddie a backstop to the mortgage market.

On the week, 2s-10s flattened 22bp and 2s-30s 30bp on significant losses at the front and big gains at the long end.  The 2-year yield rose 11bp to 1.54%, and the 5-year was unchanged at 2.345%, while the 10-year rallied 11bp to 3.32%, and the 30-year 19bp to 4.16%.  Whatever reduction in flight-to-safety trades, the 2-year losses and curve steepener unwinds might have reflected that demand for cash remained extreme, pointing to continued nervousness.  The 4-week bill’s bond equivalent yield fell 83bp to 0.34% and the 3-month 58bp to 0.59%, while overnight general collateral Treasury repo rates were very low most of the week, averaging 0.46% on Thursday.  Sharp declines in commodity prices contributed to another terrible week for TIPS, with the 5-year yield rising 19bp to 0.10% and the 10-year dipping 1bp to 0.99%.  Other interest rate markets performed strongly.  The big recent pullback in swap spreads off the wides hit a couple of weeks ago continued, with the benchmark 5-year spread falling 7bp to 86.75, down from the all-time high of 114.75 hit on March 6, and the benchmark 10-year spread fell 9.75bp to 61.75bp.  Agency MBS did very well in anticipation of and in response to OFHEO’s announcement, outperforming this significant improvement in swaps by about 25 ticks on the week.  The yield on the current coupon Fannie Mae MBS as calculated by Bloomberg fell 37bp on the week to 5.08%.  Straight agency debt also performed well.

The market took the Fed’s smaller-than-expected 75bp rate cut in its stride, with the introduction of the PDCF more than compensating for any disappointment that the Fed didn’t go 100bp, with relatively minor adjustments to Fed pricing that largely just incorporated the smaller move this week by lifting the expected trough funds target a quarter point to 1.75%.  This final 50bp reduction is priced to come at the end of April FOMC meeting, but just barely, as the May fed funds contract lost 6bp to 1.86%.  If not in April, then the move to 1.75% is seen as nearly certain by the June meeting, as the July contract lost 14 .5bp to 1.78%.  The low-rate October contract fell 18.5bp to 1.735%.  Eurodollar futures gains were long end-led, in line with the Treasury curve.  The reds (Jun 09 to Mar 10) lost 4-8bp, scaling back a bit the expected rise in rates next year off the now higher expected 1.75% trough.  The Sep 08 to Sep 09 spread fell 9bp to 40bp, and the Dec/Dec spread 8.5bp to 62.5bp.  The near-term Fed repricing combined with a 16bp drop in 3-month LIBOR to 2.61% resulted in a substantial improvement in the 3-month LIBOR/3-month OIS spread to 62bp (still a very strained level) from 81bp.

Key risk markets mostly had good weeks, though to varying extents.  The most important rally was in investment grade credit as counterparty and general financial system fears eased.  Through the early afternoon Thursday, the investment grade CDX index was trading 31bp tighter on the week at 160bp, after having come very close to hitting 200bp early Monday.  The high yield index was 40bp tighter on the week at 727bp through Wednesday’s close, but the index was trading down about 3/4 of a point midday Thursday.  Around the time of the early bond market close, the S&P 500 was up 1.8% on the week.  The commercial mortgage CMBX market had a very good week, possibly benefiting to some extent from the ability of dealers to finance CMBS positions through the PDCF if necessary, with the AAA index tightening 69bp to 194bp, AJ 178bp to 532bp, and AA 218bp to 709bp.  The leveraged loan and subprime markets were relative laggards.  The LCDX index tightened 13bp to 465bp.  The higher-rated ABX indices posted only small gains, with the AAA up 0.68 to 52.77, and the low-rated indices declined slightly. 

It was a light week for economic data, with the key monthly reports showing a steep drop in industrial output, though largely as a result of warmer-than-normal weather, a smaller-than-expected decline in housing starts – though only because of a sharp rise in the volatile multi-family component – and another ugly PPI report.  Also of note, the index of leading economic indicators declined for a fifth straight month for the first time since the first part of the 1990-91 recession.

Industrial production plunged 0.5% in February, though much of the weakness was in the volatile utilities component (-3.7%).  The key manufacturing gauge dipped 0.2%.  Motor vehicles and parts output (-1.0%) continued to sink, with assemblies hitting another new low since the 1998 GM strike.  Excluding motor vehicles, output fell 0.2%, in line with the soft hours worked figures in the employment report.  Outside of a strong gain in high-tech output and a modest uptick in machinery, weakness was broadly based.  Housing starts dipped only 0.6% in February to a 1.065 million unit annual rate but only because the volatile multi-family category gained 14% on top of a 44% jump in January to 358,000.  Multi-family starts have received support from better fundamentals in apartments, but major weakness in the condo market is likely to weigh on activity going forward.  Meanwhile, single-family starts plunged another 6.7% to 707,000, outside of one month in 1991, the low since 1982.  Single-family starts have now fallen 62% from the January 2006 peak, but we think that about another 25% drop will be needed to clear bloated inventories of unsold new homes by year-end and restore some stability to the housing market.  The producer price index rose 0.3% in February for a 6.4%Y gain, as a 0.5% surge in the core (+2.4%Y), the largest gain since November 2006, was partly offset by a pullback in food prices (-0.5%) and a temporarily more moderate gain in energy (+0.8%).   The elevation in the core was broadly based, with core consumer goods prices gaining 0.6% and capital goods 0.5% on upside across a range of items.  Early-stage readings also continued to show major upside, with the core intermediate gaining 0.6% (+4.8%Y) and core crude surging 3.3% (+20.6%Y), with the headline measures showing additional food and energy-driven upside. With domestic demand contracting and operating rates falling, business pricing power is quickly fading, so the upside in materials prices is likely to pose more of a problem for margins going forward than final prices. 

Looking ahead to the key early round of March data in two weeks’ time, the jobless claims report and early regional manufacturing surveys pointed to more weakness in the upcoming employment and ISM reports.  Initial jobless claims in the week of March 15 – the survey week for employment report – jumped 22,000 to 378,000, matching the high since the aftermath of Hurricane Katrina in October 2005.  The 4-week average rose 6,000 to 365,250, also a post-Katrina high, while continuing claims in the prior week rose 32,000 to 2.865 million, a high since August 2004.  Much of the increase in initial claims in the latest week appeared to reflect the impact of a strike at a key parts supplier to GM, which has idled an increasing number of assembly plants and where industry sources see no quick end in sight.  The impact of this strike should contribute to a particularly weak outcome for manufacturing jobs in March (and potentially even more so in April), which along with expected further weakness in construction and finance, we expect to lead to a 50,000 decline in overall non-farm payrolls.  Meanwhile, while the headline sentiment measures and underlying details swung in different directions in March, both the Empire State and Philly Fed manufacturing surveys pointed to another month of factory sector contraction.  On an ISM-comparable weighted-average basis, the Empire State survey rose 1.5 points, but remained below the 50-breakeven level at 49.6, but the Philly Fed continued to deteriorate, falling to 45.6 from 45.9 low on this basis since December 2001.  Our preliminary forecast for the national ISM is for a small further decline to 48.0 in March from 48.3 in February.

The economic calendar is very busy in the coming week, though investor focus will no doubt remain primarily on any further indicators of the stability of the financial sector (and general sentiment shifts in that regard) and the impact on the performance of credit, stocks and other risk markets.  The extent to which agency MBS and swaps can extend their recent improving trends will also be major areas of concern in the interest rate markets as the Fed inaugurates the new Term Securities Lending Facility on Thursday.  In this first TSLF operation, Treasuries will only be lent to dealers against regular open-market collateral – other Treasuries, agencies and agency MBS, which effectively means only agency MBS should end up being accepted given relative repo rates among the three collateral types.  The second operation on April 3 will be expanded to include AAA rated private-label MBS.  In addition, the latest TAF auction, at the upped US$50 billion size, will be Monday.  Economic data releases due out include existing home sales on Monday, Conference Board consumer confidence on Tuesday, durable goods and new home sales on Wednesday, revised GDP on Thursday and personal income and spending (and core PCE inflation) on Friday:

* We forecast February existing home sales of 4.88 million units annualized.  The pending home sales index has been virtually unchanged for the past three months, suggesting that resales are starting to level off.  We look for only a fractional dip in February (-0.2%).

* We look for a 75.0 reading for the Conference Board’s measure of consumer confidence in March.  Despite rising energy prices and jittery financial markets, the University of Michigan sentiment gauge for early March was little changed relative to the February reading.  We expect a similarly unchanged outcome for the Conference Board measure.

* We expect durable goods orders to rebound 1.4% in February.  Based on company reports, we look for a partial rebound in the volatile aircraft category.  This should lead to a solid gain in headline bookings.  However, the key core component – non-defense capital goods excluding aircraft – is expected to post a fractional decline (-0.2%), consistent with the recent softness in the ISM orders gauge.  Finally, core shipments are expected to be flat in February.

* We forecast February new home sales of 580,000 units annualized.  The homebuilder survey registered slight upticks in both January and February following a full year of steady deterioration.  This suggests that sales of newly built residences may be near a trough. We look for only a slight dip in February (-1.4%).

* We expect 4Q GDP growth to be adjusted down marginally to +0.5%.  Lower readings for consumption and construction should just barely outweigh a modest upward adjustment to inventories, leading to a fractional downward revision to overall GDP (relative to the prior reading of +0.6%).

* We look for a 0.3% rise in personal income in February and 0.1% rise in spending.  The labor market data pointed to another subpar advance in wage growth.  Meanwhile, the retail sales figures for February were disappointing, and thus we look for only a fractional advance in consumer spending.  Finally, the translation of the CPI data imply a 0.1% rise in the core PCE price index, with the year-on-year rate ticking down to +2.1%.

 

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