Thursday, January 7, 2010

A Note to Ryan Avent, Paul Krugman, and Arnold Kling

Do not underestimate the impact of the Fed's low interest rate policies in the early-to-mid 2000s. While there are many stories told as to how the low federal funds rate at this time contributed to the housing boom, one that is often overlooked but probably the most important is the "risk-taking" channel story of monetary policy. Leonardo Gambacorta of the BIS summarizes how this link works:
Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.
Tobias Adrian and Hyun Song Shin also explore this channel in their paper:
We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.
Both papers above empirically show the low federal funds rates were very important to the excessive leverage and big bets made by financial institutions during this time. Barry Ritholtz provides a nice summary of this channel in a recent post:
What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.


Inadequate regulations and “nonfeasance” in enforcing existing regs were, as Chairman Bernanke asserts, a major factor. But in the crisis timeline, the regulatory and supervisory failures came about AFTER the 1% Fed rates had set off a mad scramble for yields. Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates.

Now Ritholtz acknowledges there were many factors at work during this boom. However, he makes the point, and I agree, that we have failed to learn a key lessons from this crisis if we move forward with the view that the low interest rates were of no consequence during the housing boom.


  1. As a complement to this line of thought, John Cassidy has a good article in the FT concerning the Greenspan put as a significant contributory factor in building up the euphoria. Investors took on more and more risk because they had rational expectations that the Fed would come to their rescue if things went wrong. The Fed became trapped in a classic Kydland-Prescott trap.
    On a related note:
    Interesting that the President of Argentina fired the head of the central bank there today! Can we at least hope the US President will get rid of its Treasury secretary?

  2. The "search for yield" effect also impacted the concentration of risk on non-bank balance sheets.

    2003 was a boom, record year for mortgage origination as low rates spurred a flood of ARM refi's.

    To show earnings growth after 2003, originators turned to two avenues: 1) they loosened standards to keep origination volumes from falling too much; and 2) their balance sheets ballooned as they began to generate earnings by borrowing at low rates and investing in their own products.

    Its ironic. Everyone assumes the problem with securitization was that orignators did not have an incentive to manage risk because they were not the ultimate holders of the paper. Hogwash. From Merrill to Countrywide to Bear to WAMU to New Century, I can show you chart after chart of ballooning balance sheets after 2003. The problem is they kept TOO MUCH of the risk, not too little. They did so because they needed to pile on more and more risk to generate earnings growth in a low rate environment. They were woefully unprepared for high rates because they believed that if there was trouble, the Fed would just quickly lower rates again. They did, but not in time...

  3. David Pearson:

    Good points. I have a question for you on this issue; could you shoot me an email at