Sunday, December 5, 2010

Why The Low Interest Rates Mattered: Part I

This is the first of a two-part follow up to my previous post, where I argued that the Fed's low interest rate policy was a key contributor to the credit and housing boom.  Here, I want to show why the risk-taking channel of monetary policy is an important part of the story.  I will provide a more thorough summary of the Fed's role in the next post.  

The risk-taking channel of monetary policy helps us understand how the Fed's low interest rate policy worked to catalyze many of the other factors that contributed to the housing boom.  Yes, this was a perfect economic storm of sorts where financial innovation, weak governance, misaligned incentives, and globalization all came together to create the mother of all housing booms.  Yet, the role they played was largely dependent on the Fed holding the federal funds rate as low as it did for as long as it did.  How you ask? I will outsource to Barry Ritholtz to answer this question:
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 Triple AAA.
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.
It became readily clear to me once I dug into the data, legislative history, market activities, etc, that there was no one single factor that caused the collapse. Rather, an honest reading of events was that there were many, many failures occurring in a very specific order that contributed to what occurred.
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.
Enough Said.


  1. Suppose the natural interest rate falls, and markets somehow work right, so the market interest rate falls as well. Doesn't this still cause bond fund managers to seek higher yields?

    Is it desirable to set up a monetary authority to force the market interest rate above the natural rate in order to reduce the risks that bond fund managers make?

    I think not. Maybe bond fund managers should take more risk when yields are lower. It seems like a reasonable trade off.

    The role of interest rates is to coordinate saving and investment. If lower interest rates are necessary to provide coordination, then interest rates should be lower. If lower interest rates result in accepting more risk to increase return, that is fine.

    Buying mortgage backed securities where the collateral is 30% overpriced might be partially explained by a willingness to bear more risk to get more return. But I think the more likely explanation is a the projection of past price trends into the future, with an unrealistic notion that a clever trader can always sell to a greater fool.

  2. How exactly can low interest rates instigate a scramble for yield? It seems plausible, I just don't understand the stages.

    Ritholtz says that bonds managers were relatively indifferent to taking on risk for behavioural and contractual reasons, so falling interests rates forced them to accept higher risks because yield was prioritised. But then he also seems to suggest that bond managers were effectively duped into accepting high risks by the ratings agencies. Which is it?

    It seems to me like a lot of assertions without much explanation of how one ties into the other. Perhaps this merely reflects my ignorance of the matter at hand.

  3. I agree there is a global search for yields, and likely this will occur as the we seem to be able to generate capital "gluts."

    However, people who blame the Fed for excessive real estate speculation remind me of patrons who blame the bartender for getting drunk.

    Yes, there was speculation in real estate. It was aided and abetted by feeble underwriting and then a runaway (everything is AAA) MBS market. The rating agencies?

    It may be the world will have to adjust to secular low interest rates. High global savings rates mean capital is abundant. The world has changed from the 1950-80s.

    Anyway, interest rates were low in France, and they did not have a real estate crash. They have been low in Japan, and real estate has fallen by 75 percent in 20 years.

    In general, lower rates are better than higher rates. and should be encouraged.

    However, it might be worthy to require 10 percent downpayments, and that MBS issuers pay into a pool, and a rating agency is assigned at random.

  4. Bill,

    If monetary policy pushes market interest rates below the natural interest rate, then the economy is getting too much monetary stimulus. This stimulus will create a temporary surge in real economic activity and in the real returns associated with investing in the real economy. Thus, pushing market interest rates below the natural interest rate level creates an arbitrage opportunity for investors. They can borrow at the low market rates and use the the borrowed funds to seek after the temporarily higher yields associated with the temporary surge in the real economy. Pushing the market rate below the natural rate thus encourages inordinate risk taking.

    If, on the other hand, the economy tanks and pushes down the natural interest rate and ultimately the market interest rates, there is no arbitrage opportunity and no inordinate risk taking.

    I nowhere have argued that the monetary authority should force the market rate above natural rate to reduce risk taking. Rather, it should avoid pushing the policy interest rate away from natural rate. Doing so will minimize inordinate risk taking.

    My view is that there was inordinate risk taking in the early-to-mid 2000s only. Currently, this is not the case.

  5. David,

    I know you were discussing a situation where the monetary disequilibrium pushes the market rate below the natural rate.

    If market interest rates are too low, they will fail to coordinate. And, I will grant that the excessive risk taking would be one of aspects of a failure to coordinate.

    But if the natural interest rate falls (perhaps due to increased saving,) then there will be increased risk taking as well.

    I am not sure I entirely see why the arbitrage is relevant. It still seems to me that low risk real projects will be undertaken first, but higher risk one too.

    Naturally, I think the problem is inadquate resources to maintain production, and price inflation.

    Still, I am trying to express how troubling I find this line of argument. If you assume the cental bank controls interest rates as a policy variable, then the risk people take at different levels of that interest rate is just a consequence.

    For example, the way to prevent a housing bubble is for the central bank to set a high interest rate and lower taxes and expand government spending to close the output gap.

    I don't see it that way. The quantity of money should adjust to the demand to hold money. Interest rates should be free to adjust to clear markets. If people pay too much for assets, they should take losses. If banks lend against overvalued assets, they should lose money.