Is the Fed Contributing to the Credit/Mortgage Crunch?
One of the smartest hedge fund managers we know spends most of his day locked away in his office analyzing how the market consensus could be wrong. He hangs with au contraire crowd, breaking bread with contrarians and demands you check your cheerleader pom-poms at the door when visiting his office. Not that he takes action or trades on all or any of this, but his rigorous discipline of stress testing his perspectives, positions, and the conventional wisdom of the market is a lesson for all of us.
Our hope is the policymakers, especially the Fed, do the same. The world is experiencing the adverse consequences of negative real interest rates and yet the monetary policy prescription of choice is for more negative real interest rates.
In his September 6th FT piece, Bill Gross writes,
…monetary policy at the zero interest rate bound introduces a new dynamic that may conflict or even reverse standard logic that lower interest rates across the sovereign yield curve are everywhere and always stimulative to economic growth.
This potential paradox arises not just from observation of the Japanese experience over nearly two decades, but from an analysis of our modern-day financial system and its potential inadequacies. Fractional reserve banking, where only a portion of bank deposits are backed by hard cash, as well as unreserved collateral-based lending on overnight repo have allowed for an expansion of credit beyond the bounds of a central banker’s imagination.
Mr. Gross concludes the Fed’s pancaking of the yield curve through Operation Twist will destroy the banking system’s incentive to create credit by reducing the opportunity for banks to leverage a positively sloped yield curve
We add our two cents to the Bond King’s skepticism of current policy using the basic supply and demand curves of microeconomics, or what graduate students call “price theory.’ Recall how we were taught as freshman that rent control creates a shortage of rental apartments and housing when government policy distorts or represses market prices.
Take a look at the chart below, which should look familiar as it is simple adaption of the rent control analysis. The vertical axis shows the interest rate with the horizontal the quantity of loans/credit/mortgages.
It is also important to note demand and supply curves are not observable in the real world. What we see are prices and quantity. But like any economic model, supply and demand curves help us understand the underlying dynamics and the factors that determine the prices and quantity/volume which we observe.
The graph shows that points a and b are the equilibrium market clearing interest rate and quantity of long-term credit/loans/mortgages. The implementation of zero interest rate policy (ZIRP) and Operation Twist represses the rate to point a’. This reduces the supply of credit/loans/mortgages from point b to b’.
After all, who in the private sector will lend long-term money at such repressed and non-economical interest rates? Fannie and Freddie? Yes. Bill Gross and PIMCO? We suspect it’s possible for a trade. Asian investors? NFW!
Furthermore, demand increases to point c at the repressed interest rate forcing either public sector lenders to expand their balance sheets or the market to ration credit through a tightening of credit standards, higher down payments, or by other means. This analysis doesn’t even consider the reduced income on savings and the crowding out effect of the federal deficit. There’s no doubt, in least in our mind, the government is going to get funded first even if the FED has do it alone.
It’s our sense, and we could be wrong, this simple model reflects current reality and one can easily conclude that zero interest rate monetary policy may be what ails the economy and not the prescription that is going to cure it. We throw it out there to help Mr. Bernanke, at least, consider a contrarian perspective, which, like our friend, will make him a better hedge fund manager. Maybe he already has. He’s a smart guy and a professor.
(click here if the graph is not observable)
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September 28th, 2011 at 2:44 am
It’s true that demand, i.e., then number of home buyers who want home loans, is driven by the interest rate of the loan. But isn’t the lender motivated more by the spread (rate he can charge the home buyer vs rate he can obtain) than by the absolute rate?
September 28th, 2011 at 3:13 am
[...] – Fear of Fed tightening. [...]
September 28th, 2011 at 8:07 am
I’ve been trying to job my memory of where I heard this discussed before – thank you for reminding me. You can watch Bill Gross discussing this on Bloomberg back on September 8th:
http://www.youtube.com/watch?v=xCTgOUKrVn8&feature=player_embedded#!
September 28th, 2011 at 9:00 am
” Asian investors? NFW!”
Think again on that one. “Asian investors” ie central banks buy US debt because they have to. In order to keep their currencies artfically low v. the $ they must buy $. End of story.
Of any participant the “asian investors” are the one that are being most “repressed” and they SHOULD be..that is risk one takes by running a beggar thy neighbor currency scheme.
“Repression” might a good way to encourage mkt based currency prices.
September 28th, 2011 at 10:13 am
The FED is not price fixing in this scenario so I think the analysis doesn’t set up the proper framework for their model.
The FED is not setting a yield on the 30 year. They are simply buying a large amount of 30 years at whatever yield the market offers when the FED makes their move. But the absolute price is not fixed. The marginal buyer is still the ‘market’ so the price of mortgages still adjusts to meet full demand for loans. Hence if the FED is buying $300 billion in bonds and the market wants to offer $500 billion in bonds then the price of those bonds goes to whatever price the market is willing to buy what the FED isn’t buying.
Furthermore outside of buying agency securities the FED isn’t touching credit spreads. The market is still picking its own rate for the spread between ZIRP and where the money ends up going to in the market.
If the FED was setting a price on money as you suggest in the chart then you wouldn’t have a supply of loanable funds as upward sloping…it would simply be where the horizontal line for zirp intersects demand since the FED is willing to directly lend to fill demand. Hence it would create more money in the economy and the amount lent would be (And is ) point C.
September 28th, 2011 at 10:13 am
So, no shift in the demand curve due to stagnant income gains and grossly overpriced ticky-tacky housing…
September 28th, 2011 at 12:47 pm
I have often considered the Feds’ stated interest rates , short and/or long, as a kind of National “Return on Investment” or ROI reflecting the minimum rate that capital should theoretically expect to make. This has a dual nature to it tho. On the one hand, yes, if the Fed goes to zero then (theoretically) it would supposedly make ALL risk-on/investments technically feasible as their ROI would be greater than zero. However, in effect it also acts as a statement from the Fed that basically it itself sees NO investment than can beat a zero capital price and that in effect all investments may likely return less than zero (housing market anyone?). Ergo…two sides to the same coin (that both Gross and GMM are extrapolating the “other side” of Big Ben’s view as it were). In an “income recession” Bernanke’s view makes sense, but in a “balance sheet recession”, the other side increasingly makes more sense and in fact (as illustrated by GMM) may exacerbate the issue.
or of course I may just not be very proficient at understanding these things…
September 28th, 2011 at 12:56 pm
‘We throw it out there to help Mr. Bernanke, at least, consider a contrarian perspective, which, like our friend, will make him a better hedge fund manager. Maybe he already has. He’s a smart guy and a professor.’
Heh heh — ‘a smart guy and a professor’ — laying on the parody pretty thick there, aren’t you? He’s almost as good looking as George Clooney, too … as long as we’re ridiculing with absurd praise!
We both know that Benny Bubbles is Conventional Thinking personified. Right now he’s buying the top tick of a 30-year secular bond bull market. Five days after the announcement of Operation Twist (which will eventually render the Federal Reserve insolvent), almost the entire 50-basis point crash in yield following the announcement has been retraced. Watch yields skyrocket over coming months, now that the growth rate of the money-supply M’s is mushrooming.
Benny Bubbles doesn’t have a contrarian bone in his body. He is LTCM-squared, a clueless academician hell-bent on wrecking the largest hedge fund on the planet — the Federal Reserve. Fade him and make a fortune!
September 28th, 2011 at 1:42 pm
Funny, there seems to be plenty of supply of money to buy US government securities at far below mortgage interest rates.
September 28th, 2011 at 7:45 pm
Stiffing your largest creditor (aka The Asian Investor) is a dangerous game to play. Perhaps it is no coincidence that Gold tanked around the same time as Operation Twist was announced?
September 28th, 2011 at 7:49 pm
And China is very smart. I wouldn’t be surprised to see China and others starting to stockpile (Dollar-based) commodities instead of buying Treasuries. It has the same effect on the currency imbalance and the demand would push prices to create a very profitable trade. Of course, the collateral damage would, as usual, be the US consumer who will be paying higher gas prices etc with fewer and weaker dollars.
September 28th, 2011 at 7:54 pm
WTF! fractional reserve banking is an economic textbook fiction. It beggars belief that people still believe in this. An MMT description of how the monetary system works can be found here:
http://pragcap.com/resources/understanding-modern-monetary-system
But even if MMT is not your thing it is worth noting that even the bank of international settlements published a paper a couple of months ago debunking a lot of these textbook myths. In order to be able to forecast things you surely have to understand the mechanics of thing you are forecast. So Global Macro Monitor gets a big fat fail.
September 28th, 2011 at 10:21 pm
Please help me, but what am I missing here? A steep yield curve is a disincentive for banks to lend in this environment because they can just play the roll down.
Rather, bringing down the long end of the risk free rate, makes risky spread lending more attractive.
As crazy as this may seem, I really don’t think Bernanke is an idiot.
September 29th, 2011 at 9:02 am
I am not sure that you have a nice linear demand/supply curve for something like credit. The need for (or use of) credit is driven mainly by something else than cost of credit, particularly when rates are in the low end.