Did the Fed Worsen the Credit Crunch?

Many times in life, the best course of action is counterintuitive. For instance, drivers are supposed to turn into a skid to regain control on a slippery road. Despite the natural instinct to turn away, every year millions of American teens learn this lesson, which keeps them from spinning out or sliding down a hill sideways.

What if central banking is similar to managing a car in the snow? What if the Fed did the equivalent of slamming on the breaks and turning away from the skid at the very start of trouble in the summer of 2007? What if Ben Bernanke's panicked rate cuts sent the entire credit market spinning out of control, careening from bank failure to bank failure like a car smashing off guard rails and bridge abutments on an icy road?

A review of the data supports this revisionist case:

During the credit bubble banks like Citigroup (NYSE: C) created Structured Investment Vehicles (SIVs), which borrowed money using commercial paper to buy mortgage-backed securities. Because they relied on short-term funding, SIVs could be forced sell long-term assets on short notice if they had to pay back commercial-paper debts.

That's exactly what happened in August 2007 when investors started redeeming the commercial paper because of their linkages to home loans. The total amount of asset-backed commercial paper outstanding peaked at $1.2 trillion the previous month, and had no where to go but down.

One good way to make people sell commercial paper is to cut interest rates, which reduces the yield on short-term instruments and drives money into Treasuries. Oblivious to the commercial-paper threat, that's exactly what the Fed did.

Investors proceeded to redeem more than $360 billion of asset-backed commercial paper over the balance of 2007, which forced SIVs to unload approximately the same amount of mortgage-backed securities. It was the first of many forced liquidations that would bring the financial system to its knees. And, given the sequence of events and the well established link between rate cuts and money-market flows, it appears the Fed's kneejerk rate cuts accomplished the opposite of the intended effect, worsening the meltdown.

Source: Federal Reserve, Dealogic

Things had changed from earlier crises, when monetary easing helped the system weather the S&L crisis or the collapse of Long-Term Capital Management. This time, lower rates sucked capital out of "leveraged players," who were then forced to sell their holdings of longer term mortgage-backed securities.

At least two other kinds of investors were affected. First, many hedge funds had borrowed in the short term using credit lines tied to Libor and bought higher yielding long term bonds. Lower short-term rates reduced their need for yield. Second, many investors had borrowed money by selling the Japanese yen and buying dollar-denominated mortgage-bond assets. This "yen carry trade" was a huge moneymaker as the Fed raised rates between 2004 and 2006 because the dollar gradually rose against the Japanese currency. But when the Fed started cutting rates in 2007, the yen rallied and caused a massive liquidation of all "risk assets," including stocks and mortgage-backed securities.

The key theme in these three cases is that the central-bank textbook was wrong: Higher short-term rates increased risk appetite, and lower rates caused selling.

This crisis of cause and effect results from a failure of policymakers to adjust to big changes in our financial system in recent decades. Most important was the rise of securitization, the practice of bundling mortgages into bonds. Thanks to years of support from government-sponsored entities Fannie Mae and Freddie Mac, the proportion of home loans securitized rose to 62% in 2002 from 5% in 1970.

Source: Federal Reserve

Securitization was revolutionary because it allowed people to borrow even if banks didn't want to lend. But it also moved lending away from bank balance sheets, ultimately reducing the Fed's ability to regulate credit growth.

Fannie and Freddie effectively linked the mortgage industry to the multi-trillion dollar credit market, which was experiencing its own massive bull run. Between 1981 and 2005, the yield on 10-year Treasury notes would fall from over 15% in 1981 to below 5%. This boom, which owed its life to the defeat of inflation and an increasing foreign demand for U.S. bonds, didn't only inflate the housing bubble. It also fueled several junk-bond frenzies and two private-equity bubbles.

The combination of securitization and strong fixed income made the American economy heavily reliant on capital markets as everything from car loans to commercial mortgages became linked to the bond market.

The chart below shows the rise of credit-market debt relative to banks as a source of lending in the economy.

Source: Federal Reserve

So far, policymakers have only nibbled around this reality and been painfully slow implementing the Term Asset-Backed Securities Loan Facility (TALF), the only measure with a prayer of breathing life back into the securitization market. Until they start prioritizing healthy capital markets rather than just putting band-aids on the banks, we will remain in crisis.