Richard (Rick) Mills
Ahead of the Herd
Page 2 of 4
Fog the mirror
“Many economists see the power to manipulate policy in reaction to the ups and downs of the economy as the natural evolution of fiscal policy. The purpose of this power is to ward off or lessen financial disasters through keeping rates artificially low or introducing more money into the system, or doing the opposite to rein in inflation during periods of growth.” The Atlantic
Alan Greenspan was chairman of the Federal Reserve from 1987 to early 2006. Greenspan used monetary policy to ignite one of the longest economic booms in history. Of course booms can soon turn to bust and nowhere was the boom more evident than in the housing industry - the sub-prime crisis collapsed the housing boom just after Greenspan left the Fed.
The Great Recession started in December of 2007 and took a sharp downward turn in September 2008. It was started by the U.S. sub-prime crisis which burst the housing bubble. Businesses failed, consumers lost wealth estimated in the trillions of dollars and economic activity and international trade slowed:
- Between 1997 and 2005 mortgage fraud increased by 1,411 percent.
- In 2001 the US Federal Reserve lowered the Federal funds rate eleven times, from 6.5 percent to 1.75 percent.
- Mortgage denial rates were 28 percent in 1997, in 2002 – 2003 they were 14 percent for conventional home purchase loans. “Fog the mirror loans” were common, if you breathed you got a loan.
- In June 2002 President George W. Bush set out to increase minority home ownership by 5.5 million. Bush’s lofty goals would be accomplished by tax credits, subsidies and Fannie Mae committing $440 billion to establish Neighbor Works America.
- In June2003 Federal Reserve Chair Alan Greenspan lowered the federal reserve’s key interest rate to one percent - the lowest rate in 45 years.
- Throughout 2003 Fannie Mae and Freddie Mac bought $81 billion in subprime securities. President Bush signed the American Dream Down payment Act – the Act provided a maximum down payment assistance grant of either $10,000 or six percent of the purchase price of the home, whichever was greater.
- U.S. homeownership rate peaked to an all time high of 69.2 percent in 2004.
- From 2004 to 2006 Fannie Mae and Freddie Mac purchased $434 billion in securities backed by subprime loans.
- In late 2004 the Securities Exchange Commission (SEC) suspended net capital rule for five firms - Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley. Free from government imposed limits on the amount of debt they could assume, they all levered up, as much as 40 to 1.
- TheUnited States housing market bubble burst in the fall of 2005. By year-end a total of 846,982 properties were in some stage of foreclosure. From the fourth quarter of 2005 to the first quarter of 2006, median prices nationwide dropped off 3.3 percent.
- The U.S. Home Construction Index was down over 40 percent as of August 2006. A total of 1,259,118 foreclosures were filed in 2006, up 42 percent from 2005. Homeowners were going underwater (they owed more than the house was worth) and many had had questionable credit to start with.
- In 2007, lenders started foreclosure proceedings on nearly 1.3 million properties, a 79 percent increase over 2006.
- Foreclosure proceedings increased to 2.3 million in 2008, an 81 percent increase over 2007 and increased by another half million in 2009 to 2.8 million. By January 2008, the mortgage delinquency rate had risen to 21 percent and by May 2008 it was 25 percent.
- By August 2008, 9.2 percent of all U.S. mortgages outstanding were either delinquent or in foreclosure. By September 2009, this had risen to 14.4 percent.
After Fed chairman Greenspan left office, the Federal Reserve, under the stewardship of new chairman Ben Bernanke, started easing monetary policy aggressively. By December of 2008, the federal funds rate was between 0 and 1/4 percent. The Fed had used up its traditional stimulus, all the ‘Creature from Jekyll Island’ had left was the ability to print money so they started throwing cash at everything.
Additional stimulus was injected into the economy by:
- The System Open Market Account (SOMA) purchased mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae (agency MBS).
- The Term Auction Facility was $40 billion in loans to rescue the banks. It wasn’t near enough, the Treasury department got authorization to spend $150 billion more to subsidize and eventually take over Fannie Mae and Freddie Mac, they also bailed out AIG.
- Dollar Swap Lines exchanged dollars with foreign central banks for foreign currency to help address disruptions in dollar funding markets abroad.
- The Term Securities Lending Facility auctioned loans of U.S. Treasury securities to primary dealers against eligible collateral.
- The Primary Dealer Credit Facility provided overnight cash loans to primary dealers against eligible collateral.
- The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility provided loans to depository institutions and their affiliates to finance purchases of eligible asset-backed commercial paper from money market mutual funds.
- TheCommercial Paper Funding Facility provided loans to a special purpose vehicle to finance purchases of new issues of asset-backed commercial paper and unsecured commercial paper from eligible issuers.
- The Term Asset-Backed Securities Loan Facility supported the issuance of asset-backed securities (ABS) collateralized by loans related to autos, credit cards, education, and small businesses. In March 2009, the Fed announced that it was expanding the scope of the TALF program to allow loans against additional types of collateral.
- The Troubled Asset Recovery Program was proposed and $350 billion was approved by Congress – the money was used to buy bank and automotive stocks.
Late in 2008 there was a run on ultra safe money market accounts – according to AMG Data Services a record $140 billion was pulled out in one day.
In response to the continuing crisis and a stalling economy the US Federal Reserve initiated Quantitative Easing and Operation Twist.
Quantitative Easing (QE) 1, 2, & 3
In September of 2008 the $1.7 trillion QE1 was started. The Fed purchased mostly mortgage backed securities and established a commercial paper lending facility.
In October of 2010 QE2 started. At $600 billion, QE2 was much smaller then QE1 and its buying was mostly confined to purchasing long term government bonds.
QE1 & QE2 failed to restart the economy and housing market.
Operation Twist is the Fed’s initiative of buying longer-term Treasuries while simultaneously selling shorter-dated issues in order to bring down long-term interest rates.
By purchasing longer-term bonds, the Fed drives up prices which forces yields down - price and yield move in opposite directions. Selling shorter-term bonds causes their yields to go up because their prices fall. These two actions “twist” the shape of the yield curve, hence the name Operation Twist.