PHILADELPHIA REFLECTIONS
The musings of a Philadelphia Physician who has served the community for nearly six decades

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Philadelphia Economics
economics

Whither, Federal Reserve? (1)
The Federal Reserve seems to be a big black box, containing magic. In fact, it's high-wire acrobatics that must not be allowed to fail.

OUR NICE HOUSING BOOM COLLAPSES

Three Basic concepts at work:

  • Steep yield curves (the normal situation) are good for banks; inverted curves (a rarity) are not. The 2006 inversion was caused by the bond market accepting abnormally low long-term interest rates, so the "spread" between risky loans and safe ones displayed a diminished "risk premium".
  • The Federal Reserve then lowered short-term rates by printing more currency.
    This caused an inverted yield curve to return to its normal shape, but the 2006 problem was caused by too much(Chinese) money and this action added to it. The banks were rescued, but the currency was inflated.
  • This innovative response will probably become a standard readjustment.
    But it only keeps the ship from tipping over after a sudden wave; it doesn't address the approaching storm.
{top quote}
Risk premiums soared in August 2007.

What seemed safe, abruptly was risky, only available at higher prices. {bottom quote}

What happened in August?....The "risk premium" --and, consequently, mortgage interest rates-- suddenly went back to normal. About $90 billion of foreclosures seemed probable. We had built far too many houses for people who couldn't afford them. Surplus houses remain for ten years, depressing all real estate prices, making everybody feel poor. Recession, anyone?

What did the Federal Reserve do? To protect the banks, Bernanke dropped short term interest rates. (This steepens the yield curve.) As the panic spread, he dropped rates some more (This floods the country with money). Inflating the currency cheapens the dollar, which robs foreign investors. Foreigners sold stock to escape, prices fell. Seeing prices fall, everybody else sold stock. 1929, anyone?

So what? They're only foreigners. If Bernanke raises interest rates, we may get a recession. If he keeps them low, we may get hyperinflation. So, he probably hopes to drop them for a couple months, then raise them again. Jimmy Carter got "stagflation" trying this sort of thing. Green eyeshades, anyone?

Remember how naughty "redlining" was? Well, now we bash the banks for "stupid mortgages". Banks issued cheap mortgages for inflated real estate -- and immediately sold the "subprime loans" to investment bankers as "collateralized bonds". We are still uncertain who holds these things, but at least $40 billion were in the hands of Wall Street when the music stopped. Wall Street had to sell perfectly good (?) stock to pay their debts. Blue chips, anyone?

Why was the risk premium so low? The Far and Middle East had something to do with it. But mainly, securitization led to undue emphasis on statistics. In a housing boom, foreclosure rates seem to go down but are really only being diluted by new loans. The fall of BNP Paribas was a sudden wake-up. Then, the computers of the "quants" exposed a flaw in their programs when they detected heavy selling of perfectly good stock, and announced the End of the World..

Thank heaven it happened before things got serious.

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