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Wall Street History
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06/06/2008
How We Got Here
I said I was going to do more on energy this week, but after I saw and read Federal Reserve Chairman Ben Bernanke’s speech to the International Monetary Conference on June 3rd, I thought I’d take advantage of it and note his comments on the genesis of the problems we face today, this being a column titled “Wall Street History,” after all.
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Ben Bernanke
The Sources of the Financial Turmoil: A Longer-Term Perspective
Although the severity of the financial stresses became apparent only in August, several longer-term developments served as prologue for the recent turmoil and helped bring us to the current situation.
The first of these was the U.S. housing boom, which began in the mid-1990s and picked up steam around 2000. Between 1996 and 2005, house prices nationwide increased about 90 percent. During the years from 2000 to 2005 alone, house prices increased by roughly 60 percent – far outstripping the increases in incomes and general prices – and single-family home construction increased by about 40 percent. But, as you know, starting in 2006, the boom turned to bust. Over the past two years, building activity has fallen by more than half and now is well below where it was in 2000. House prices have shown significant declines in many areas of the country.
A second critical development was an even broader credit boom, in which lenders and investors aggressively sought out new opportunities to take credit risk even as market risk premiums contracted. Aspects of the credit boom included rapid growth in the volumes of private equity deals and leveraged lending and the increased use of complex and often opaque investment vehicles, including structured credit products. The explosive growth of subprime mortgage lending in recent years was yet another facet of the broader credit boom. Expanding access to homeownership is an important social goal, and responsible subprime lending is beneficial for both borrowers and lenders. But, clearly, much of the subprime lending that took place during the latter stages of the credit boom in 2005 and 2006 was done very poorly.
A third longer-term factor contributing to recent financial and economic developments is the unprecedented growth in developing and emerging market economies. From the U.S. perspective, this growth has been a double-edged sword. On the one hand, low-cost imports from emerging markets for many years increased U.S. living standards and made the Fed’s job of managing inflation easier. Moreover, currently, the demand for U.S. exports arising from strong global growth has been an important offset to the factors restraining domestic demand, including housing and tight credit.
On the one hand, the rapid growth in the emerging markets and the associated sharp rise in their demand for raw materials have been – together with a variety of constraints on supply – a major cause of the escalation in the relative prices of oil and other commodities, which has placed intense economic pressure on many U.S. households and businesses.
In the financial sphere, the three longer-term developments I have identified are linked by the fact that a substantial increase in the net supply of saving in emerging market economies contributed to both the U.S. housing boom and the broader credit boom. The sources of this increase in net saving included rapid growth in high-saving East Asian countries and, outside of China, reduced investment rates in that region; large buildups in foreign exchange reserves in a number of emerging markets; and the enormous increases in the revenues received by exporters of oil and other commodities. The pressure of these net savings flows led to lower long-term real interest rates around the world, stimulated asset prices (including house prices), and pushed current accounts toward deficit in the industrial countries – notably the United States – that received these flows.
To be sure, the large inflows of savings and low global interest rates presented a valuable opportunity to the recipient countries, provided they invested the inflows wisely. Unfortunately, this did not always occur, as an increased appetite for risk-taking – a “reaching for yield” – stimulated some financial innovations and lending practices that proved imprudent or otherwise questionable. Regulators identified some of these issues in real time; for example, federal banking regulators issued new guidance on nontraditional mortgage lending and on commercial real estate lending. The Federal Reserve, in cooperation with the other supervisors, encouraged improvements in market infrastructure and conducted a series of targeted reviews designed to improve risk-management practice with respect to derivatives, exposures to hedge funds, leveraged lending, and other areas. And, in preparation for the new Basel II capital regulations, supervisors required more-demanding standards for the measurement and management of risk. Despite these efforts, however, the risk-management systems of many financial institutions proved inadequate in the face of a major housing downturn and substantial disruptions in market liquidity.
The current economic and financial situation reflects, in significant part, the unwinding of two of these longer-term developments – the housing boom and the credit boom – and the continuation of the pressure of global demand on commodity prices.
The housing boom came to an end because rising prices made housing increasingly unaffordable. The end of rapid house price increases in turn undermined a basic premise of many adjustable- rate subprime loans – that home price appreciation alone would always generate enough equity to permit the borrower to refinance and thereby avoid ever having to pay the fully-indexed interest rate. When that premise was shown to be false and defaults on subprime mortgages rose sharply, investors quickly backpedaled from mortgage-related securities. The reduced availability of mortgage credit caused housing to weaken further.
The losses from subprime mortgages have been significant in themselves, but their greater impact was to trigger the end of the broader credit boom. Notably, as subprime losses forced the credit rating agencies to downgrade what had been highly rated mortgage-backed securities, investors also came to doubt the reliability of ratings that had been awarded to other highly complex securities. As a result, investors became much more cautious and reversed their aggressive risk-taking of the credit boom period. The resulting pullback affected a much broader range of securities, including leveraged and syndicated loans, asset-backed commercial paper, commercial mortgage-backed securities, and a variety of structured credit products. Large financial institutions, especially in the United States and Europe, were particularly affected by these events, having reported a total of roughly $300 billion in writedowns and credit losses. These institutions have also been forced to bring onto their balance sheets the assets of sponsored investment vehicles that can no longer be financed on a standalone basis. Fortunately, most financial institutions entered this episode with strong capital positions, and many have raised substantial amounts of new capital. Still, balance sheet pressures and the relatively high cost of new bank capital have reduced the willingness and ability of these institutions to make markets and extend new credit. Prospectively, financial conditions seem likely to be closely tied to both domestic and global economic developments, including the course of the prices of oil and other commodities.
This brief overview makes clear that both global and domestic factors have played important roles in recent developments in the United States. The housing and credit booms were driven to some extent by global savings flows, but they also reflected domestic factors, such as weaknesses in risk measurement and management and lax standards in subprime lending. Higher commodity prices are for the most part a global phenomenon, but U.S. dependence on oil imports makes this country quite vulnerable on that score.
[Source: Federalreserve.gov]
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I’ll offer more comments on the here and now in my “Week in Review” column.
Wall Street History returns next week. Back to energy.
Brian Trumbore
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