The U.S. economy may be at a turning point: as manufacturing jobs are being shipped overseas, the financial system is experiencing tremendous hardship, largely of its own making. The spread of economic woes caused by the subprime mortgage crisis highlights the failures of national ratings and regulatory systems as well as the dangers posed by companies passing along risks associated with questionable investments and borrowing excessively. The current situation illustrates the need for an increase in the government’s fiscal responsibility and a reevaluation of the federal regulatory bodies that oversee lending practices.

Roots of the Problem
The present crisis can be traced to the low-interest rate environment created by the Federal Reserve in the early 2000s in response to the burst of the dotcom bubble. Low rates and large demand encouraged banks to issue “subprime” loans to borrowers who would not normally qualify for credit. The banks packaged subprime loans into instruments known as mortgage-backed securities and sold them to financial institutions that inherited the returns on these investments as well as the attendant risks of default. Attractive yields and large profits from MBS resulted in lax standards that allowed banks to take on more loans, and since MBS were rather new financial innovations, there was no accurate way to value these investments. When risky borrowers began to default on their mortgages, the value of mortgage-backed securities fell precipitously and accordingly crippled banks that held them.

Banks’ practice of operating on leverage, or relying heavily on borrowed funds for investment purposes, has further exacerbated short-term problems by magnifying losses caused by defaults. In an interview with the HPR, Jim Leach (R-IA), former Chairman of the House Committee on Banking and Financial Services, cautioned against this practice, stating that banks unwisely presumed that the breadth of their operations made leverage relatively safe. Financial economist John Campbell of Harvard University told the HPR that this crisis has shown that “leverage can be risky.”

Current Monetary Policy
As MBS lost value, investors became wary of other types of loan packages, or securities, as well. Doubts about credit sources and the looming specter of a large economic slow-down are severely damaging consumer confidence in the economy. George Zettler, managing director of Ellington, a hedge fund that does significant MBS trading, told the HPR that “high-grade mortgage-backed securities are trading reasonably well,” but he also acknowledged that “there are not a lot of new loans being written…nor associated securities issued,” and that there is almost no transparency in the market where these securities are traded.

In order to make borrowing cheaper and encourage more corporate activity, the Federal Reserve has cut interest rates drastically from 5.25% to 3%, but investor skepticism towards credit markets has made the Fed’s efforts largely ineffective. Campbell noted that the issue might be “less of a liquidity problem and more…that banks have made bad loans and now their capital has been wiped out.” Zettler added that the reason we are not seeing much new investment is that “many of the guys in the industry whom these securities would be sold to have black eyes already.” Thus, monetary policy may be useless in addressing present stagnation, and if markets cannot correct themselves an alternate solution would involve fiscal policies aimed at boosting consumer spending.

Reviving the Economy Through Spending
The increasing trend of home foreclosures in recent months and the resulting decline in housing prices has dampened households’ perceived wealth and hence their spending on consumer goods. To remedy this, on Feb. 13 President Bush signed into law a $168 billion stimulus package designed to bolster spending. The package gives tax rebate checks to individuals and couples making less than $75,000 and $150,000, respectively, as well as other rebates and measures for the business sector. However, Campbell expressed regret that the stimulus was “not particularly targeted at poorer people,” who would more likely spend the money. As Leach noted, “the best that can be said for this is that it reached consensus between the two principle institutions of government [i.e. Congress and the executive branch], on economic policy, in a surprisingly short period of time.” He also stressed the relative weakness of this solution, remarking that “in a $10 trillion economy, several hundred billion is a relatively modest amount.” Holes in the Economic Fabric
The inadequacy of the recent stimulus package brings up an important issue for the federal budget. How effectively can the government stimulate the economy when the country is, as Leach characterizes it, running “twin deficits” in trade and its budget? The federal government also cannot legitimately encourage financial institutions to curb their excessive borrowing when it has financed a war and other expensive policies almost entirely on debt. The government’s tendency to live outside its means has significantly curbed its ability to address economic slowdowns and discourage risky practices.

Another important structural concern is that the Federal Reserve seems ill-equipped to regulate mortgage markets in order to minimize the incidence of high-risk loans. According to Leach, the “great mistake of the Fed has been a regulatory one.” He claims that the Fed, the Treasury, and state regulators have been “inadequately attentive to some of the practices of the subprime lenders and the subsequent slicing and dicing of [mortgages].” If the pricing of MBS is to be safe and accurate, the Federal Reserve and the federal government must devise a set of standardized conventions for subprime loans. Laws regarding the scope of appropriate lending practices should also be clarified, since, as Zettler noted, “people are too scared to write some loans now, for fear that they might be classified as ‘predatory’.”

Finally, government credit ratings agencies are in dire need of re-examination. Credit rating agencies have been accused of being too close to companies that they rate, and too slow in changing ratings. CRAs are justified in charging credit issuers for their rating services, but the government must assess how this practice might bias ratings in favor of the rated and promote overvaluation of credit securities. A more accurate ratings industry should better inform investors and lessen the consequences when “laying off of risk for an individual or an institution can increase risk for the system itself,” as Leach commented.

The next administration and Congress must address the sizable challenges of reassessing federal regulatory and rating systems and reducing fiscal irresponsibility if the economy is to be more flexible and resilient. If they fail to deal with these long-standing structural woes, future crises like the present one will worsen, and policymakers will find themselves desperately searching for quick-fix solutions like those currently on the table, which offer little hope for sustained economic recovery. ]]>http://hprsite.squarespace.com/got-title-042008/rss-comments-entry-1788453.xml