The Theory of Monetary Policy

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The financial Crisis

At the beginning of 2007, very few people had heard of the word ―Subprime‖. This was about to change by the end of the year17 with the unraveling of the subprime crisis.
A subprime loan is a type of loan that is offered with a premium to people who would not otherwise qualify for loan via regular credit channels. This concept was extended to mortgages. When a borrower applies for a mortgage, the lender checks the borrower’s ability to pay back the loans via credit reporting agencies. The assessment of the borrower’s riskiness is referred to as underwriting the loan. Subprime mortgages are handed out to people, who do not qualify for prime mortgages.
In the 90’s the subprime mortgage represented 5% ($35 billion) of total mortgages in the U.S., and by 2005, it had jumped to 20% ($600 billion) of total mortgages18. In 2006, the percentage of defaults started to rise in this particular segment, and would trigger what would be called the subprime crisis. The subprime crisis would contaminate to the whole U.S. financial sector and spread to the world to give birth to the global financial crisis.
How has trouble in a $600 billion market managed end up triggering a global recession and costing up to $7.7 trillion and wipe out 14% market capitalization?
What follows is a thorough analysis of the unraveling of the crisis, how it has spread out and how policy makers have dealt with it. The analysis will be limited to the United States.

How the system set up the crisis

A combination of macroeconomic and microeconomic factors set the founding blocks of the crisis.

Macroeconomic Imbalance

The U.S. current deficit is the starting point in the analysis. In 1991, the U.S. posted its first current surplus in 8 years 0.7% of GDP. Ever since Uncle Sam grew a current deficit of $811 billion (6.1%) by 2006; the biggest deficit ever contracted by a country. The current account represents the net result of saving and investments. The U.S. savings rate had sharply fallen from 7.5% in 1991 to 1.9% at the end of 2006. The difference was made up by borrowing from surplus countries such as Germany, China and OPEC countries. By 2005, the U.S. absorbed 80 percent of international saving that crossed borders.
Ben Bernanke (2005) explains that the problem emanated from the rest of the world and that the U.S. imbalance is a reaction to it. Bernanke states that, the growing surplus generated by oil exporting countries, countries with an aging population (Germany, Japan) and countries with huge trade surpluses (China, South Korea….) are the causes of the U.S. deficit. Bernanke refers to the excess saving outside the U.S. as the “saving glut”. These countries do not have capital markets capable to absorb the surplus; therefore, they turn to the U.S., which has the deepest and liquid markets in the world19. The U.S. reacted as a magnet to foreign capital. This surplus of demand gave rise in asset prices in the 90’s. Higher stock market wealth, stimulated Americans to consume more thus save less and less while contracting more debt.
Bernanke’s theory provides a suitable external explanation to the deficit. Internal causes have to also be factored in. The U.S. budget deficit kept growing at the same pace as the current deficit, giving birth to the “Twin deficit” hypothesis.
However, the sparks accelerating the imbalances came after the burst of the dotcom bubble in 2000. We thus examine the role of monetary policy during the Greenspan era In January 2001, the technology bubble, which had built up over the past 5 years, went burst. The tech wreck threatened to send the economy into recession. Staying faithful to his standards, “Ride the booms and cushion the bursts”, Greenspan lowered interest rate in order to keep the economy afloat. Shortly afterwards the September 11 events occurred and sent shockwaves throughout the system. The Fed, determined to avoid a Japan style deflation, which cost Japan a decade’s worth of growth, began a series of rate cuts in order to provide liquidity to the market to fend of the deflationary pressure and keep the economy form falling into a painful recession. After 13 rate cuts, as shown in Table 3, the Fed funds stood at 1% in June 2003 from a high of 6 percent in January 2001. Rates would be maintained at 1% for a year.
Extremely low interest rate helped a highly leveraged indebted corporate America restructure its balance sheets and navigate through the storm. Low rates also helped created a new imbalance, this time in the housing market. Low interest rates implied low mortgage rates leading to a boom in mortgages. This had two implications: 1) the excess demand for housing lifted house prices and directly increased household net worth. As Americans, felt richer they started consuming their newly acquired wealth. Consumption soared to more than 70 percent of GDP and saving fell to as low as 1.9 percent, this led to more and more imports, widening the current account deficit. 2) As mortgage lending soared the market began to saturate, so lender turned to more risky customers with subprime mortgaged increasing demand in an already buyers’ market. Mortgage companies also started to pop up like mushrooms. This was made easy because lending terms were eased by banks20.
Low interest rates are not the only culprits in the housing boom; legislative measures set the bedrock for the boom, which started well before 2001 as shown in Figure 2. Congress pushed Freddie Mac and Fannie Mae, two government sponsored enterprises (GSE), to increase their purchase of mortgages going to low and moderate income borrowers. In 1996, specific targets were given to our two GSE’s: 42 percent of mortgage refinancing was to go to borrowers with income below the median income of their area. The figure rose to 50 and 52 percent respectively for 2000 and 2002. Meeting targets was easy because Freddie Mac and Fannie Mae both enjoyed government backings; they were thus able to borrow at very low rates. By 2006, the two enterprises had bought billions of subprime mortgages.
The Fed’s policy indirectly increased world liquidity via two channels: 1) increasing foreign exchange reserves in net exporting countries. With American consumption at its highest, Asian countries enjoyed a boom in export to the U.S.. They accumulated huge amounts of dollar reserves. Leading the pack, China and Japan saw their reserves grow respectively from $212.2 and $387.7 billion in 2001 to $ 1,104.7 and $880 billion in 2007. Some of this money found its way back in the U.S. through financial markets, adding more liquidity to the U.S. market thus driving prices higher. 2) Countries such as China and most Asian countries have their currency pegged to the dollar; they indirectly imported Uncle Sam’s expansionary policies resulting in an increase in domestic liquidity.
Why wasn’t this increase in global liquidity translated into inflation? The 80’s hawkish monetary policies proved successful, average inflation of OECD members was reduced from 15 percent to less than 5 percent. Volatility in inflation was also reduced considerably. This was coupled with the ―great moderation‖ a decrease in GDP volatility throughout the world and fierce competition which drove prices down (especially among Asian countries). Monetary institutions had the faith of the private sector in keeping low inflation. The result was low inflation expectation in the short run and medium run.
Microeconomic shakiness, the quest for higher return and securitization
Macroeconomic imbalance gave ground to microeconomic shakiness in the financial sector and gave birth to excessive risk taking and complex financial products.
After the dotcom bubble burst, panic could be read all over the market. In such time investor run for in fixed income markets, government bonds, especially the U.S. treasury market. This situation is referred to as flight to safety; investors weather the storm by taking refuge in fixed income security. Treasury securities offered security but the returns were miserable consequence of historically low interest rates. With global liquidity at its highest in decades, banks held excess liquidity and face heavy competition from alternative funds (private equity firm and hedge funds) that generated double-digit returns. Their returns differed from others due to their high leverage ratios. With interest rates so low, this did not constitute a problem in the short term. Alternative fund started poking investor from traditional investment banks, which were not able to offer the same returns. In a need to bolster returns investment banks began to be more and more creative and started taking more and more risk. This is the beginning of an unprecedented boon in complex financial products. Traditional banks also started to soften lending term in order to increase returns, leading to a boom in mortgage lending. For regulatory purposes, an increase in loans needed to be couple with an increase in capital. Banks and lenders have found a brilliant way to go around this: Securitization
Securitization contrary to common believes is not a new practice, it has been used for over half a century. The first such operations were completed by GSE (Freddie Mac and Fannie Mae). Securitization is a financial technique used to transform traditional illiquid bank loan into marketable securities. Securitization only concerned mortgages at that time and were referred to as mortgage-backed securities (MBS).
Thanks to financial innovation, securitization would be extended to all type of credits and GSEs would no longer hold the monopoly. Asset backed securities (ABS) are securities backed by a pool of loans other than mortgages (Consumer credit, auto credit etc…) Collateral debt obligations (CDO) are securities backed by a pool of marketable loans (Bonds, commercial papers). The returns of the securities are guaranteed by the interest paid on the loans.
Securitization transfers the credit risk from the lenders to the markets, it takes the loans of the lenders’ balance sheet therefore no need to increase capital and even better, they could give out more loans. Securitization has developed very quickly; total securitized market was worth $10 trillion representing 40 percent of the bond market21 at its peak in 2006. Securities were sold by different category of risk meaning different type of returns.
The riskiness of the new securities was accessed by rating agencies. Based on the ratings assigned to each tranche of security, their valuations are determined. Senior tranches were the most secure and rated AAA/Aaa, then came mezzanine, with a little more risk and rated BBB/Bbb and equity tranches the riskiest of them all with non-predefined retunes and with a high-expected return.
Securitization expanded so rapidly, institutions started buying securitizes securities on the market. It became so complex, bankers did not know who had what, hence were not able to access the risk related to these securities. This did not matter much to them because they had bling faith in the rating assigned by rating agencies and they believed that the risk had been spread out throughout the markets.

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The Meltdown

The previous subsection explained the frail built up of the system. The frail system was a castle of card. All was well until on component moved or defected, triggering a mass domino effect.
The perennity of the system was based on two pillars. The first pillar was stable and low interest rates. This allowed interest paid on debt to be low. It also allowed lenders to be more expansionists. The second pillar is a direct consequence of the first, housing prices should continue to rise, hence making household richer and entitling them to borrow more with their houses as collateral.
Pillar 1 was brought down with the tightening of monetary policy for fear of rising inflation. Interest rate progressively climbed from 1 percent to 5.25 percent between 2001 and 2006. The rise in Fed fund rates constitutes the triggering of the domino effect that led to frenzy in the markets.
With a high volume of adjustable mortgages, household felt the pinch when interest rates their upward march. This increased the delinquency rate on mortgage payment as shown in figure 3.
A rise in delinquency rate meant that cash flows to holders of MBS’s were not guaranteed. This in turn prompted rating agencies to reevaluate their rating on MBSs. The dominos effect was set in motion.
Moody’s degrade 131MBS from AAA to BBB and put 250 more on their watch list.
S&P put $7.3 billion worth of on a negative watch list and Moody’s degrades $5 billion MBSs from AAA to BBB. Moody’s puts 184 tranches of TGC Home’s MBS on negative watch list.
Sales of new home fell almost 6.6 percent compared to a year earlier.
With interest rate going up less and less borrowers were able to shoulder the burden of the monthly mortgage rate. By end, 2007 there was a serious gap between offer and demand for new houses in favor of the former. This drove house prices down destroying the second pillar of the system and gave way to the free fall. Figure 5 explains the series of chain reactions that followed.
Excess housing put downward pressure on prices. This decreased household’s net wealth and made it hard to refinance under favorable terms. Monthly mortgage rate increased and lower end borrowers were not able to meet repayments deadlines. This in turn decreased the cash flow to securitized asset, therefore prompting rating agencies to lower ratings. A lower rating highlighted more risk, which implied a higher rate of returns. This drove the prices drown. Banks bought the AAA rated securities and used them as collateral in their balance. With most of the MBSs downgrade, they did not meet the standards of collaterals imposed by Basel II. Banks had to recapitalize in order to satisfy regulation.
At this point, none of the major financial institutions knew what the length of their exposure to these toxic assets. An accelerator of the downfall was the mark-to-market or fair value accounting. This obliged institutions to value certain categories of asset (this included MBS, ABS and CDO) held on their balance sheets at market value. During the crisis this was a huge problem, there was no market for these securities because no one was buying them and their prices just kept on collapsing, prompting another series of write-downs and recapitalization.
The rapidity of the contagions was due to the sophistication of new financial products, the mispricing of risk, and the inability to evaluate holdings. Nobody knew what others exposures were and this triggered a confidence crisis. Banks were unwilling to lend to each other even on the shortest term, overnight. The interbank market dried up. What had started out as a subprime crisis due to over liquidity had mutated in to a confidence and liquidity crisis.
The road to recession come through the credit channel, banks in urgent need to bolster their balance sheet, simply stopped giving out credits. This has the same effect as to cash strap business that was not able to roll over their debts. This in response triggered massif layoffs. Fewer workers meant less disposable income as a whole thus less consumption. Consumption is the main propeller of the U.S. economy, a steep drop in consumption led to the economy to a grinding halt, which in turn led to more layoffs, thus lowering consumption, and the vicious circle goes on.

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Policy response

The Fed has been aggressive in combatting this crisis and to avoid a total market meltdown. The Fed’s main priority during the crisis was financial stability. Ben Bernanke, widely renowned as one of the best experts of the great depression, was the right man for the job. The Fed used convention and unconventional methods within its legal limits to ensure stability. The conventional methods are the usual rate cuts during FOMC meeting. The rate cut are displayed in Table 4.

Table of Content
Figures 
Tables 
1 Introduction 
2 Monetary Policy in the U.S.
2.1 The Theory of Monetary Policy
2.2 Role of Monetary Policy
2.3 The Federal Reserve System and Monetary policy
3 The financial Crisis
3.1 How the system set up the crisis
3.2 The Meltdown
3.3 Policy response
4 Empirical Analysis
4.1 Methodology and Data
4.2 Analysis and Results
4.3 Results
5 Conclusion 
References
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The Global Financial Crisis and the Monetary Policy of the United States of America

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