Bernanke's No-Win Interest Rate Decision
Interest-Rates / US Interest Rates Sep 17, 2007 - 12:51 PM GMT
Martin Weiss and Mike Larson write: We feel sorry for Ben Bernanke. He didn't create the sputtering, explosion-prone tanker truck he's trying to maneuver.
Nor did he get any training on how to shift gears.
But he's certainly getting plenty of not-so-subtle prods and catcalls from a diverse group of back-seat drivers.
Put yourself in his shoes. Sit down in a face-to-face meeting with them. And with decision-time just 24 hours away, imagine what it must feel like to hear their ever louder demands …
Showdown with the Fed: A Fictional Debate on the Eve Of a Monumental Decision
Assembled around a long mahogany table are the nation's most powerful monetary and fiscal policymakers … along with an eclectic group of CEOs from the U.S. industries most severely impacted by the credit crisis — home builders, mortgage lenders and Wall Street bankers.
Federal Reserve Chairman Bernanke, seated at the head of the table, knows that each of the attendees is feeling the compulsion to have the first — or, even better, the last — word. And he recognizes that all believe their single industry is the pivotal factor in bringing the U.S. economy to a momentous fork in the road. So as he opens the meeting, he takes great care not to direct his gaze to one group more than any other.
Bernanke: Over the past month, our staff — and the staff of the Treasury Department — have heard from each of you privately. But despite the staffs' efforts to convey the contradictions in your divergent expectations, those expectations — and demands — continue to escalate.
So this meeting is as much an opportunity for us to hear you as it is for you to hear each other — to witness, first-hand, the conflicting pressures the Federal Open Market Committee, the Treasury Department and other policy-making bodies are experiencing, and to convey to you a better understanding of the severe constraints under which we operate.
From several of the industries represented here today, the bottom-line demand, although never expressed in quite those words, is very simple: You want a bailout.
In effect, you want the government to restore an environment of risklessness … and even recklessness — the very same atmosphere that brought us to this impasse we are here to discuss today.
If that's your true agenda — and I fear it may be — the discussion is likely to be nonproductive. If, however, we can come away from this debate with a better recognition of the complexities and limitations of policymakers, I think it would be a productive outcome.
Pulte Homes: Mr. Chairman, I am volunteering to speak first because the nation's leading home builders — including ourselves, D.R. Horton, Lennar, Centex and others — were the canaries in the coal mine, the first to feel the shifting winds of this storm. Specifically, I'm talking about the downturn in the pace of new home sales which began many months before the subprime mortgage crisis.
That's where it all started. It's from that critical turn in our market that the chain of events unfolded — the decline in home values, the foreclosures, the mortgage meltdown, the credit crunch.
And that's also where I believe a new phase of this crisis is now beginning — where we're on the brink of a second, far more serious decline — which, if allowed to happen, will not only stall the nation's economic engine but could throw it into reverse.
Here's what's happening: Due to overwhelmingly large stockpiles of unsold homes, accompanied by a further, sharper decline in the pace of sales, many in our industry are on the verge of announcing deep discounts in home prices. But they dare not lest it set off a panic in our marketplace.
So what we're doing is to try, in effect, to disguise the real price declines by offering — even showering — home buyers with lavish incentives, freebies if you will.
We're doing our best to hold the line, but we cannot keep that up much longer. Sooner or later, one or more of our members is going to break ranks and start a pattern of cut-throat, competitive price reductions. Those, in turn, are going to precipitate deeper declines in the price of existing homes. And all of this is then going to show up in the national stats compiled by the National Association of Realtors and others.
When homebuyers see those stats, even the few buyers with cash or top credit ratings will be spooked. And they will vanish.
So what I'm saying is that you are right. We are asking for a bailout, and we're doing so unabashedly. Without it, the Fed's prime objective of maintaining economic growth is dead on arrival.
Bernanke: I recognize and understand your passion in this matter. But I hasten to warn you — and everyone here — that overstating the nature of the crisis could have a perverse impact on our response.
Countrywide Financial: Allow me to respond to that, Mr. Chairman. Since last week, I, along with several others in the mortgage industry, have been in intense discussions with the Treasury on this entire matter. And from our various conversations with policymakers, we sense a broad undercurrent of reluctance to provide support to risk-takers in this market.
I understand that. I even agree with the broad, high-level philosophy that it represents. But if there ever was a time when on-the-ground conditions warranted suspending those concerns — setting them aside temporarily — this is it.
So I, too, have no hesitation in using the term "bailout" with reference to what we're asking for.
The reason is this: There's no way — and certainly no time — to quarantine risk-takers. There's no mechanism for separating "legitimate" first-time homebuyers from part-time investors, or to separate part-time investors from all-out speculators. In fact, there have always been blended elements of both investment and speculation in the housing and mortgage marketplace.
Moreover, the urgency of the situation — to save the entire marketplace, to prevent a collapse of the housing and mortgage industries — supersedes, in our view, any longer term, philosophical goals, no matter how much we may all subscribe to such goals.
Please allow me to leave you with this one thought: I know there are conflicting demands on policymakers from different industries represented around the table, from foreign investors, from members of the Federal Open Market Committee. But we need to stop and ask: How will a deeper collapse in home prices — and a broader meltdown in the mortgage market — impact the others in this room? What will that do to the U.S. economy? How would that constrain Fed policymaking?
Freddie Mac: I have asked that same question of our economists who track the impact of housing on the broader economy, and I feel I can answer it without equivocating: If the housing market is allowed to deteriorate much further, the risk of recession, which is already high, would be close to 100%.
Indeed, I don't think it would be an overstatement to affirm that any further housing collapse dooms the U.S. economy to one of its deepest recessions since the Great Depression.
Right now, it's safe to say that large segments of the mortgage market, especially those carried or sponsored by government agencies like ourselves and our colleagues at Fannie Mae, are sound. But how sound will they be if the serious concerns raised by Pulte Homes and Countrywide Financial are not addressed? If their worst fears are confirmed?
Think about it. We're already experiencing the worst credit crisis in decades just because certain segments of the U.S. mortgage market have been wounded. Imagine where we'll be if most, or all, of the mortgage market is wounded, mortally or not!
How can we — or anyone — write, package or underwrite mortgages if subprime high-risk borrowers are defaulting by the millions AND, at the same time , even prime borrowers are putting up homes for collateral which are sinking in value?
Yes, we know that the task of removing risk from the marketplace is not the Fed's role or goal. But that's precisely what we must have nonetheless.
Bernanke: What precisely do you gentlemen have in mind?
[The Fed Chairman asks the question and turns his gaze to three men representing Wall Street's largest investment bankers. The Chairman expects the gentleman who's the most senior among them to voice a dissenting opinion. But it's his junior colleague who speaks next. ]
Bear Sterns: What we want is either a half-point rate cut tomorrow, or if that isn't possible, a quarter-point cut accompanied by a clear indication that more rate cuts are imminent.
To better understand the urgency of this request, compare where we are today in the credit markets to where we were just a couple of months ago when Bear Sterns first evaluated and revealed the difficulties we were having with our two hedge funds in this sector:
First, we are witnessing a far broader-than-expected fall-out from subprime mortgages in other credit markets. Everyone who has ever said it was contained has repeatedly been proven wrong. And every time credit market participants begin to say "fear is fading" and "confidence is returning," another situation blows up.
Look at what happened just late last week in Britain. Northern Rock PLC eclipsed all previous European casualties from the subprime crisis. It suffered a run on deposits, just like our banks did in the early 1930s. And had the Bank of England not acted promptly, God only knows what the consequences might have been!
Do we know who's next? No. But one thing we do know is that nonbank banks can have consumer deposits just like true banks. And like the true banks of yesteryear, nonbank banks are vulnerable to a run on those deposits. Is that what we want? A situation like the 1930s? A situation in which millions of consumers and investors are pulling their money out of hedge funds … then nonbank banks … then other financial institutions? I don't think so.
And that's why we say that, if the Open Market Committee decides not to cut its target rate for Fed funds by a half point tomorrow, it must at least signal its intention to do so incrementally … and quickly.
[A contagious round of nodding spreads around the table, engulfing not only industry representatives but also many of the Fed's staff. However, one not-so-senior staff economist at the Fed shakes his head, and by so doing attracts the stares of nearly all others. Most are a bit outraged that he even dares speak — let alone speak his mind.]
Fed economist: Gentlemen, although you may have read some of my reports, you probably do not know me. But at the risk of being the fly in your ointment, please allow me to add my voice of dissent to this otherwise unanimous discussion.
If you have been watching the financial markets, you have no doubt noticed a few recent events that have immediate bearing on the FOMC's upcoming decision.
First, gold. Gold is a market that our former chairman often paid attention to — not because of its intrinsic monetary importance, but as an early indicator of inflationary expectations in the marketplace. And if he were a part of these discussions today, he'd probably be saying — or at least thinking — that to ignore the inflationary expectations implied in gold's recent surge past $720 per ounce would be a grave error.
Second, crude oil. I don't have to remind you that last week's price surge to $80 per barrel is more than just a sign of inflation. It's an actual source of inflation that propagates and multiplies through the global economy in the form of rising costs for hundreds of products derived from petroleum, in the form of a parallel rise in the cost of nearly all forms of energy, and in the form of the costs required to make or transport millions of products.
Third, the dollar. The dollar's decline is not just a signal of inflation. And it's not just a source of inflation. The dollar's decline — to a 15-year low last week and to a likely all-time low any day — could be precisely the factor that triggers the collapse everyone is trying so hard to avoid.
Where do you think most of the money for the housing boom came from? Who do you think financed the single biggest share of subprime mortgages? Mortgage-backed securities? Mortgage-backed commercial paper?
It was foreign investors, using the hard-earned savings of foreign citizens in foreign currencies.
The foreign investors sold their currencies to buy U.S. dollars. They used those dollars to buy our subprime mortgages, or securities derived from subprime mortgages.
And now, for reasons that should be obvious to everyone, they're trying to get the hell out.
Bear Sterns just pointed out what happened in Britain last week with Northern Rock. You also saw what happened in Germany last month. And you know that this is just the tip of the iceberg.
So now, on top of giving foreign investors more risk for their money, you also want to give them less yield for their money?
So now, with the dollar already falling and with foreign investors already spooked, the proposal on the table is not only to cut U.S. interest rates, but also to do so at double the normal pace?
Don't you see? This is where the chickens come home to roost, where the dots connect back to everything that has been said here today: That foreign money you're turning away was the single largest source that financed the U.S. mortgage bubble, that financed the U.S. housing boom.
So go ahead. Do what you're proposing. Send foreign investors home packing. And then see what that will get you: For every dollar of bailout money you pour into this mess, another two … three … four … or more dollars of foreign financing will be pulled out from this mess.
I rest my case.
Back to Non-Fiction
This meeting never took place and probably never will. But it represents a realistic composite of fervent discussions being held in recent days and leading up to Bernanke's decision tomorrow.
We don't know precisely what they're saying. But we do know this: The lone voices of those warning of the dollar's decline are being drowned out by the din of voices shouting for interest-rate relief.
Bottom line: Count on a rate cut tomorrow. But don't count on it satisfying the demands being made on the Fed.
And after some possible initial cheers from Wall Street, expect a wave of disappointment — first in the foreign currency market, then spreading to the U.S. bond markets and also infecting the U.S. stock market.
What should you do on the eve of Mr. Bernanke's no-win decision?
Simply follow the prudent steps we laid out in our recent Crash Alerts.
Plus, join Martin on the Web at noon Eastern Time the day after tomorrow, as we lay out a new strategy for urgent self-defense and massive profit opportunities.
Just remember: The deadline to register for this free event is midnight tonight.
Best wishes,
By Martin and Mike
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