The "R" Word

Here at the Fed, we've been in a bit of a tizzy, looking for signs that we are, in the words of former Chairman Greenspan, undergoing a "cumulative dynamic unwinding of economic activity that feeds upon itself," also known as a recession. To make things even more interesting, I am in the finance group, which means I have an upfront view of the hottest-burning fires. It's ironic that I came to the Fed because I wanted nothing to do with investment banking...yet here I am, 6 months later, learning all sorts of things about finance, albeit from a much more theoretical vantage. Who knows, I may end up working at a big bank after all...

A lot of people have been asking me questions like "Why does the economy suck balls?" The short non-answer is, it's complicated. In a nutshell, in the aftermath of 9/11, the Fed lowered interest rates and credit became cheap, e.g. borrowing money was really easy. Mortgage brokers began underwriting loans to borrowers with checkered credit histories. Why would you lend money to unreliable borrowers though? Well, here's an innovative idea: you can bundle these subprime mortgages into new securities and sell them to investors, like other banks, hedge funds, institutional investors, etc. That way, rather than holding the loans on your balance sheet, you can resell these securities and escape risk-free. But who would buy securities based on crappy loans? Well, we could bundle a large portfolio of mortgages into separate tranches, with a range of risk levels, say, AAA through CCC. If some borrowers default, investors in the lower-rated tranches will not get paid, but the higher-ranked senior tranches will continue to pay. To compensate for the increased risk, junior tranches will also receive higher interest pay-offs. Wow, now we've even managed to create AAA securities out of a bundle of sketchy loans! This process sort of cycles through (you can repackage securities again), until homeowners decide they can't afford their mortgage payments, bank balance sheets are a black hole of intangible assets, and investors suddenly realize the emperor is wearing no clothes.

To further complicate matters, most of the financial terminology being thrown around is confusing for economists, not to mention reporters and novitiate news readers. Alt-A mortgages? SIVs? ABS? CDOs? CLOs? A new acronym seems to pop up every week. No wonder the mainstream press is replete with errors when they try to explain the unfolding events. When our department gathered for a meeting earlier this week, someone commented, "Who knew 3 weeks ago what an auction-rate security was?" This garnered a lot of laughs.

The combination of bubbles in the housing market and the financial sector is a bludgeoning one-two blow to the economy. Whereas a few years ago, credit was too cheap, now credit is too expensive, and businesses and consumers who should be able to borrow are being denied loans. Banks are nervous about lending out money, particularly to each other, and the anxiety is pervasive. This credit crunch is unusually far-reaching in scope, and seems to be taking down arcane sectors of the financial markets that have nothing to do with housing. A month ago, the leveraged loan market was under pressure. The next week, it was municipal bonds and student loans. The week after that, auction-rate securities fell victim. And now, it looks like Bear Stearns (the 5th largest investment bank on Wall St) is on the verge of going bust.

This news scares me more than any other development so far. Basically, at the beginning of the week, rumors and speculation began swirling that Bear Stearns didn't have the cash flows to meet the demands of its creditors. Despite releases and press conferences by Bear Stearns' top brass stating that their liquidity positions were sound, the market's fears were not eased. By Thursday, investors were pulling funds out en masse, and by Friday, it was clear that, regardless of whether the original rumors were true, Bear Stearns' "liquidity position in the last 24 hours had significantly deteriorated." Take a good, hard look, because we have just witnessed the modern-day equivalent of a bank run. For more details, Felix Salmon has an excellent, clear explanation of what just blew up.

Luckily, J.P. Morgan and the Federal Reserve are working to partially bail-out Bear Stearns. Amusingly enough, almost exactly one century ago, J. P. Morgan himself stepped with large sums of cash to quell the Panic of 1907, and stabilize the US economy.

As FDR once said, the only thing we have to fear is fear itself.

The next FOMC meeting is on Tues the 18th. I intend to take my final exam for stochastic processes (man, those quarters zip by fast compared to semesters!), and then dash back to my computer to see what sort of rate cut will be unfurled.