The danger of raising rates

Posted: Jul 12, 2005 12:00 AM

Two weeks ago, the Federal Reserve again raised short-term interest rates. The federal funds rate now stands at 3.25 percent. This is the rate banks charge each other on overnight loans and is generally the lowest interest rate in existence, setting a floor for all other rates. In June 2004, it stood at just 1 percent.

 So far, financial markets have shrugged off the Fed's actions. Indeed, mortgage rates are actually lower now than they were before the Fed started tightening, fueling a housing "bubble" in the opinion of many economists. The lack of response in markets suggests that the Fed will have to tighten much more than it originally planned in order to achieve its goal of keeping inflation in check.

 Despite the paucity of evidence that Fed tightening is having any meaningful economic impact, Fed officials are very concerned that it could come about quite suddenly. The Fed raises interest rates by tightening the money supply, the growth of which has fallen sharply over the last year. Historically, this always leads to an economic slowdown with a lag of about 18 months.

 But long before the impact of Fed tightening shows up in the gross domestic product figures, it will begin impacting on financial markets. The danger is that with markets so interconnected, with so many extremely complex linkages, problems can quickly spread, affecting areas far removed from the original source. For example, some years ago, the failure of a small Iowa bank almost brought down one of the largest banks in Chicago, which threatened the health of the entire banking system before the Fed engineered an emergency bailout.

 On June 14, Federal Reserve Board Governor Susan Schmidt Bies issued what for the Fed is a pretty explicit warning about the systemic dangers in the housing bubble. Her comments are worth quoting at length.

 "We worry," she said, "that borrowers could become increasingly speculative, buying beyond their means and hoping for asset price appreciation -- whether they are buying for their own use or strictly for the sake of investment. We worry that competitive pressures could drive banks to lower their underwriting standards, implicitly encouraging such speculation. And we worry that, in the inevitable downturn, credit quality could deteriorate to the extent that some banks could experience significant losses."

 Continuing, Bies said: "We see indications that underwriting standards are beginning to weaken. For example, 'affordability products' -- such as interest-only loans, negative amortizations and second mortgages with high loan-to-value ratios -- are becoming more popular; subprime lending is growing faster than prime lending; adjustable-rate mortgages, or ARMs, have grown substantially and now account for more than a third of all mortgage originations, the highest level since 1994. Industry experts are increasingly concerned about the quality of collateral valuations relied upon by home equity lending and residential refinancing activities."

 What she's saying in Fedspeak is this: In years past, people bought houses with substantial down payments; today they are buying them with virtually nothing down. Mortgage payments used to include a paydown of principal; today, there often is none. People used to need good incomes and credit to get mortgages; today, people with poor credit are buying houses they really can't afford. Consequently, there is much less of a cushion for banks should borrowers begin defaulting on loans.

 As with all financial bubbles, everything works as long as prices keep going up. People build equity quickly and may be able to "flip" a property for a fast profit. Others can use their equity to get easy cash through refinancing or second mortgages, which they may use for investments or conspicuous consumption.

 But if prices fall even a little, many people may quickly find themselves overextended, with investment properties that can't be rented profitably, mortgage payments that are rising automatically and mortgages that may exceed the value of their property. At that point, they may decide to just walk away or declare bankruptcy, leaving lenders holding a lot of bad paper and in possession of real estate that isn't worth what was paid for it.

 We have been through this many times before, most recently in the early 1990s, when hundreds of banks went belly-up, requiring a taxpayer bailout of $150 billion to protect depositors. And just five years ago, we saw the stock market bubble burst, wiping out vast sums of wealth. Both of these incidents resulted from a tight Fed policy and came about unexpectedly, while many experts told us that economic fundamentals were sound.

 I believe that there are a lot of stresses and strains in our financial system right now resulting from the housing bubble, Fed tightening, large budget deficits and international financial imbalances. We might survive a threat from one, but not all. Sooner or later, there is going to be a correction.