U.S. Mortgage Crisis Rivals S&L Meltdown

Today's Wall Street Journal has a lengthy article about the subprime mortgage crisis.

Northern Rock: the first mass run on an English bank since 1866

Northern Rock is a British bank. It experienced this summer what Chris Giles, Economics Editor of the Financial Times, calls "the first mass run on an English bank since 1866." (FT.com: Oct 25, 2007)


Northern Rock had a peculiar business model: In Mr. Giles' words, the Bank of England characterized Northern Rock "with its dependence on securitisation, the concentration of its asset base in mortgages and the narrowness of its margins - [as] an outlier in British banking."

Where was the lender of last resort? "The Bank [of England] now acknowledges that officials did partly fumble the lender of last resort operation for Northern Rock.

Moral Hazard

Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently at the peril of the other party. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.

If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlord require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.

Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions

Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.

In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me.

In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's do?

If it can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.

The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from new loans that it can get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for more profitable but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off.

Neither the the bank nor the depositors are behaving they way they would in the absence of deposit insurance. That is the essence of moral hazard.

FT: Martin Wolf, "Securitisation: life could follow death"

Securitisation: life could follow death

By Martin Wolf, FT.com site
Published: Oct 02, 2007

"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." Chuck Prince, Financial Times, July 10 2007.

"A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him." John Maynard Keynes, 1931.

The dance has stopped: Mr Prince's Citigroup has just announced $6bn in write-downs and losses for the third quarter of 2007. He is far from alone. More bad news is no doubt to come. As Keynes foretold, the banks joined Mr Prince's dance together and are leaving it together. Until the dance ends, nobody knows what a bank's profits are: bankers report (and pay themselves) on the basis of profits that are normally offset by write-offs when the bad lending comes to light.

What is remarkable about the present crisis is how traditional it is, despite the modern paraphernalia of securitised lending. We are seeing old-fashioned bad lending and old-fashioned mispricing of risk. What is remarkable, in addition, is the severity of the consequences. The US market in asset-backed paper contracted by 21 per cent between August 8 and October 1. The flight from risk also brought about big divergences between interest rates on commercial paper and US Treasury bills and between central bank interest rates and those in interbank three-month markets. This disruption, moreover, has taken place at the core of the world economy: the US housing market and debt markets of advanced countries.

I admit to both surprise and disappointment. No, I am not surprised by the repricing of risk. On the contrary, together with a host of outside observers, I was astonished by the willingness of yield-seeking investors to take on risks for small reward. If anything, the repricing has been remarkably small, at least so far: equity markets are buoyant; spreads over US Treasuries of emerging market bonds in the JPMorgan emerging market composite bond (EMBI Plus) index rose by a mere 39 basis points between July 6 and October 1; on Baa-rated corporate bonds, they rose by 59 basis points; and even on Caa-rated bonds, they rose by no more than 191 basis points.

What I am surprised by is how toxic securitisation of subprime mortgages has turned out to be for the financial markets. I admit that I thought securitisation had attractive features: it should allow banks to remain in the mortgage business as originators and intermediaries without taking too much of the interest-rate, term and liquidity risks on to their own highly leveraged books; it should allow banks to transfer those risks on to investors who want longer-term, higher-yielding assets; and, in the process, riskier borrowers should have access to more credit than before.

In 2005, Alan Greenspan himself, then Federal Reserve chairman, remarked that advances in technology had revolutionised lending: "where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending."* Oops!

So what went wrong? There are two chief answers. The first has nothing to with securitisation itself: it is that a fit of all-too-familiar euphoria overwhelmed both lenders and borrowers at a time of low interest rates and rapid rises in the prices of the underlying collateral (namely, housing). But the second has a great deal to do with securitisation: it is that the process of removing lending from the books of the initiators encouraged sloppy lending ("it is not going to end up on our books") and greater belief that banks were free of the risk ("this special purpose vehicle has nothing to do with us") than turned out to be the case.

Why did this happen? As Robert van Order of the universities of Aberdeen and Michigan points out, securitisation necessarily creates a chain of transactors where bank lending interposes just one institution between the borrower at one end and the depositor at the other. Such chains depend on trust or, as he puts it, "reliance on originators and servicers to originate good loans and service them properly". The trust proved misplaced and has duly vanished: credit means "he (or she) believes". Alas, he no longer does.

In trust's absence, ignorance not only of what securitised assets are worth but also of who holds them has dried up asset-backed paper markets. That has forced banks to lend directly to the conduits, special purpose and special investment vehicles they created. The need to fund these has dried up lending and, above all, the provision of liquidity to interbank markets. One result (among many) was the collapse of Northern Rock's business model in the UK.

An obvious reaction to this debacle is to recommend going back to the old bank-based lending model. But that would be a big mistake. The potential advantages of securitisation, vis a vis "plain vanilla" bank lending, remain, because banks are inherently so fragile. But if these markets are to recover, the errors must be fixed: first, a way must be found to demonstrate integrity of lending; second, transparency of the securities will have to increase; and, third, banks must insure themselves adequately against the need to provide liquidity to their off-balance-sheet vehicles. It is not impossible to sell complex products safely: Boeing and Airbus manage it. But only companies that demonstrably care about their reputations are able to do so. It is up to originators of securitised liabilities to do the same.

A great deal of dust still has to settle in housing markets, financial markets and the world economy. The world that emerges will look different, in many ways. But there is no reason securitisation should not become as normal and reliable an element in financial markets as corporate "junk bonds" and loans to emerging markets have also turned out to be. It is always possible to have too much of a good thing. In this case, the world has had far too much of something that was not as good as it ought to have been. But securitisation is a good thing, all the same. It can re-emerge, provided the lessons of the financial markets' dance are learnt.

*Remarks by Chairman Alan Greenspan, April 8 2005, www.federalreserve.gov/BoardDocs/speeches/2005/20050408/default.htm

**On the Economics of Securitization, http://deepblue.lib.umich.edu/handle/2027.42/55302

martin.wolf@ft.com

Sources for charts: Federal Reserve; Thomson Datastream

FT: Martin Wolf on "Challenge of rescuing world economy"

Challenge of rescuing world economy

By Martin Wolf, FT.com site
Published: Sep 11, 2007

The financial markets have taken the world economy hostage. This has presented the world's central banks with a dilemma. They fear the consequences of paying off those responsible for the mess. But they cannot let hundreds of millions of innocents suffer. Last week's announcement of the first US monthly fall in employment for four years has made a cut in interest rates from the Federal Reserve this month a virtual certainty. So act it will. But making the right decisions is going to be hard.

Martin Feldstein of Harvard university put the case for big cuts in a powerful summing up at this year's Jackson Hole monetary conference.* He argued that the US housing sector was at the heart of three interrelated events. First was "a sharp decline in house prices and the related fall in home-building that could lead to an economy-wide recession ". Second was "a subprime mortgage problem that has triggered a substantial widening of all credit spreads and the freezing of much of the credit markets ". The third was "a decline in home equity loans and mortgage refinancing that could cause greater declines in consumer spending ".

Prof Feldstein pointed, for example, to a 3.4 per cent year-on-year decline in US house prices, with the chance of substantially more to come. Robert Shiller of Yale argued at the same conference that US house prices might ultimately fall by as much as 50 per cent, which would lower US household wealth by more than $10,000bn.

Prof Feldstein also noted the damage done to the financial markets by the crisis in subprime lending. This is partly because credit spreads are correcting, albeit modestly so far. More important, "as credit spreads widened, investors and lenders became concerned that they did not know how to value complex risky assets ". With confidence gone, banks have been forced to advance loans to their off-balance-sheet "special investment vehicles ", which uses up their capital and so starves other borrowers.

Finally, as house prices and borrowing fall, household saving rates will rise towards more normal levels and residential investment fall still further. This combination seems sure to generate a rapid decline in the personal sector's financial deficit (discussed in my column of August 21 2007).

Prof Feldstein concluded by recommending a "risk-based approach ", which treats the risk of a recession as more important than that of an upsurge in inflation. If the latter were indeed to happen, "the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level. How well it would succeed in doing this will depend on its ability to persuade the market that a risk-based approach in the current context is not an abrogation of its fundamental pursuit of price stability. "

If the Fed did what Prof Feldstein recommends, it would risk undermining its credibility. How, then, did it get into this mess? At Jackson Hole, John Taylor of Stanford university - inventor of the "Taylor rule " (which relates monetary policy to movement in output and inflation) - blamed the Fed for excessively loose policy between 2002 and 2006.

Thus, Prof Taylor believes the Fed made a mistake under Alan Greenspan's leadership. Prof Feldstein suggests it should risk repeating it. But these distinguished academics and, indeed, most of the US academic discussion ignore the international dimension to both the origin and resolution of this turmoil.

Prof Taylor dismisses the "savings-glut " explanation for the low US interest rates, with the observation that global savings rates are lower than three decades ago. But the world, without the US, had a rapidly rising excess of savings over investment in the early 2000s, much of it directed to the US. Given the huge capital inflow, the Fed's monetary policy had to generate a level of demand well above potential output.

The international dimension also shapes the resolution of the crisis. The Fed has a delicate judgment to make, not just between saving the hostages and rewarding the hostage-takers, but also between saving the US economy and risking confidence in the dollar.

In essence, the dollar needs to weaken, but not to crash. The Fed cannot risk a big rise in long-term interest rates, in response to loss of confidence in US price stability and an exchange-rate collapse.

Yet when house prices are expected to fall, lower interest rates themselves are unlikely to persuade people to borrow and spend. Thus a large part of the impact of lower interest rates must come via a weaker dollar and large improvements in the external balance.

This is another way of saying that the era in which the world could rely on the engine of US consumption is now at an end. If anything, the engine is more likely to go into reverse.

So the long-awaited and much-discussed "rebalancing " of the world economy is about to accelerate. Should the rest of the world fail to respond appropriately, a significant global slowdown is foreseeable.

Yet the US is not the only country in such a predicament. In an era of low interest rates, house prices soared in a number of developed countries. These also are vulnerable to a house price correction.

Much of the adjustment to lower growth, or even a decline, in US consumption must come elsewhere. Among others, China will be in the eye of this storm. Suppose, for example, that the dollar went down against the floating currencies, notably the euro, accompanied by the renminbi. Suppose, too, that the Chinese authorities took no measures to expand domestic demand. Then the external adjustment would fall elsewhere in the world. This would prove highly disruptive, particularly in continental Europe. Even the commitment to open markets might be endangered.

The combination of house price falls with a financial crisis in the core country of the world economy means big challenges for policymakers everywhere, particularly for the Fed, since it must respond without destroying trust in the dollar, and for policymakers in savings-surplus countries, who must anticipate a world in which the US demand engine slows sharply. Will they manage to keep the world economy expanding stably? A year or so from now we will have a far better idea of the answer.

* 'Housing, Housing Finance and Monetary Policy', September 1 2007, www.kc.frb.org

martin.wolf@ft.com

Richard Green's Three principles for avoiding future subprime messes

Changes in policy should accomplish three things:

(1) It should make sure that all parties in the lending chain have “skin in the game.” While reputational risk mitigates against bad behavior, there is no substitute for financial incentives.

(2) It should make sure that all parties in the lending chain are subject to federal supervision. This will reduce regulatory arbitrage.

(3) It should do what it can to improve disclosures throughout the lending chain. Borrowers must be better informed as to the consequences of their lending choices (although this will be difficult); ratings must be consistent, and securities must be more transparent.

Milton Friedman on Bubbles and Busts.

You can read another version of this on the Hoover Digest 2006 No. 4.

How Might The Fed's Lowereing Its Interest Rate Target Be "Bad News?"

The Fed pushes down the Federal funds rate by buying securities with high powered money which increases bank reserves. Increasing bank reserves allow banks to compete for more deposits that will fund more loans.

More loans mean more business, more economic activity, more demand for goods and services, and potentially more rapidly rising prices (i.e., inflation.)

More inflation penalizes saving and investment, encourages unproductive activities, and capriciously reallocates wealth.

Eventually the Fed will have to rein in the money supply to reduce inflation which will mean real pain.

The bond market voted with its feet yesterday: long term bond yields rose in response to the rate cut and bond prices fell. Bond investors were expecting more inflation.

Where the Jobs Are: Wealth Management

To you Millennials and Gen Xers, the Baby Boomers may be a pain, but they will have plenty of assets to manage. And there are some nice jobs to be had managing them!

Josee Rose reports in today's (September 24, 2007) Wall Street Journal that "Turbulence in the mortgage and credit markets has darkened the outlook for Wall Street's jobs machine, but wealth and asset management are proving to be bright spots.

In the midst of talk about lower bonuses, possible layoffs and a likely drop in employment within the financial-services industry, firms continue to expand their asset- and wealth-management units. Investment options are exploding, and companies are searching for employees whose understanding of money management goes beyond stocks and bonds."

What's a Minsky Moment?

The Wall Street Journal's Justin Lahart reports that the "Minsky moment has become a fashionable catch phrase on Wall Street. It refers to the time when over-indebted investors are forced to sell even their solid investments to make good on their loans, sparking sharp declines in financial markets and demand for cash that can force central bankers to lend a hand."

The Financial Times' David Bowen is a Central Bank Website Junkie

Subtleties and hilarities of central banks

By David Bowen

Published: September 3 2007 10:50 | Last updated: September 3 2007 10:50

Visitor numbers to central bank sites must have been breaking records this month. Both professionals and the “interested punter” will have wanted to see what the Fed and its equivalents round the world have been saying and doing about the tremors running through the financial world.

One of my dark secrets – not a great chat-up line – is that I find central bank websites extraordinarily interesting. First, almost every country has one, which means I can wander around the world seeing how essentially the same job is being done in Tajikistan (www.nbt.tj), Tonga (www.reservebank.to) and Thailand (www.bot.or.th). The Bank for International Settlements, the central banks’ central bank, lists 163 central bank links on its own excellent site (www.bis.org), and that’s without including all 13 banks the greedy old US has.

Second, as I have said, central banks are trying to serve two very different markets - professional and public – which is like to trying to combine an academic journal and a popular newspaper into one publication. The core market is made up of specialists in the markets, governments, academia and the like; they want announcements, speeches briefings and publications, and also vast quantities of data. But as publicly owned institutions central banks (or most or them) also feel a duty to explain the financial and banking system to their owners: us. This month more of both groups, I would guess, have been visiting the Fed and its equivalents around the world. They will have found that some central banks manage to serve everyone with panache; others (too many) do not.

Unfortunately one of the less successful efforts is the US Federal Reserve site (www.federalreserve.gov), which is a bit of a mess. “Breaking news” is a dramatic heading that is quickly undermined by headlines such as “Approval of proposal by The State Export-Import Bank of Ukraine”. These are simply the latest press releases – hardly “breaking news”. One headline is related to the crisis - “FOMC statement”’ – would be recognised by professionals, but would mean little to the passer-by.

Am I being harsh? After all, the Fed has to be incredibly careful what it says, and how it says it. I don’t think so. Look at some of site belonging to some of the other banks in the Federal Reserve System, and you will find much clearer approach. The St Louis Fed home page (www.stlouisfed.org) provides a headline that actually says something (”FOMC: Ready to mitigate effects of financial disruption”) as well as a summary of two relevant releases. In other words, it uses simple editorial techniques to shed light on the obscure.

Inside, many pages on the Fed site appear to have no navigational links – unless you scroll right down to the bottom and find a small and varying selection. This is breaking the first rule of navigation:[Click to read on.]

In the Financial Times, Professor Charles Goodhar Argues that "Capital, not liquidity, is the problem"

Capital, not liquidity, is the problem

By Charles Goodhart

Published: September 13 2007 18:06 | Last updated: September 13 2007 18:06

There are several odd features about current financial difficulties. They appear to have been initiated by relatively minor problems, rising defaults in a subsection of the US housing market, when the world’s economy was otherwise in splendid shape. If this is enough to cause the financial system to have a “heart attack”, there must be underlying systemic problems. What are these?

First, there is a lack of information and transparency. Regulators, in their financial stability reviews, have been complaining for years that financial innovation has made it difficult for them to observe where risk has become concentrated. What was overlooked was that it made risk just as difficult for anyone else to observe. So once risk aversion started rising, everyone came under suspicion. How does one know how many structured investment ­vehicles your bank has tucked away off-balance-sheet?

Second, one, usually valuable, source of information, ratings agencies, has been criticised for failing to provide good-enough up-to-date ratings assessments, and many investments are based on agencies’ ratings rather than on direct credit analysis. When ratings come under suspicion, entire funds and institutions likewise become suspect.

Rather than a blanket call for regulation, we should ask what information is required to keep markets operating efficiently, and how to get it.

The third issue is that, just as the central bank is lender of last resort to banks, so banks are lenders of last resort to capital markets, especially to their own clients in such markets. When those markets seize up, whether private equity deals or asset-backed commercial paper (ABCP), contingent claims on banks become transformed into huge loan obligations. Such sudden extensions of credit can cause banks to reach prudent lending limits quickly. Whether regulators have had sufficient information on, and control over, such contingent commitments is a question needing answers.

The problem is not the availability of cash (liquidity in that sense). In order to keep market rates close to the policy rate, central banks have to inject whatever the banking system wants. Indeed Barclays has stated that it is “awash with cash”, as are probably most other commercial banks. Nor does it matter in which market the central bank operates; as long as the central bank wants short rates at a particular level, it must inject a given quantity of cash; whether by operations in the overnight, one-week, three-month or longer-term gilt market is a second-order issue. Of course, a central bank could target the three-month London interbank offered rate, rather than a one-week or overnight rate, but doing so now would be tantamount to a large cut in the existing policy rate.

Nor is it a good idea for central banks to widen the range of assets acceptable as collateral. Central banks want commercial banks to hold a stock of undoubtedly liquid assets. If every time a market seizes up, the authorities move to liquefy the assets involved, in this case ABCP, what incentive is left for banks to hold lower-yielding Treasury or government bonds? A liquidity bail-out has just as severe a moral hazard consequence as a capital bail-out.

Meanwhile the contingent commitments are coming home to roost. The financial system needs the banks to lend more, possibly much more, if only temporarily. Banks are currently struggling to find the necessary funding. No wonder they will not lend to each other; they need all their spare resources for themselves. If the primary reason for the high interest rates in the three-month interbank market had been counter-party credit risk, we should have seen much more tiering of rates, between different categories of bank, than has been reported.

But in the longer term the underlying problem will become capital availability, not funding problems and certainly not cash liquidity. Worsening risk raises capital adequacy requirements, and lower profits and higher write-offs reduce the capital base. The Basel II framework for regulating banks’ risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the start of 2008, many banks will find their prior cushions of capital, above the required limit, eroding fast. That could extend and amplify the crisis.

Several of my colleagues at the financial markets group foresaw the dangerous pro-cyclicality of Basel II. Our foreboding may turn into reality sooner than we expected.

The writer is emeritus professor of banking and finance at the financial markets group, London School of Economics

Copyright The Financial Times Limited 2007

Samuel Brittan Writes in the Financial Times about the Challenge facing the ‘academic,’ i.e., Ben Bernanke

Challenge facing the ‘academic’

By Samuel Brittan

Published: September 13 2007 17:31 | Last updated: September 13 2007 17:31

One of the more ridiculous charges against Ben Bernanke, chairman of the Federal Reserve, aired on the lower reaches of Wall Street is that he was an academic and that now was not the time for an academic. This only shows how some of the foot soldiers in the marketplace are the worst advocates of capitalism.

I would propose a deceptively simple test for any actual or proposed intervention by the central banks to shore up financial institutions. This is: could you justify the measures to a blue-collar worker who has been made redundant in a British car factory or an American cotton mill and who has spent some of his enforced leisure mastering the principles of economics?

It so happens that Mr Bernanke’s academic work is highly relevant. It has nearly all been on the Great Depression of the 1930s, whose scars still remain on American life and thought. When he first joined the Fed in 2002, Mr Bernanke had to lay aside 120 pages of a book he was writing on that depression. This must have been forced on him by a middle-level security-obsessed bureaucrat. Surely the Fed ought to have the benefit of its chairman’s research, especially when dealing with credit crunches such as the present one? He himself ought to have the opportunity of revising his text in the light of recent developments.

Fortunately, before he became entangled in these restrictions he did edit and help write a book, Essays on the Great Depression*. The volume does not claim to be the complete story. Mr Bernanke’s motive was that understanding the depression would provide important clues to what can go wrong with capitalist market systems.

Like Milton Friedman, Mr Bernanke stresses the monetary roots of the depression. There is another wrinkle that Mr Bernanke introduces. This is that a weakening of financial institutions can aggravate a slump quite directly, apart from the effects on the money supply. Neither he nor Friedman has attempted a complete explanation of the weakening of economic activity that preceded it. Their interest has been in the forces that turned what might have been a normal recession into the greatest economic disaster of the 20th century.

But Mr Bernanke adds quite a lot to the original Friedman analysis, mainly through international comparisons. The depression was a world phenomenon. But its depth, time of onset and speed of recovery varied from one country to another and the differences were strongly correlated with the behaviour of the money supply in each of the countries. Bernanke also emphasises the role of the international gold standard in the spread of depression. Those countries that abandoned the gold standard recovered more quickly than countries that clung on to unsuitable gold parities.

Given these background studies it is quite ludicrous to suppose that Mr Bernanke is impervious to the dangers of US and world recession. Obviously he has to convince other members of the Fed Open Market Committee; and he has to convince himself that he is not adding to moral hazard by injecting “cheap money and plenty of it” when inflation may still be lurking around the corner. An approach like that of the Charge of the Light Brigade might impress Nicolas Sarkozy, the new French president, but few serious economic actors. The principle of what needs to be done is pretty well known and was proclaimed by the English writer Walter Bagehot a century and a half ago. This is that the central bank must be willing to lend to responsible market participants unlimited sums but at a penalty rate, and avoid bailing out individual financial institutions from their own mistakes.

But what should central banks do about their policy rates, such as the Bank Rate in the UK and the official Fed Funds rate in the US, which determine normal lending to the financial markets? Would it be an inflationary bail-out to reduce some of these official rates not long after central bank heads have been giving warning of likely future increases in them? The answer here must surely depend on the general economic outlook. If the Fed or the European Central Bank were to reduce its official rates because it saw recession on the horizon, this would not be a bail-out for institutions that had indulged in excessive risk, but a general stimulus all round. It would be quite consistent with charging distressed borrowers a penalty rate. For even if they had to pay less than they do now it would still be at above prevailing market rates.

There is another unresolved problem. According to the Goldman Sachs European Weekly Analyst, the ECB remains convinced that general monetary policy and liquidity management are two distinctly different jobs. I hope that Mr Bernanke’s studies of the Great Depression have convinced him otherwise.

The Goldman Sachs economists do indeed discuss some of the channels from the financial side to the real economy. But they still seem to me to minimise them. “In what we presently see as an extreme case,” they say, “our 2.3 per cent growth forecast for the euro area for 2008 could be cut to 1.6 per cent.” We should be so lucky.

*Princeton, 2000

www.samuelbrittan.co.uk

Copyright The Financial Times Limited 2007

How Do You Say "Transparency" in German and French?

German Chancellor Angela Merkel and French President Nicolas Sarkozy "called for a European effort to help ensure greater transparency in financial markets following the past month's turbulence" on Monday.

Whither Goes the Economy: The Debate Rages at the Fed

Fed Officials Suggest Division Over Interest-Rate Cut (Update3)

By Scott Lanman and Vivien Lou Chen

Federal Reserve Bank of San Francisco President Janet Yellen, speaks during the National Association for Business Economics (NABE) Washington Economic Policy Conference in Arlington, Virginia, March 13, 2006. Photographer: Stephen Voss/Bloomberg News

Sept. 10 (Bloomberg) -- Federal Reserve bank presidents suggested they are divided on how much to cut interest rates, offering a range of views on the economy after the first decline in payrolls in four years.

Janet Yellen, head of the San Francisco Fed, today cited ``significant downward pressure'' on growth because of housing and financial-market turmoil. Dallas Fed President Richard Fisher said he's ``generally encouraged'' about the economy, while Atlanta's Dennis Lockhart backed off remarks he made four days ago that the housing slump was having a limited impact.

The scope of remarks may reflect a debate inside the central bank over whether to lower the benchmark rate on Sept. 18 by a quarter-percentage point, or a half-point as some investors expect, Fed watchers said.

``It sounds like everyone's marked down their growth outlook, and everyone realizes the credit-market events are something that require a Fed response,'' said Michael Feroli, an economist at JPMorgan Chase & Co. in New York who used to work at the Fed. ``It's just a question of magnitude.''

Treasuries rallied as traders interpreted the officials as confirming a reduction in borrowing costs to preserve the six- year expansion.

The job market began slowing in June, data now indicate, Lockhart told an audience in Atlanta today. Employers cut 4,000 workers in August, the Labor Department said Sept. 7. Revised figures showed job gains diminished from a 188,000 pace in May to 69,000 in June and 68,000 in July.

Main Indicators

Payrolls are one of the main indicators, along with sales, wages and production, which help determine the start of economic contractions.

``It is critical to take a forward-looking approach -- gauging the effects of recent developments on the outlook, and, importantly, the risks to that outlook,'' Yellen, 61, said in a speech to a conference in San Francisco. Declining home prices and rising unemployment may cause ``significant'' risks to consumer spending, she said.

Lockhart and Yellen both vote on rates in 2009, and Fisher votes next year, though they participate in the FOMC discussions. Officials gather in Washington on Sept. 18. Fed Governor Frederic Mishkin speaks later today.

`Real Debate'

``The real debate in the end, although nobody's saying this, is whether they're going to cut 25 or 50'' basis points, said Nariman Behravesh, chief economist at researcher Global Insight Inc. in Lexington, Massachusetts. ``They should do 50, but I think they'll do 25, precisely because they've got a bit of a debate going on.''

A basis point is 0.01 percentage point.

Gains in Treasuries sent the yield on the benchmark two-year note down to the lowest since September 2005. The yield fell to 3.85 percent at 5:30 p.m. in New York, below the Fed's 5.25 percent target rate for overnight loans between banks. The Standard & Poor's 500 Index fell 0.1 percent.

``Last Thursday, I said in a speech that I have not seen conclusive signs of weakness in the broader economy,'' Lockhart, 60, said at an event sponsored by the Atlanta Business Chronicle. ``Friday's data, however, shows employment was beginning to soften back in June. This news should be evaluated with recently positive reports in retail sales.''

Fisher, speaking in Laredo, Texas, said that ``our economy appears to be weathering the storm thus far.''

No `Major Impact'

``As yet, tighter credit conditions do not appear to have had a major impact on overall economic activity outside of real estate,'' said Fisher, 58, the bank's president since 2005.

Speaking with reporters afterward, Fisher said he was ``not necessarily'' taking a different position from Yellen. He said he hadn't read Yellen's remarks.

Charles Plosser, 58, who took his post in August 2006, said at the weekend that policy makers shouldn't put too much stress on the loss of jobs in August, and that he hadn't made up his mind yet on a rate cut.

``We want to be careful not to overweight one piece of information,'' Plosser said in an interview after a speech in Waikoloa, Hawaii, on Sept. 8. While the employment drop ``was not encouraging,'' he said ``there's a lot of conflicting data out there,'' noting gains in retail sales.

Economists and investors expect the Federal Open Market Committee to lower its main interest rate by at least a quarter- percentage point from 5.25 percent next week.

After the Fed on Aug. 7 said inflation was still its ``predominant'' concern, the central bank revised its outlook on Aug. 17 to say that economic risks had risen ``appreciably.''

That assessment ``apparently is similar to that of market participants,'' Yellen said in her first speech on the economic outlook in almost two months. ``Investors' perceptions of increased downside risks have resulted in a notable decline in the rates on federal funds futures contracts,'' she said.

Still, market turmoil sometimes has little effect on the economy, Yellen cautioned. In 1998, when forecasters feared the implications of a Russian debt default and the Fed lowered rates three times, ``growth turned out to be robust,'' she said.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net ; Vivien Lou Chen in San Francisco at vchen1@bloomberg.net .

Last Updated: September 10, 2007 17:31 EDT

FT.COM: The R-word surfaces on Wall Street

The R-word surfaces on Wall Street
By Eoin Callan in Washington
Published: September 10 2007 03:52 | Last updated: September 10 2007 03:52


The R-word is usually avoided by Wall Street’s economists. It tends to be a conversation-stopper when investment bank clients are told to prepare for the worst.

“It is like looking a client in the eye and telling them that their child is ugly,” says David Rosenberg, chief economist at Merrill Lynch. “It is not what people want to hear.”

But the parameters of polite conversation have shifted following the shock decline in the employment market revealed last week. Recession is the word on everyone’s lips.

“The probability of recession has increased pretty dramatically,” says John Silvia, chief economist at Wachovia. The first monthly fall in employment in four years has undermined one of the few remaining pillars of the economy – a strong job market – that policymakers thought they could rely on to support consumer spending.

With that cornerstone of economic growth weakened, some on Wall Street fear the economy could be dragged into a hole by the gravitational pull of the collapsing housing market.

“You are talking about a $23,000bn asset class – there is nothing on the planet as big as that,” says Mr Rosenberg, who is predicting a fall in house prices nationally of up to 15 to 20 per cent.

The bearish economist points out that “there has never been real estate deflation in this country that failed to end in a destabilising recession”.

He says the historical conditions are falling into place for a deterioration in household wealth and spending by the fourth quarter.

Homebuilding has fallen by a fifth from a year ago to the lowest level in a decade.

Big falls have in the past been followed by recessions, except during the Vietnam and Korean wars, which created offsetting demand.

The housing downturn has caused economic shocks, triggering a crisis of confidence in credit markets and a tightening of lending conditions amid rising defaults on subprime mortgages.

Mr Rosenberg says it may be “too late” for the Federal Reserve to prevent a recession by cutting interest rates aggressively this month.

But many economists are more sanguine, reassuring clients that rate cuts will help restore stability to markets and prevent the economy going into a tailspin.

“It is too soon to call a recession at this point,” says Peter Hooper, chief economist at Deutsche Bank. “The risks have been certainly moving in that direction.”

Bruce Kasman, chief economist at JPMorgan, has pared back his forecasts but sees moderate growth averaging about 2 per cent over the next two quarters. But he warns that economists are “making forecasts these days with pencils not pens”.

Edward Lazear, economic adviser to President George W. Bush, says the White House is not expecting a downturn. “There is always a chance of recession. We don’t think it’s likely.”

The job of declaring recessions – generally defined as two consecutive quarters of economic contraction – does not belong to the White House or Wall Street. That task belongs to Martin Feldstein, head of the National Bureau of Economics.

Mr Feldstein has been blunt about his outlook.

He used the word recession seven times in a recent speech to central bankers, telling them that “a sharp decline in house prices and the related fall in home-building ... could lead to an economy-wide recession”.

He said the type of collapse in housebuilding recorded in recent months was “a precursor to eight of the past 10 recessions”; there was “a significant risk of a very serious downturn”. It was not a popular message.

Copyright The Financial Times Limited 2007

Bloomberg: Dollar Falls on Reduced Concern Housing Will Slow Global Growth by Bo Nielsen

Dollar Falls on Reduced Concern Housing Will Slow Global Growth
By Bo Nielsen

Aug. 25 (Bloomberg) -- The dollar fell the most against the euro since March on diminished concern that U.S. housing weakness will slow global growth.

The yen posted its biggest weekly decline versus the euro since 2003 as investors returned to carry trades in which they borrow in Japan to invest in higher-yielding assets elsewhere. Global stocks rose and volatility fell as traders increased bets the Federal Reserve will cut rates in September.

``Things are calming down sufficiently enough for the market to go back to the trades that dominated prior to the shake-out: buying other currencies against the yen and selling the dollar,'' said Brian Dolan, chief currency strategist at FOREX.com, a unit of online currency trading firm Gain Capital in Bedminster, New Jersey, with about $250 million in funds under management.

The dollar dropped 1.5 percent this week to $1.3675 per euro, for the biggest weekly decline since mid-March. The dollar rose 1.8 percent to 116.44 yen. The yen plummeted 3.4 percent to 159.26 per euro, for the biggest loss since September 2003.

``People are calmer because they expect the Fed will cut rates in September,'' said Mark Meadows, a strategist at currency-trading company Tempus Consulting Inc. in Washington.

The yen advanced last week by the most against the euro since 2000 as the subprime mortgage crisis spread through global credit markets, spurring investors to sell riskier assets funded by loans made in Japan.

Housing Report

Purchases of new U.S. homes unexpectedly rose 2.8 percent to an annual pace of 870,000 last month, the Commerce Department said yesterday. The level exceeded the highest estimate in a Bloomberg News survey of 73 economists.

The Standard & Poor's 500 Index rose 2.3 percent for the week, the biggest gain since March. The Chicago Board Options Exchange's VIX index of stock volatility fell to 20.70 this week after reaching 37.50, the highest since 2002, on Aug. 16, the day before the Fed cut the discount rate it charges banks.

Interest rate futures show traders are certain the Fed will cut its 5.25 percent target rate for overnight loans between banks at least a quarter-percentage point by its Sept. 18 meeting. Bets a month ago suggested a 10 percent chance of a rate cut.

Goldman Sachs Group Inc. and Merrill Lynch & Co. cut their forecasts for the dollar this week. Goldman said the dollar will weaken to a record of $1.43 in three to six months, from a previous estimate of $1.35. Merrill forecast $1.40 by December, compared with $1.36 before last week.

2007 Economic Growth

``The fundamental picture has deteriorated quite materially for the dollar,'' said Jens Nordvig, a New York- based analyst for Goldman Sachs.

The dollar reached an all-time low of $1.3852 on July 24.

The U.S. economy is forecast to expand 2 percent this year, according to a Bloomberg News survey published Aug. 9. That's 0.1 percent lower than the July forecast.

The yen dropped against all of the 16 most active currencies this week as traders returned to carry trades after the Bank of Japan on Aug. 23 kept its benchmark borrowing cost at 0.5 percent, the lowest among major economies.

Japan's key rate compares with 4 percent in the euro region, 11.5 percent in Brazil and 8.25 percent in New Zealand. The Swiss franc, another source of funding for the carry trade, fell 0.9 percent against the euro this week. Switzerland's benchmark rate is 2.5 percent.

To contact the reporter on this story: Bo Nielsen in New York at bnielsen4@bloomberg.net

Last Updated: August 25, 2007 00:50 EDT

Saving

Tha portion of income that is not consumed. Saving = income - consumption.