- The Washington Times - Tuesday, July 12, 2005

Two weeks ago, the Federal Reserve again raised short-term interest rates. The federal funds rate now stands at 31/4 percent. This is the rate banks charge each other on overnight loans and generally the lowest interest rate, setting a floor for all others. In June 2004, it was just 1 percent.

So far, financial markets have shrugged off the Fed’s actions. Indeed, mortgage rates are actually lower now than before the Fed started tightening, fueling a housing “bubble” in many economists’ opinion. The lack of response in markets suggests the Fed will have to tighten much more than it originally planned to keep inflation in check.

Despite the paucity of evidence Fed tightening has any meaningful economic effect, Fed officials are very concerned it could occur 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 slows the economy, with a lag of about 18 months.

But long before the effect of Fed tightening shows up in the gross domestic product data, it will begin affecting 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, failure of a small Iowa bank nearly brought down one of the largest Chicago banks, which threatened the health of the entire banking system before the Fed engineered an emergency bailout.

On June 14, Federal Reserve Board Gov. 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, Ms. 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 buy them with virtually nothing down. Mortgage payments once included a paydown of principal; today there often is none. People once needed 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 if borrowers begin defaulting on loans.

As with all financial bubbles, everything works as long as prices keep rising. 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. Just five years ago, we saw the stock market bubble burst, wiping out vast sums of wealth. Both incidents resulted from a tight Fed policy, came about unexpectedly and while many experts told us economic fundamentals were sound.

I believe there are many stresses and strains in our financial system right now due to 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 will be a correction.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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