The Coming Financial Crisis: Revenge of the Mortgage-Backed Securities

Brewing in the cauldron of the Federal Reserve is a disaster of epic proportions that will come to a head at the next financial crisis.

As the famous quote often attributed to Yankees legend Yogi Berra goes: “it is difficult to make predictions, particularly about the future.” Nevertheless, I will make some bold predictions here about the potential consequences the United States financial system will face during the next financial crisis, with a specific focus on the Federal Reserve Bank. In his analysis of the post-crisis condition of the Federal Reserve Bank after the last crash, Marvin Goodfriend (2011) states: “the Fed and other central banks around the world have undergone a ‘stress test’ that is still very much in progress.” Goodfriend concludes that one of most important goals for the Federal Reserve Bank in passing this test is to: “reinforce the sense that the Fed has the political independence and the determination to unwind its emergency liquidity measures while limiting their inflationary potential.” Revisiting this goal in 2017, the results of this test appear to suggest a failing grade.

Rather than winding down the balance sheet in a return to its historical lean position and asserting its political independence, the actions of the Federal Reserve Bank have done the exact opposite. In fact, the balance sheet has ballooned to a size of pure uncertainty. More alarming than the bloated total, however, is the risky composition of these assets, specifically the $1.8 trillion in Mortgage-Backed Securities (MBS). “Revenge of the Mortgage-Backed Securities” appears in the title of this post because I believe that these problematic assets, far from being removed from a position of systemic risk, are perhaps in a more threatening position for the health of the United States – and therefore world – financial system today than they were even in 2007-08. On the topic of political independence, John H. Cochrane’s concept of unpleasant fiscal arithmetic puts forth the argument that monetary policy in the modern financial world is never truly independent, but rather dependent on fiscal policy. The fact that the monetary policy actions of the Federal Reserve Bank are beholden to the fiscal policy actions taken by United States politicians does not bode well for the next financial crisis.

One thing that is definitive as a part of the basis for a dire prediction is that current fiscal policy has continued and even expanded the unsustainable spending practices that will inevitably lead the United States toward a Greek-style crisis. The budget deal in FY 2017 has put the nail in the coffin of the long-false yet often-circulated idea that the modern Republican party represents even a shred of fiscal responsibility in their actions.With Republicans controlling both houses of Congress as well as the presidency, a golden opportunity to pass long-promised fiscally responsible policy, spending in this budget still increased in a year over year manner. The unpleasant fiscal arithmetic of the United States government’s ever-increasing debt burden ties the hands of the Federal Reserve so as to prevent counter-cyclical action such as raising interest rates to back above crisis levels (let alone pre-crisis levels). John H. Cochrane’s (2010) analysis of the financial situation of the United States in his aptly titled paper Understanding Policy in the Great Recession: Some Unpleasant Fiscal Arithmetic reads like a prophecy: “At some point fiscal constraints must take hold… at that point, inflation must result, no matter how valiantly the central bank attempts to split government liabilities between money and bonds. Long before that point, the government may choose to inflate rather than further raise distorting taxes or reduce politically important spending.” As John Maynard Keynes presciently observed, everyone dies in the long run, but for those alive today it appears the fiscal policy consequences of the long run are about to arrive.

Right now the current bull market in the United States is 98 months old, just 15 months’ shy of setting the record for the longest bull market of all time. While it is far from a guarantee that we enter a bear market before August 2018, if the Federal Reserve balance sheet is not unwound and interest rates have not returned to a more normal percentage by that time then the coming crisis will, in all likelihood, be much worse than what occurred in 2008. At that time the Federal Reserve Balance Sheet had ample space to expand in order to provide systemic liquidity, which it did, and interest rates had plenty of room to be slashed, which they were. The failure of the Federal Reserve Bank to reverse these actions during the long bull market means that these tools will not be effective as counter-cyclical measures in the coming financial crisis as they were in the previous one.

With the Federal Funds rate sitting at 0.90% as of April 2017, there is almost no room to slash rates in the event of a crisis today without breaking the zero lower bound. Furthermore, raising rates to the point where slashing them back down would have a meaningful positive effect becomes less possible with each passing day. According to Bernanke and Gertler (1995), “GDP begins to decline about four months after a tightening of monetary policy, bottoming out about two years after the shock.” Bernanke and Gertler include in their definition of a shock that it must be unanticipated, meaning that even if such an unanticipated shock occurred today it would likely not have its full negative effect take place until the spring of 2019. If the economy is already in the grips of recession at that point then this action it is likely to exacerbate it, and if there has not been a correction at that time then such an event would be likely be the catalyst for recession. What is brewing in the cauldron of the Federal Reserve Bank today is a disaster of epic proportions.

In its role of de facto lender of last resort for the global financial system, it is prudent for the Federal Reserve Bank to maintain a light, easily manageable balance sheet. This is important because the Fed’s status as a risk-free provider of funds is key to this functionality, and avoiding the compilation of risky assets on its balance sheet is essential to maintaining its risk-free status. Throughout its history, the Federal Reserve Bank of the United States has been prudent in keeping a lean balance sheet that affords it broad maneuverability to take drastic action in the event of financial crisis. Like many things in the financial world, however, this changed significantly after the Great Recession: “Since the beginning of the financial market turmoil in August 2007, the Federal Reserve’s balance sheet has grown in size and changed its composition. Total assets of the Federal Reserve have increased significantly from $869 billion on August 8, 2007 to well over $2 trillion.” Even this potentially ominous statement, directly from the Federal Reserve bank’s website, is a misleading gross understatement: “well over $2 trillion” in this case means $4.5 trillion at the time of writing, including the previously mentioned $1.8 trillion in MBS which, unlike Treasury Bonds, carry inherent risk.

While Treasury Bonds will likely always remain risk-free as a result of the United States Government’s ability to collect taxes and/or “print money,” the Federal Reserve Bank itself can potentially lose its risk-free status by shifting its asset mix to a more risky portfolio. Today’s bloated balance sheet including almost 50% MBS means that the Federal Reserve Bank is in a precarious position should it again be faced with the prospect of needing to purchase toxic assets that no commercial bank will touch in the name of providing systemic liquidity. The risk-free status of Federal Reserve Bank debt offerings has allowed its bonds to be functionally equivalent to cash in terms of default risk; however, this will no longer be the case if the Federal Reserve Bank is seen as holding even a small risk of default. The difference between its offerings being risk-free and minimally risky, while seemingly a semantic and insignificant detail, may prove to be the difference between the continuing operation and complete collapse of the 100-year-old Federal Reserve Bank system.

 

References

  1. Goodfriend, M. (2011). Central banking in the credit turmoil: An assessment of Federal Reserve practice. Journal of Monetary Economics, 58(1), 1-12. doi:10.1016/j.jmoneco.2010.09.008
  2. https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
  3. http://www.crfb.org/blogs/appropriations-watch-fy-2017
  4. http://fortune.com/2017/03/09/stock-market-bull-market-longest/
  5. https://fred.stlouisfed.org/series/FEDFUNDS
  6. http://quoteinvestigator.com/2013/10/20/no-predict/
  7. https://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab9
  8. DUYGAN-BUMP, B., PARKINSON, P., ROSENGREN, E., SUAREZ, G. A. and WILLEN, P. (2013), How Effective Were the Federal Reserve Emergency Liquidity Facilities? Evidence from the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility. The Journal of Finance, 68: 715–737. doi:10.1111/jofi.12011
  9. Bernanke, B., & Gertler, M. (1995). Inside the Black Box: The Credit Channel of Monetary Policy Transmission. American Economic Association, 9(4). doi:10.3386/w514

Leave a Reply