Policymaking Through a Panic Mark M. Zandi November 3, 2008 anic has gripped the global In an effort to restart money and attract the private capital ultimately financial system, pushing the credit markets, the Federal Reserve has needed to bolster the financial system. Pglobal economy into recession. vastly expanded its role. The central In practice, the auctions may not go as The U.S., Europe, Canada and Japan are bank can now lend to whomever and well given the complexity of the assets contracting, while emerging economies buy whatever it deems necessary, to be purchased, but if so then the costs from Brazil to China that had been essentially without limit. The Fed has involved in trying will also be small. growing rapidly are now weakening. also engineered an unprecedented A much larger and comprehensive The proximate cause of the global crisis coordinated interest rate cut with other foreclosure mitigation plan will almost is the collapse of the U.S. housing market, central banks, more than doubled certainly be needed. Millions of and the resulting surge in mortgage loan the size of its balance sheet to pump homeowners owe more than their home defaults. Hundreds of billions of dollars in liquidity into the financial system, and is worth, and unemployment is rising losses on these mortgages have undermined is buying commercial paper and other quickly; foreclosures, already at record the financial institutions that originated and money-market instruments directly from high levels, are sure to mount. The Hope invested in them, including some of the issuers and money-market funds. for Homeowners program faces severe largest and most venerable in the world. Policymakers have also worked impediments, and even under the best of Many have failed and most are struggling to to directly shore up the housing circumstances will likely be overwhelmed survive. Banks are fearful about extending and mortgage markets and broader by the wave of foreclosures still coming. credit to each other, let alone to businesses economy. A number of efforts have No plan will keep house prices from and households. With the credit spigot been put in place to enable stressed falling further, but quick action could closing, the global economy is withering. homeowners to avoid foreclosure. These avoid the darker scenarios in which Global stock investors have dumped their include programs called FHA Secure, crashing house prices force millions holdings as they come to terms with the Hope Now, and most recently Hope more households from their homes, implications for corporate earnings. A for Homeowners, a plan that allows completely undermining the financial self-reinforcing adverse cycle has begun: mortgage owners to convert some of system and economy. the eroding financial system is upending their troubled loans into FHA-insured Additional monetary and fiscal the economy, putting further pressure on mortgages in exchange for taking write- stimulus is also necessary. With inflation the financial system as the performance of downs on the loans. Fiscal stimulus, receding and deflation concerns likely everything from credit cards to commercial including this summer’s tax rebates and to predominate soon, there are few mortgage loans sours. the investment tax incentives that remain impediments to further interest rate cuts This cycle can only be mitigated by in place through the end of the year, has by the Federal Reserve. The only issue is aggressive and consistent government provided some economic support. how close to zero the federal funds target action. In the U.S., the public policy Yet more needs to be done to quell rate can go before it begins to undermine response to the financial crisis is without the financial panic and mitigate what money-market funds, which need some precedent. The full faith and credit of the threatens to become the worst economic return on their investments to cover their United States government now effectively setback since the Great Depression. The operating costs. More importantly, with backstop the financial system; significant reverse auctions for mortgage assets the Fed’s new ability to pay interest on parts of which have been nationalized. initially envisaged for the TARP need bank reserves, there is no limit on how With the takeover of Fannie Mae and to go forward quickly. In theory, the much liquidity the Fed can provide to Freddie Mac, the government makes nearly auctions are an elegant way to determine the financial system. all the nation’s residential mortgage loans. market values for these currently The government’s next fiscal And as the $700 billion troubled asset impossible-to-price assets. With price stimulus package should both cut taxes relief fund is deployed, the government discovery will come clarity about which and increase spending beginning early is gaining sizable ownership stakes in the financial institutions are undercapitalized next year, when the economy is likely to nation’s largest financial institutions. and by how much. Clarity, in turn, will be at its most vulnerable. The stimulus Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 13 Chart 1: A Financial Panic the crisis deepened Credit markets remain badly shaken. Difference between three-month Libor and Treasury bills and continued Bond issuance has come to a standstill 3.0 on, those with no residential and commercial- worries hindered backed securities issuance in recent 2.5 policymakers far months and very little issuance of junk Subprime financial too long, allowing corporate bonds and emerging market 2.0 shock the current panic debt. Asset-backed issuance of credit to develop. With cards, vehicle and student loans and LTCM 1.5 Y2K so many suffering municipal bond issuance also remains S&L crisis so much financial severely disrupted. Investment-grade Peso Thai Tech 1.0 Bhat Orange crisis bust loss, moral hazard bond issuance has held up somewhat County is no longer an better, but even this all but dried up in 0.5 issue; debate over October. Credit spreads—the extra yield whether it is fair investors require to be compensated for 0.0 to help stressed the perceived added risk of investing in 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 households stay riskier bonds—also remain strikingly in their homes wide, as investors shun anything but appears quaint. risk-free Treasury bonds. The difference must be large, equal to at least 2% of Their problems are clearly everyone’s between yields on junk corporate GDP, as GDP seems set to decline by at problems. Only quick, overwhelming bond bonds and 10-year Treasuries least that much without it. Extending and consistent government action will has ballooned to some 1700 basis unemployment insurance benefits, food instill the confidence necessary to points, and between emerging debt and stamps, and aid to state governments restore financial stability and restart Treasuries to well over 1300 basis points. would be the most effective spurs to economic growth. Historically, yield spreads for both have economic growth, but even increased Economic backdrop. The need averaged closer to 500 basis points. infrastructure spending could be desirable for more policy action is evident in Commodity and foreign currency considering the economy’s problems are the increasingly dark financial and markets have been roiled. Oil prices likely to last for some time, giving such economic backdrop. The financial panic have fallen more than 50% from their spending enough time to be of help. that began in early September with the record peaks in early July, and prices for With government making so many nationalization of Fannie and Freddie commodities from copper to corn have monumental decisions in such a short may have passed its apex, but the plunged. Global commodity demand is period of time, there will surely be collective psyche remains frazzled. And weakening rapidly as the global recession unintended consequences. Some may even if the panic soon subsides, economic undercuts the financial demand that had already be evident: Nationalizing Fannie damage has been done. The collapse in sent prices surging this past summer. Mae and Freddie Mac while not rescuing confidence, the massive loss of wealth, Economies reliant on commodity Lehman Brothers from bankruptcy may and the intensifying credit crunch ensure production have been hit hard and their very well have set off the current financial that the U.S. economy will struggle currencies have rapidly depreciated. The panic. And policymakers need to be wary through the remainder of the decade. Canadian dollar, which had been close of the costs of their actions, as global Money markets are improving, to parity with the U.S. dollar as recently investors will eventually demand higher thanks to massive intervention by global as this summer, has dropped below 80 interest rates on the soaring volume central banks, but remain far from cents, and the Brazilian real has fallen of U.S. Treasury debt. Any measurable normal. The difference between 3-month more than 40% against the dollar since increase in long-term interest rates Libor and 3-month Treasury bill rates—a the panic began.2 would be counterproductive; its effect good proxy for the angst in the banking Volatility in global stock markets on the housing market and the rest of system—is still an extraordinarily wide has been unprecedented, and the price the economy would offset the economic 275 basis points (see Chart 1).1 This is declines nerve-wracking. Since the benefits from the fiscal stimulus. down from the record spreads of mid- downdraft began a few weeks ago, global But policymakers’ most serious October, which topped 450 basis points, stock prices are off a stunning 30% in missteps so far have come from acting too but it is still stratospheric compared local currency terms and more than 40% slowly, too timidly, and in a seemingly with past financial crises, not to mention from their year-ago highs.