ith the onset of economic
recovery, the challenge
for lenders is to anticipate
the exit strategy from both
monetary and fiscal policy.
Problems with the Federal
Reserve’s exit strategy are
far more complex for private
markets than the casual
assurances that are given
would lead to lower real interest rates.
There was concern at the time that low
real rates were would lead to exces-
sive risk-taking and indeed they did, as
consumers did finance, by credit, a pace
of housing and auto spending that was
unsustainable over the long run.
By early 2005 subprime mortgage
delinquency rates had already started
to turn upward and, along with this, by
mid-summer 2005, home price apprecia-
tion was peaking. Meanwhile, aggregate
consumer and residential loan delin-
quencies were clearly on the upswing.
Consumer credit risk had clearly been
underpriced for lenders; the credit qual-
ity implications hit home by mid-2007.
So far this year, conditions in a num-
ber of financial markets have improved.
As evidence of improvement, there has
been a significant narrowing of the Fed
spread as well as average 5-year CDS
bank spreads. Meanwhile, in the critical
asset-backed and mortgage-backed
markets, there has also been marked
improvement. For asset-backed (ABS)
securities, the Fed’s actions through the
TALF facility have helped the financing
of credit card and auto securities.
However, despite this success,
concerns remain that the Fed’s posi-
tion as credit policeman in selected
markets, and only to a varying degree
in those markets, is creating distortions
in asset-pricing and credit availability.
For secured lenders, the problem is one
of pricing credit, given that traditional
spreads are unlikely to return and new
standards of quality remain undefined.
Operationally, the Fed has been an
effective policeman as Fed purchases
have favored the short-end of the yield
curve. However, at the long-end of the
curve, Treasury and mortgage rates
are also being affected by the growing
perception that “temporary” deficits are
increasingly perceived as permanent.
Moreover, sustained high levels of feder-
al debt issuance have increased investor
fears of monetization through monetary
policy and thereby rising interest.
For lenders, the economic recovery
suggests opportunity, but there are
three risks to consider— higher than anticipated inflation, rising interest rates
and a weaker dollar. What makes credit
policy so difficult today is that these
three are not independent risks.
Over the last few weeks, we have
seen capital markets react to continued
credit-easing by the Federal Reserve
with a steeper yield curve and a declining dollar. Moreover, there is creeping
suspicion the public policy is increasingly oriented to restoring the very prior
expansion conditions of excess consumer demand. For lenders, any attempt by
policymakers to replay the low interest
rate environment of earlier this decade
will conjure up nightmares of an instant
replay of a credit crisis. TSL
Dr. John Silvia is chief economist,
BY DR. JOHN SILVIA
First, the impact on credit pricing and
liquidity will be significant in those
markets where the magnitude of Fed
actions has been very large relative to
size of the markets—mortgage backed
securities (MBS) and asset-backed securities (ABS), for example. Second, inflation
expectations are rising. Third, contrary
to policymaker assertions, many investors already doubt that federal deficit
estimates and expectations suggest that
such deficits represent a permanent, not
temporary, fiscal policy. Already, private
deficit estimates are rising and long-term Treasury and mortgage rates are
rising in turn. With the passage of time,
the exit from easy fiscal/monetary policy
is becoming more expensive and more
fraught with risks for lenders.
Long before the collapse in the
housing market, the global glut in savings was cited as a possible force that