Bernanke’s Test

Johnan Van Overtveldt, “Bernanke’s Test (Bernanke, Greenspan, and the Drama of the Cetral Banker), Agate Publishing, 2009, 246 Pages

This book closely examines the two most recent chairmen of the Federal Reserve Board, Alan Greenspan and Ben Bernanke, especially Bernanke. These two are the central figures in the developments since the financial crisis emerged in August 2007 as the American subprime mortgage market collapsed. The author does not fault Greenspan’s low interest rate policy as a primary cause of the asset bubble; he does, however, blame Greenspan’s failure to tend to the regulatory side of the Fed’s responsibilities as a very significant factor. This crisis was the first time a securitization-based financial system had truly been stress tested and the results were a near catastrophe.

My Notes:
Pg. 11: Economic growth and prosperity are created primarily by what economists call ‘real’ factors-the productivity of the work force, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. But extensive practical experience, as well a much form research, highlights the crucial supporting role that financial factors play in the economy…Healthy financial conditions help a modern economy realize its full potential.

Central banks bear the primary responsibility for creating and maintain those ‘health financial conditions.’ This requires price stability and a sound and efficient financial system. Arguably, central bankers’ most important role among these responsibilities is their ability to act as lender of last resort—their power, in other words, to create money.

Pg. 19: Economist Charles Kindleberger recognized four distinct asset price bubbles in the last 15 years of the 20th century. The first was in real estate and stocks in Tokyo in the second half of the 1980s and the second, at about the same time, was in real estate and stocks of three of the Nordic countries—Finland, Norway, and Sweden. The third was in Bangkok, Kuala Lumpur, Jakarta, and Hong Kong and nearby national financial centers in the mid 1990s, and the fourth was un U.S. technology stocks in the second half of the 1990s. Then of course, worst of all, is the current August 2007 bursting of the U.S. housing market.

Pg. 33: The Great Inflation of 1965 to the mid-1980s was the central monetary event of the latter half of the twentieth century. Its economic cost was large. It destroyed the Bretton Woods system of fixed exchange rates, bankrupted much of the thrift industry, heavily taxed the U.S. capital stock, and arbitrarily redistributed income and wealth.

Pg. 63: The Federal Reserve Act (originated in 1913, rephrased in 1977, and reaffirmed in 2000) dictates that monetary policy should be used ‘to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.’ Hence, the Fed has a dual mandate with two objectives—maximum employment and stable prices—that are considered to be equally important.

Pg. 161: The bubble begins to burst: On February 8, 2007, HSBNC Holdings, one of Europe’s biggest banks, pointed specifically to increasing bad debts in its U.S. subprime lending portfolio as the reason behind its first-ever profit warning. Less than two months later, New Century, a major subprime lender in the U.S., filed Chapter 11 bankruptcy. In June 2007, investment bank Bear Stearns announced serious losses at several of its hedge funds specializing in collateralized debt obligations (CDOs), which are bonds of bundled repackaged mortgages. Suddenly, Standard & Poor’s and Moody’s rating agencies began to downgrade bonds and other securitized paper related to subprime and other mortgage loans.

Pg. 185: U.S. no-recourse policy regarding mortgages: In the U.S. lenders have no claim on the house’s owner beyond the value of the house. Because of this, people with negative equity in their homes have a strong incentive to default. [This statement needs some research; I believe each state is different].

Pg. 190: Fannie Mae and Freddie Mac are crucial to the American housing and mortgage market, as they own roughly half of the $12 trillion in home loans outstanding. Between them, the two companies have a relatively small capital base--$80 billion of regulatory capital supporting $5.4 billion in mortgages. By mid-year 2008 they were forced to write down $11 billion on their mortgage portfolios. Of course, they have now been effectively nationalized.

Pg. 208: By the end of October 2008, equity markets worldwide had lost about half of their capitalization value since the beginning of the year.

Pg. 223: Securitization is a structured finance process that involves pooling and repackaging cash-flow-producing financial assets as securities, which are then sold to investors. In principle, all financial assets that generate cash flows are candidates for securitization (mortgages, cars, student loans, credit cards, etc.). Securities that are the outcome of the securitization process are generally defined as asset-backed securities (ABSs). The total amount of outstanding ABSs exploded over the last decade, from under $500 billion in 1996 t close to $2,500 billion in 2007.

Pg. 226: With overall loan origination continuing to climb sharply, the share of mortgages considered low quality (subprime and alt-A) increased from 7 percent of total mortgage originations in 2001 to 33 percent in 2006. The percentage of mortgage originations with extremely attractive repayment conditions for the short term—such s interest-only payments and negative amortization conditions, where borrowers’ payments do not even cover the interest that accrues each month, and the balance on the loan rises over time—also rocketed, from 1 percent of total originations in 2001 to 29 percent in 2005.

Pg. 230: According to the IMF, more than 90 percent of securitized subprime loans were turned into securities with a AAA rating. This occurred primarily because the rating agencies did not understand the extremely complex securitized products being developed and their underlying collateral. Moreover, there was a clear conflict of interest, as the fees received by the rating agencies were positively related to the delivery of top ratings. Because rating agencies are paid by the issuers that request ratings, they may have the incentive to rate the underlying security too highly to ensure that the issuer can attract buyers and when conditions deteriorate, to avoid downgrading the rating too quickly so as to appear to have a stable and credible rating system.