The Next Financial Crisis

One group of analysts believes the Fed is doing the right thing by dramatically increasing its balance sheet and keeping interest rates low. Others believe the moves are creating a new set of problems. They compare the recent actions to those that caused the housing and debt bubbles in the last century. A good analysis of the latter point is from Institutional Risk Analytics, a firm that primarily analyzes banks for investors. It can get a little technical, assuming some finance knowledge. But most of it is accessible to everyone and makes clear that IRA believes the Fed is pushing problems down the road instead of solving them. And a big part of the problem isn’t the Fed but the unwillingness of other policymakers in Washington to take action.

But when Chairman Bernanke shows his naiveté by stating in public that there is no problem with the housing sector or that Fed rate policy is not causing problems for financial institutions, we have to worry. The problems with housing we think are pretty much in our collective faces, even if Chairman Bernanke and other inhabitants of Washington refuse to admit that a problem exists.

Chariman Bernanke should re-read the Federal Reserve white paper published in early January to understand what ails housing finance and why the large banks and GSEs are preventing the most reliable monetary policy transmission mechanism — housing refinance — from working. But how about the mounting problem of interest rate risk created by the Fed’s zero rate policies? Our friend Alan Boyce wrote two years ago about the duration risk created by Fed low rate approach:

“The Federal Reserve has been successful in raising the price of mortgage backed securities. They have withdrawn several years of duration from the bond market and created the world’s largest short options position. They have not been able to stimulate a large refinancing wave, which would have been the most effective mechanism to reduce the stress on homeowners having a hard time making their mortgage payments. They have not eliminated the threat to the bond market from the gigantic duration extension event buried in our existing mortgage system. Mortgage extension risk remains as the ‘other shoe to drop’ in the slowly unfolding drama of the financial crisis. The scale of the extension risk is multiples of the risk to the bond market from extended periods of large budget deficits or the threat of coordinated selling of Treasuries by foreign central banks.”