Credit, Housing, Commodities and the Economy Chartered Financial Analysts Institute Annual Conference

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1 Credit, Housing, Commodities and the Economy Chartered Financial Analysts Institute Annual Conference May 13, 2008 Janet L. Yellen President and CEO Federal Reserve Bank of San Francisco

2 Overview Financial turmoil and the credit crunch Downturn in housing markets Surge in commodity prices Implications for the outlook and policy May 13, 2008 Federal Reserve Bank of San Francisco 2

3 The unwinding of a credit market bubble A bubble-like situation had developed in the credit markets. Very low long-term real interest rates Investors accepted meager rewards for risk Abundance of liquidity was reflected in: Easy financing for leveraged buyouts Carry trades Rapid growth in subprime lending Suggested a benign view of underlying risks. May 13, 2008 Federal Reserve Bank of San Francisco 3

4 What caused the bubble? Securitization and financial engineering appeared to improve risk-return tradeoff. Up-front origination fees undermined strong underwriting incentives. Institutions in the shadow banking sector sought to increase leverage and reach for yield. Overreliance on credit ratings that proved unreliable. Some lessons: Inadequate risk management by many sophisticated institutions. Shortcomings in financial supervision and regulation. May 13, 2008 Federal Reserve Bank of San Francisco 4

5 Underwriting standards deteriorated Combined Loan-to-Value Ratios (2/28 Subprime Mortgages) Percent without Full Documentation (2/28 Subprime Mortgages) May 13, 2008 Federal Reserve Bank of San Francisco 5

6 What caused the bubble? Securitization and financial engineering appeared to improve risk-return tradeoff. Up-front origination fees undermined strong underwriting incentives. Institutions in the shadow banking sector sought to increase leverage and reach for yield. Overreliance on credit ratings that proved unreliable. Some lessons: Inadequate risk management by many sophisticated institutions. Shortcomings in financial supervision and regulation. May 13, 2008 Federal Reserve Bank of San Francisco 6

7 Subprime mortgage delinquencies are rising Mortgage Delinquency Rates Reported quarterly; fraction of outstanding loans Percent 22 Subprime ARM Subprime FRM Delinquent mortgages are 30 days or more past due but not in foreclosure. May 13, 2008 Federal Reserve Bank of San Francisco 7

8 Subprime delinquencies rose as house price appreciation slowed percent Mortgage Delinquency Rates and OFHEO House Price Index Changes Delinquency rates*, subprime ARMs (left scale) OFHEO Index, 4-quarter growth (right scale) percent Sources: Office of Federal Housing Enterprise Oversight and Mortgage Bankers Association * 60 days or more past due or in foreclosure 0 May 13, 2008 Federal Reserve Bank of San Francisco 8

9 Subprime delinquencies and house price changes vary inversely across MSAs May 13, 2008 Federal Reserve Bank of San Francisco 9

10 Prime mortgage delinquencies are rising too Mortgage Delinquency Rates Reported quarterly; fraction of outstanding loans Subprime ARM Prime ARM Subprime FRM Delinquent mortgages are 30 days or more past due but not in foreclosure. Percent 22 Prime FRM May 13, 2008 Federal Reserve Bank of San Francisco 10

11 Subprime problems triggered financial market disruptions Rising subprime delinquencies triggered disruptions in the markets for asset-backed securities (ABS). Contagion to municipal bonds and other ABS markets Prices fell, imposing losses on ABS holders. Heavy ABS exposure of banks and shadow banks -- highly leveraged institutions that borrow short to hold long-term assets including ABS. Includes investment banks, hedge funds, SIVs/conduits. May 13, 2008 Federal Reserve Bank of San Francisco 11

12 The emergence of a credit crunch Financial institutions are deleveraging scaling back their balance sheets. Commercial banks experienced unanticipated buildup of loans on their balance sheets. Many financial institutions are raising capital. But banks are tightening credit terms and restricting availability. May 13, 2008 Federal Reserve Bank of San Francisco 12

13 Banks are tightening credit standards Credit Conditions, Domestic Commercial Banks Net SLOOS respondents Net percent of respondents tightening credit standards Consumer Commercial real estate Q2 60 Prime C&I Residential Source: Federal Reserve Senior Loan Officer Opinion Survey -40 May 13, 2008 Federal Reserve Bank of San Francisco 13

14 New issuance of ABS has plummeted Private-Label RMBS and CMBS Issuance 3-month moving average Billions of $ RMBS CMBS Apr Source: Asset-Backed Alert 0 May 13, 2008 Federal Reserve Bank of San Francisco 14

15 The interbank lending market is under stress Basis Spread between LIBOR and Expected Funds Rate points Daily closing; expected funds rate from Overnight Indexed Swap (OIS) contract 120 Three-month / One-month Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 20 0 LIBOR: London InterBank Offered Rate May 13, 2008 Federal Reserve Bank of San Francisco 15

16 Corporate bond spreads have risen Corporate Long-Term Bond Yields Daily closing High-yield-index bonds Percent /7 8 A-index bonds year treasury 5 4 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May 3 May 13, 2008 Federal Reserve Bank of San Francisco 16

17 Fed initiatives to improve market liquidity Enhanced discount window lending Reduced rate spread and lengthened term of lending Established Term Auction Facility (TAF) Term discount window loans at auction rate; $150 billion Initiated term repurchase (repo) transactions Agency debt accepted as collateral for 28-day repos; $100 billion Established Term Securities Lending Facility (TSLF) Lends Treasuries for highly rated ABS; up to $200 billion Provided financing for acquisition of Bear Stearns Term financing to support purchase by JP Morgan; $29 billion Established Primary Dealer Credit Facility (PDCF) Overnight borrowing from discount window by primary dealers May 13, 2008 Federal Reserve Bank of San Francisco 17

18 New facilities change the composition of Fed s balance sheet Billions of $ Selected Federal Reserve Assets Billions of $ Other $78.0 b Primary Dealer Credit Facility $18.6 b Primary Credit $11.6 b Term Auction Credit Facility $100.0 b Repurchase Agreements $107.5 b week of April Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May Term Sec Lending Facility $145.6 b Overnight Sec Lending Facility $17.8 b US Treasuries held outright less securities to dealers $385.3 b May 13, 2008 Federal Reserve Bank of San Francisco 18

19 Spreads on MBS receded in wake of Fed initiatives MBS Spreads Fannie Mae, 30 yr option adjusted spread Freddie Mac, 30 yr option adjusted spread CMBS, 10 yr AAA spread over swap Basis points /30 5/ Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 0 May 13, 2008 Federal Reserve Bank of San Francisco 19

20 The housing price-to-rent ratio soared Price-rent ratio Source: BLS. Data are adjusted as in Gallin (forthcoming) May 13, 2008 Federal Reserve Bank of San Francisco 20

21 Housing markets have hit the skids 2400 Housing Thousands, seasonally adjusted Housing starts (left scale) Mar Vacant for sale (left scale) New for sale (right scale) May 13, 2008 Federal Reserve Bank of San Francisco 21

22 House prices are still heading down House Prices Case-Shiller national index with futures Q4 Index Futures May 13, 2008 Federal Reserve Bank of San Francisco 22

23 The price of crude oil has jumped Price of Oil West Texas Intermediate; weekly closing price Futures 5/9 $/Barrel May 13, 2008 Federal Reserve Bank of San Francisco 23

24 Prices of other commodities are also up Spot Price 1000 Prices of Wheat, Corn and Metals Monthly average $/Bushel CRB Metals Index (left scale) Apr Hard Wheat Yellow Corn May 13, 2008 Federal Reserve Bank of San Francisco 24

25 Consumer spending growth and sentiment are down Consumer Sentiment and PCE Growth Index 1966 = quarter percent change Consumer sentiment (left scale)* PCE growth (right scale) *Source for consumer sentiment is Reuters/Michigan Survey. May 13, 2008 Federal Reserve Bank of San Francisco 25

26 Employment is shrinking and unemployment rising Percent Employment Situation Seasonally adjusted Unemployment Rate (left scale) Empl. Change Jan. -76 K Feb. -83 K Mar. -81 K Apr. -20 K Millions of Employees Apr Nonfarm Payroll Employment (right scale) May 13, 2008 Federal Reserve Bank of San Francisco 26

27 Capital spending has slowed Nondefense Capital Goods (Ex. Aircraft) Seasonally adjusted; 3-month moving average Billions of $ 70 Orders Mar Shipments May 13, 2008 Federal Reserve Bank of San Francisco 27

28 U.S. net exports are a source of strength U.S. U.S. Net Net Exports Exports Billions of chained 2000 dollars Billions of chained 2000 dollars May 13, 2008 Federal Reserve Bank of San Francisco 28

29 Economic growth has stalled Real Gross Domestic Product (GDP) Percent change at seasonally adjusted annual rate Percent Q May 13, 2008 Federal Reserve Bank of San Francisco 29

30 Headline inflation has risen PCE Price Inflation 12 month percent change Percent 4 Overall PCE Price Index 3 2 Core PCE Price Index May 13, 2008 Federal Reserve Bank of San Francisco 30

31 Stagflation involves high inflation and weak growth Total CPI and Real GDP 4-quarter percent change Total CPI Core CPI Real GDP Q May 13, 2008 Federal Reserve Bank of San Francisco 31

32 Stagflation involves a wage-price spiral Total CPI and Unit Labor Cost 4-quarter percent change Total CPI Q Unit Labor Cost May 13, 2008 Federal Reserve Bank of San Francisco 32

33 Inflation expectations drive the wage-price spiral Rate of inflation University of Michigan Inflation Expectations Michigan 12 months out Michigan 5-10 Years Out May 13, 2008 Federal Reserve Bank of San Francisco 33

34 Monetary policy has eased Interest Rates Daily closing Percent 7 Federal Funds Target Discount Rate yr. Treasury 3 5/5 2 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun May 13, 2008 Federal Reserve Bank of San Francisco 34