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

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

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

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

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

Underwriting standards deteriorated Combined Loan-to-Value Ratios (2/28 Subprime Mortgages) Percent without Full Documentation (2/28 Subprime Mortgages) 90 88 86 84 82 80 78 76 45 40 35 30 25 20 15 74 10 72 5 70 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 May 13, 2008 Federal Reserve Bank of San Francisco 5

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

Subprime mortgage delinquencies are rising Mortgage Delinquency Rates Reported quarterly; fraction of outstanding loans Percent 22 Subprime ARM 20 18 16 14 12 Subprime FRM 98 99 00 01 02 03 04 05 06 07 08 10 8 6 Delinquent mortgages are 30 days or more past due but not in foreclosure. May 13, 2008 Federal Reserve Bank of San Francisco 7

Subprime delinquencies rose as house price appreciation slowed percent 30 25 20 15 10 5 Mortgage Delinquency Rates and OFHEO House Price Index Changes Delinquency rates*, subprime ARMs (left scale) OFHEO Index, 4-quarter growth (right scale) percent 16 14 12 10 8 6 4 2 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 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

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

Prime mortgage delinquencies are rising too Mortgage Delinquency Rates Reported quarterly; fraction of outstanding loans Subprime ARM Prime ARM Subprime FRM 98 99 00 01 02 03 04 05 06 07 08 Delinquent mortgages are 30 days or more past due but not in foreclosure. Percent 22 Prime FRM 20 18 16 14 12 10 8 6 4 2 0 May 13, 2008 Federal Reserve Bank of San Francisco 10

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

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

Banks are tightening credit standards Credit Conditions, Domestic Commercial Banks Net SLOOS respondents Net percent of respondents tightening credit standards 100 80 Consumer Commercial real estate Q2 60 Prime 40 20 0 C&I Residential -20 90 92 94 96 98 00 02 04 06 08 Source: Federal Reserve Senior Loan Officer Opinion Survey -40 May 13, 2008 Federal Reserve Bank of San Francisco 13

New issuance of ABS has plummeted Private-Label RMBS and CMBS Issuance 3-month moving average Billions of $ 60 50 RMBS 40 30 20 CMBS Apr. 10 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Asset-Backed Alert 0 May 13, 2008 Federal Reserve Bank of San Francisco 14

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 100 80 5/7 60 40 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

Corporate bond spreads have risen Corporate Long-Term Bond Yields Daily closing High-yield-index bonds Percent 12 11 10 9 5/7 8 A-index bonds 7 6 10-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

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

New facilities change the composition of Fed s balance sheet Billions of $ 1000 900 800 700 600 500 400 Selected Federal Reserve Assets Billions of $ 1000 900 800 700 600 500 400 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 300 200 100 week of April 30 0 0 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 300 200 100 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

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 400 350 300 250 4/30 5/6 200 150 100 50 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 0 May 13, 2008 Federal Reserve Bank of San Francisco 19

The housing price-to-rent ratio soared Price-rent ratio 29 27 25 23 21 19 17 15 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 Source: BLS. Data are adjusted as in Gallin (forthcoming) May 13, 2008 Federal Reserve Bank of San Francisco 20

Housing markets have hit the skids 2400 Housing Thousands, seasonally adjusted 600 550 2000 1600 Housing starts (left scale) Mar. 500 450 400 1200 350 300 800 Vacant for sale (left scale) New for sale (right scale) 250 200 400 78 82 86 90 94 98 02 06 150 May 13, 2008 Federal Reserve Bank of San Francisco 21

House prices are still heading down House Prices Case-Shiller national index with futures Q4 Index 235 210 185 Futures 160 135 110 85 1988 1993 1998 2003 2008 60 May 13, 2008 Federal Reserve Bank of San Francisco 22

The price of crude oil has jumped Price of Oil West Texas Intermediate; weekly closing price Futures 5/9 $/Barrel 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 15 135 125 115 105 95 85 75 65 55 45 35 25 May 13, 2008 Federal Reserve Bank of San Francisco 23

Prices of other commodities are also up Spot Price 1000 Prices of Wheat, Corn and Metals Monthly average $/Bushel 14 900 800 700 600 CRB Metals Index (left scale) Apr. 12 10 8 500 400 300 200 Hard Wheat Yellow Corn 6 4 2 100 2000 2001 2002 2003 2004 2005 2006 2007 2008 0 May 13, 2008 Federal Reserve Bank of San Francisco 24

Consumer spending growth and sentiment are down Consumer Sentiment and PCE Growth Index 1966 = 100 115 4-quarter percent change 6.00 105 5.00 4.00 95 3.00 85 2.00 75 65 Consumer sentiment (left scale)* PCE growth (right scale) 1.00 0.00-1.00 55-2.00 1999 2001 2003 2005 2007 *Source for consumer sentiment is Reuters/Michigan Survey. May 13, 2008 Federal Reserve Bank of San Francisco 25

Employment is shrinking and unemployment rising Percent 6.5 6.0 5.5 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. 139 138 137 136 135 5.0 134 4.5 133 132 4.0 Nonfarm Payroll Employment (right scale) 131 130 3.5 2000 2001 2002 2003 2004 2005 2006 2007 129 May 13, 2008 Federal Reserve Bank of San Francisco 26

Capital spending has slowed Nondefense Capital Goods (Ex. Aircraft) Seasonally adjusted; 3-month moving average Billions of $ 70 Orders Mar. 65 60 Shipments 55 50 2000 2001 2002 2003 2004 2005 2006 2007 2008 45 May 13, 2008 Federal Reserve Bank of San Francisco 27

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 0-100 -200-300 -400-500 -600-700 1995 1997 1999 2001 2003 2005 2007 May 13, 2008 Federal Reserve Bank of San Francisco 28

Economic growth has stalled Real Gross Domestic Product (GDP) Percent change at seasonally adjusted annual rate Percent 8 6 4 Q1 2 0 2000 2001 2002 2003 2004 2005 2006 2007-2 May 13, 2008 Federal Reserve Bank of San Francisco 29

Headline inflation has risen PCE Price Inflation 12 month percent change Percent 4 Overall PCE Price Index 3 2 Core PCE Price Index 2000 2001 2002 2003 2004 2005 2006 2007 2008 1 May 13, 2008 Federal Reserve Bank of San Francisco 30

Stagflation involves high inflation and weak growth Total CPI and Real GDP 4-quarter percent change Total CPI Core CPI Real GDP 1970 1975 1980 1985 1990 1995 2000 2005 2008 Q1 16 14 12 10 8 6 4 2 0-2 -4 May 13, 2008 Federal Reserve Bank of San Francisco 31

Stagflation involves a wage-price spiral Total CPI and Unit Labor Cost 4-quarter percent change Total CPI 16 14 12 10 2008 Q1 8 6 4 2 Unit Labor Cost 1970 1975 1980 1985 1990 1995 2000 2005 0-2 -4 May 13, 2008 Federal Reserve Bank of San Francisco 32

Inflation expectations drive the wage-price spiral Rate of inflation University of Michigan Inflation Expectations 12.0 10.0 8.0 6.0 4.0 2.0 0.0 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Michigan 12 months out Michigan 5-10 Years Out May 13, 2008 Federal Reserve Bank of San Francisco 33

Monetary policy has eased Interest Rates Daily closing Percent 7 Federal Funds Target Discount Rate 6 5 4 2-yr. Treasury 3 5/5 2 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun 1 2007 2008 May 13, 2008 Federal Reserve Bank of San Francisco 34