Yellen Uncensored

July 3, 2014 Updated: April 24, 2016

What do Fed chairs have in common? They deny responsibility for past wrongdoing and stick their heads in the sand when it comes to future problems. Janet Yellen continues this policy, with Paul Volcker being a notable exemption.   

Let’s start with past wrongdoing. In her speech at the IMF on Wednesday, Yellen admitted policymakers “overlooked” the risks in the system in the mid-2000s but flat-out denied former chairman Alan Greenspan’s low rates were responsible for it.

Of course, other factors, such as skewed incentives in loan underwriting and moral hazard were at play. However, low rates are the necessary condition for bubbles and Yellen is wrong to deny this.

Any project’s economic feasibility, whether it is buying a house or building a company, depends on the rate at which future payments and/or profits are discounted. At lower rates, financing is cheaper and therefore more projects become feasible if other factors such as wages or revenues stay the same.

Applied to the housing market, this means banks as well as buyers simply couldn’t have afforded to do the dodgy transactions at higher rates.

The borrower could not have done it because interest payments would have been higher throughout the life of the mortgage. But more importantly, the banks couldn’t have done it, even if they had wanted to apply lax lending standards and waivers.

When rates are high, banks not only collect higher payments on loans, they also have to pay more money to deposit holders or in the interbank funding market. So any shortfall in income because of waivers or defaults hurts much more if your cost of funding is 5 percent rather than if it is 1 percent.   

Rate Change

In addition, if Yellen’s argument is true and low rates don’t matter, then why did raising rates from 1 percent in 2004 to 5.25 percent in 2006 lead to the deflation of the housing bubble?

Precisely for the reasons named above. Higher rates and higher prices scared away buyers and an oversupplied market led to price declines. The initial declines led to more selling by people who were underwater on their mortgages and could not refinance at higher rates, leading to a vicious cycle—something that Fed Chairman Bernanke at that time didn’t see coming.   

Future Risk

Greenspan wasn’t concerned with the tech bubble, Bernanke didn’t see the housing crash and Yellen is oblivious to bubbles in the stock market, corporate bonds and student loans, powered by an all-powerful shadow banking system the Fed never addresses publicly but does everything in its power to prop up with its policy.

So Yellen said leverage in the official financial system has declined, which by and large is true.

However, the IMF came out with a paper last week saying that leverage in the lesser regulated but equally large shadow banking system of prime brokers and hedge funds is at a similar level as it was in 2007.

The spread of junk bonds to Treasurys is now as low as it was before the market routs in 1994, 1997, and 2007. Conversely, these low yields make historically low dividend yields of stocks artificially attractive. They also propel valuations, such as the stock market value to GDP ratio to red hot levels.

Student loans never took a breather, rising almost sixfold since 2003 to $1.1 trillion. By now they are the largest portion of consumer debt. Tuition prices have also risen compared to household income, pushing the ratio up from 19.2 percent in 2003 to 26.7 percent in 2012.

Higher prices and a lower probability to find well-paid jobs have pushed 90-day delinquencies up to $124.3 billion or 11 percent of the total.

This is not dissimilar to housing in 2006 where the lowest quality borrowers, mostly unemployed people—and students are unemployed people—defaulted first. Ironically, from a systemic view, since there is no collateral, nothing can be sold to push prices down and lead to more selling, as it happened with house prices.

However, since there is no collateral, there is nothing to recover either and the taxpayer will ultimately have to foot the bill. 

No Regulation

Finally, Yellen wants to reduce risk by introducing more regulation instead of returning to a more sensible interest rate policy. This is akin to giving a compulsive gambler an unlimited line of credit but prohibiting him from going to Las Vegas.

The gambler will find other places to lose his money. So will the speculators in this market.