Governor Frederic S. Mishkin

At the U.S. Monetary Policy Forum, New York, New York

February 29, 2008

On "Leveraged Losses: Lessons from the Mortgage Meltdown"

The paper being discussed today, "Leveraged Losses: Lessons from the Mortgage Meltdown," by David Greenlaw, Jan Hatzius, Anil Kashyap, and Hyun Song Shin, examines the following puzzle:  How could the recent residential mortgage-market meltdown, which the authors estimate will lead to credit losses of around $400 billion--less than 2 percent of the outstanding $22 trillion in U.S. equities--possibly have such large negative effects on economic activity in the United States?  After all, a 2 percent decline in stock market prices sometimes happens on a daily basis and yet leads to hardly a ripple in the U.S. economy.

The authors conclude that these losses have such a large potential impact because they are borne by highly leveraged financial institutions, primarily banks.  Their theory is basically as follows:  Because banks have so much leverage, they contract their lending by a multiple of their credit losses in order to restore their balance sheets.  The resulting contraction in bank lending then leads to a substantial decline in aggregate spending, because bank loans cannot be replaced by credit from other sources.  Banks are "special"--that is, they have intermediation capabilities not fully shared by other financial market participants, and those capabilities allow banks to overcome informational barriers between borrowers and lenders and thus make loans that otherwise could not be made.

I find the basic story the paper tells to be reasonably plausible and, therefore, find the paper to be valuable.  I do, however, want to put the analysis of the paper in a broader perspective and provide some different views on their results.¹

The Residential Mortgage Meltdown:  A Financial Development Perspective
The first part of the paper provides a nice summary of how recent events in the credit markets led to the subprime meltdown.  Let me offer my own view on how the recent disruptions to financial markets have many features in common with typical cycles in financial development.

Financial markets perform the essential economic function of channeling funds to those who have productive investment opportunities (which can include consumer purchases of goods and houses).  As I have argued elsewhere,² this function of financial markets is critical to a well-functioning economy; without it, countries, and their populations, cannot get rich.  Enabling financial markets to effectively perform this essential function is by no means easy; financial markets must solve information problems to ensure that funds actually go to those with productive investments, so that they can pay back those who have lent to them.  Financial development involves innovations or liberalization of financial markets that improve the flow of information.  Unfortunately, however, financial liberalization and innovation, often have flaws and do not solve information problems as well as markets may have hoped they would.  When these flaws become evident, financial markets sometimes seize up, often with very negative consequences for the economy.

I would argue that we have been experiencing exactly such a cycle in recent years.  Advances in information and communications technology have allowed for faster and more disaggregated mortgage underwriting decisions.  A mortgage broker with an Internet connection could quickly fill out an online form and price a loan for a customer with the help of credit-scoring technology.  The same technological improvements would allow the resulting loan to be cheaply bundled with other mortgages to produce mortgage-backed securities, which could then be sold off to investors.  Advances in financial engineering could take the securitization process even further by aggregating slices of mortgage-backed securities into more complicated structured products, such as collateralized debt obligations (CDOs), to tailor the credit risks of various types of assets to risk profiles desired by different kinds of investors.

As has been true of many financial innovations in the past, the benefits of this disaggregated originate-to-distribute model may have been obvious, but the problems less so.  The originate-to-distribute model, unfortunately, created some severe incentive problems, which are referred to as principal-agent problems, or more simply as agency problems, in which the agent (the originator of the loans) did not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan).  Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality.  When loans went bad, originators lost money, mainly because of the warranties they provided on loans; however, those warranties often expired as quickly as ninety days after origination.  Furthermore, unlike traditional players in mortgage markets, originators often saw little value in their charters, because they often had little capital tied up in their firm.  When hit with a wave of early payment defaults and the associated warranty claims, they simply went out of business.  While the lending boom lasted, however, originators earned large profits.  

Many securitizers of mortgage-backed securities and resecuritizers, such as CDO managers, also, in retrospect, appear to have been motivated more by issuance and arrangement fees and less by concern for the longer-run performance of these securities. 

These agency problems combined to lower underwriting standards, so that borrowers with weaker financial histories had access to larger loans.  When the housing market cooled and house prices no longer rose at a rapid pace, these subprime borrowers found themselves unable to either repay their loans or refinance out of them.  Investors apparently failed to realize the importance of these agency problems and, it seems, did not insist on practices to align the incentives of originators, securitizers, and resecuritizers with the underlying risks.

When these problems came to light with the end of the house-price boom, investors--including leveraged financial institutions--took large losses as mortgage-related assets were marked down in anticipation of high defaults.  The market for newly issued subprime and alt-A mortgage-backed securities virtually closed.  In addition, investors realized that they were sadly mistaken regarding their assumption that structured credit products with high credit ratings embodied very little risk.  The unprecedented losses on, and downgrades of, those products suggested that they were far more opaque than investors had suspected, and that investors had had too much confidence in the ability of the credit rating agencies to assess the true risk of these securities.  The result was that the originate-to-distribute business model, as well as structured credit products more broadly, have come into question.  In turn, this situation has had a chilling effect on securities markets and has put pressure on the balance sheets of leveraged financial institutions.

Although the perspective I have outlined here is consistent with the story told in the paper, it does emphasize that there are two parts of the recent disruption in the credit market: credit losses at banks and the near-collapse of broad classes of securities markets.  This perspective raises the issue, which I will return to later, of whether the negative consequences of the decline in intermediation required both of these elements to be present.

Estimating Mortgage-Credit Losses
The paper performs a very useful function by providing estimates of the credit losses likely to be realized on the current stock of outstanding loans.  Not only is this calculation crucial for their analysis, it is a useful survey of three different methodologies for arriving at loss estimates.  The authors first use a standard vintage curve analysis on outstanding mortgage-backed securities.  Although this method makes the strong assumption that future loss curves will follow the same shape as previous loss curves, albeit at much higher levels, it provides a reasonable rough guess of the magnitudes of the losses.

The second method the authors use is ABX pricing of subprime mortgages plus standard loss estimates on prime and near-prime mortgages to come up with loss estimates.  ABX prices, in principle, ought to reflect the up-to-the-minute credit losses expected by market participants as well as changes in the price of liquidity and market risk.  Indeed, I was worried that ABX pricing might overestimate credit losses because it carries premiums for these other risks, and trading may be light.  For example, the AAA-rated tranches of recent vintages are trading for around sixty-six cents on the dollar, which seems to build in either extreme credit-loss estimates or compensation for other risks.  However, the authors weight the various vintages and tranches of the ABX by outstanding dollar amounts and get reasonable estimates, which suggests that this approach to estimating mortgage-credit losses may have some value.    

The authors' third method is quite clever and uses state-level foreclosure models to estimate how declines in house prices would increase foreclosure starts and thus lead to losses.  Figure 1 displays a reasonably tight relationship between the rate of foreclosures started in the third quarter of 2007 and the previous four-quarter change in house prices in the fifty states and the District of Columbia.  This figure provides some backing for their approach, which, in effect, uses the historical relationship between house price declines and foreclosure starts in states that have had significant house price declines to estimate the likely effect of current projected house price declines on foreclosure starts.  However, their method requires the assumption that future foreclosures will respond to house prices as they have in the past.  In addition, past experience was with prime mortgages, because there was little subprime lending.  Will foreclosures in the subprime market in the current episode have a similar pattern of behavior to that which has occurred for prime mortgages?

Although each method of calculating mortgage credit losses has problems, the beauty of the authors' approach is that they go at the problem in very different ways.  It is striking that three very different methodologies produce similar estimates of around $400 billion in total credit losses over the next couple of years.  The authors then estimate that roughly half of mortgage loans are held by U.S. leveraged financial institutions, which include commercial banks, thrifts, hedge funds, the government-sponsored enterprises, and others, and come up with losses to this sector of around $200 billion.  This estimate might not be unreasonable, but it is very rough, because it assumes that institutions do not differ significantly in the kinds of risk they take on and that mortgage-related securities are evenly distributed across these financial institutions.

Effect of Credit Losses on Domestic Lending
The authors go on to show that what might appear to be a small amount of losses to financial institutions can lead to an amplified decline in domestic lending.  This amplification can then explain how modest losses can lead to a substantial effect on the overall economy.  Their calculation is fairly straightforward.  They assume that leveraged financial institutions have a target 10-to-1 leverage ratio, so that each dollar of a loss of capital will lead to a contraction of their balance sheet, and hence lending, by $10.  Assuming that institutions can make up half of their $200 billion mortgage credit losses by raising new capital, leaving them with a decline of capital of around $100 billion, they come up with a contraction of domestic lending near $1 trillion.  Actually, the authors' calculation is a bit more complicated than my simple characterization.  They assume that the target leverage of banks and others decreases, as it has in previous lending cycles, but they also net out reduced lending from one leveraged entity to another.  On balance, under their baseline scenario, they predict that lending to the unleveraged sector will decline by about $910 billion.

These mechanical calculations are useful, but they miss some important subtleties.  First, small losses can hit key institutions, such as bond and mortgage insurers, and have large, unpredictable effects.  Second, if leveraged financial institutions such as banks were the only ones that had credit losses and, as a result, cut back lending, other institutions or securities issuance could replace some of the lost lending.  Put another way, although banks are special because they have advantages in processing information and making loans, a big contraction in their assets would not necessarily choke off all lending.  Banks are special, but not that special.  As I discussed earlier, a key characteristic of this episode of financial disruption is that it has spread far beyond leveraged financial institutions.  It has led to a sharp decline in securities issuance; this decline has to be an important part of the story of why the current financial market turmoil is affecting economic activity.  In other words, mortgage credit losses are a problem because they are hitting bank balance sheets at the same time that the securitization market is experiencing difficulties.

Effect of Decreased Leveraged Institution Lending on Aggregate Spending
The paper then examines the well-known correlation between growth in debt and gross domestic product (GDP) to estimate the effect of the $910 billion decline in leveraged institution lending on economic growth.  The authors first estimate an ordinary-least-squares (OLS) regression of quarterly GDP growth on four lags of GDP growth and the past four-quarter growth rate of domestic nonfinancial debt growth.  They find that if debt growth falls by 1 percentage point and stays below baseline for a year, quarterly GDP growth is predicted to fall by 0.14 percentage point initially and by 0.22 percentage point over time.  The authors rightfully recognize, however, that the coefficient on debt growth may be biased upward because of reverse causality--that is, causality might run from higher economic growth to higher debt growth, because when desired purchases increase, households and business finance them by borrowing more.  Another way of stating the problem is that the debt-growth coefficient may not only reflect the affects of changes in credit supply but also changes in the demand for credit.

To deal with the possible bias in the OLS regression and estimate the effect of credit supply on economic growth, the authors appropriately turn to instrumental variable (IV) estimation by instrumenting debt growth in their regression with two instruments, the Treasury-Eurodollar (TED) spread and the Senior Loan Officer Opinion Survey on the willingness of banks to make installment loans.  The IV estimate of the coefficient on debt growth more than doubles, so that a 1 percentage point decline in debt growth predicts a decline of 0.34 percentage point in GDP initially and 0.44 percentage points in the long run.  Because a standard reverse causality story from GDP growth to debt growth suggests that the OLS estimate of the debt-growth coefficient is upwardly biased, the finding that the IV estimate is larger than the OLS estimate is indeed quite surprising.

This surprising finding raises several questions.  It can call into question the validity of the instruments, which, to be valid, need to be correlated with debt growth and yet be unaffected by economic growth.  This assumption, however, is unlikely to be correct because poor prospects for economic growth surely raise credit risk, thereby leading to a higher TED spread and less willingness to lend on the part of banks.  Thus, a higher TED spread and less willingness to lend may reflect the likelihood of tougher economic times ahead and not an exogenous shift in credit supply.

The final calculation in the paper is to combine the authors' IV estimates with their estimate of the decline in lending from leveraged institutions of $910 billion to estimate the impact on GDP growth.  The $910 billion drop in debt against a $30.3 trillion amount of nonfinancial debt outstanding is a 3 percentage point drop in nonfinancial debt growth, which when multiplied by the 0.44 long-run coefficient on debt growth, lead to a slowing of GDP growth of 1.3 percentage points over the following year.

Although this number is not implausible, there are reasons to be suspicious of it.  On the one hand, even if you accept the IV coefficient estimate, despite the reasons to doubt its accuracy, it might overstate the impact of the decline in leveraged institution lending on the economy; as mentioned earlier, other sources of lending might come online if leveraged institutions stop lending.  On the other hand, the estimated impact on the economy could be too low.  As I have discussed, the disruption to the financial system is far broader than just to leveraged institutions.  To the extent that the meltdown in the mortgage market has revealed even deeper problems in the financial system, the negative impact on economic activity could be even larger.

Conclusion
I very much enjoyed reading this paper.  Many of the calculations in the paper are especially useful and help us get a better handle on how the recent turmoil in credit markets can affect the economy. I agree with the basic story that the authors tell, which is that relatively small losses in one sector of the credit market can have an outsized impact on aggregate economic activity if they cause a disruption to the financial system that leads to an amplified impact on lending.  However, as my comments suggest, the authors may not have the full story.  It is not just the impact on leveraged financial institutions that matter, but on the overall ability of the financial system to channel funds to those institutions with productive investment opportunities.

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Footnotes

1. I thank Andreas Lehnert for his excellent assistance and helpful comments.  My remarks reflect only my own views and are not intended to reflect those of the Federal Open Market Committee or of anyone else associated with the Federal Reserve System. Return to text

2.  Frederic S. Mishkin (2006), The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich, Princeton: Princeton University Press. Return to text

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Figure 1

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Chairman Ben S. Bernanke

Semiannual Monetary Policy Report to the Congress

Before the Committee on Financial Services, U.S. House of Representatives

February 27, 2008

Chairman Bernanke presented identical testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, on February 28, 2008

Chairman Frank, Ranking Member Bachus, and other members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress.  In my testimony this morning I will briefly review the economic situation and outlook, beginning with developments in real activity and inflation, then turn to monetary policy.  I will conclude with a quick update on the Federal Reserve's recent actions to help protect consumers in their financial dealings.

The economic situation has become distinctly less favorable since the time of our July report.  Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses.  The growth of real gross domestic product (GDP) held up well through the third quarter despite the financial turmoil, but it has since slowed sharply.  Labor market conditions have similarly softened, as job creation has slowed and the unemployment rate--at 4.9 percent in January--has moved up somewhat.

Many of the challenges now facing our economy stem from the continuing contraction of the U.S. housing market.  In 2006, after a multiyear boom in residential construction and house prices, the housing market reversed course.  Housing starts and sales of new homes are now less than half of their respective peaks, and house prices have flattened or declined in most areas.  Changes in the availability of mortgage credit amplified the swings in the housing market.  During the housing sector's expansion phase, increasingly lax lending standards, particularly in the subprime market, raised the effective demand for housing, pushing up prices and stimulating construction activity.  As the housing market began to turn down, however, the slump in subprime mortgage originations, together with a more general tightening of credit conditions, has served to increase the severity of the downturn.  Weaker house prices in turn have contributed to the deterioration in the performance of mortgage-related securities and reduced the availability of mortgage credit.

The housing market is expected to continue to weigh on economic activity in coming quarters.  Homebuilders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries.

Consumer spending continued to increase at a solid pace through much of the second half of 2007, despite the problems in the housing market, but it appears to have slowed significantly toward the end of the year.  The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in spending, as did the declines in household wealth associated with the weakness in house prices and equity prices.  Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the three months ending in January, compared with an average increase of almost 100,000 per month over the previous three months.  However, the recently enacted fiscal stimulus package should provide some support for household spending during the second half of this year and into next year.

The business sector has also displayed signs of being affected by the difficulties in the housing and credit markets.  Reflecting a downshift in the growth of final demand and tighter credit conditions for some firms, available indicators suggest that investment in equipment and software will be subdued during the first half of 2008.  Likewise, after growing robustly through much of 2007, nonresidential construction is likely to decelerate sharply in coming quarters as business activity slows and funding becomes harder to obtain, especially for more speculative projects.  On a more encouraging note, we see few signs of any serious imbalances in business inventories aside from the overhang of unsold homes.  And, as a whole, the nonfinancial business sector remains in good financial condition, with strong profits, liquid balance sheets, and corporate leverage near historical lows. 

In addition, the vigor of the global economy has offset some of the weakening of domestic demand.  U.S. real exports of goods and services increased at an annual rate of about 11 percent in the second half of last year, boosted by continuing economic growth abroad and the lower foreign exchange value of the dollar.  Strengthening exports, together with moderating imports, have in turn led to some improvement in the U.S. current account deficit, which likely narrowed in 2007 (on an annual basis) for the first time since 2001.  Although recent indicators point to some slowing of foreign economic growth, U.S. exports should continue to expand at a healthy pace in coming quarters, providing some impetus to domestic economic activity and employment.

As I have mentioned, financial markets continue to be under considerable stress.  Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil.  However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for economic growth, have also roiled the financial markets in recent months.  To help relieve the pressures in the market for interbank lending, the Federal Reserve--among other actions--recently introduced a term auction facility (TAF), through which prespecified amounts of discount window credit are auctioned to eligible borrowers, and we have been working with other central banks to address market strains that could hamper the achievement of our broader economic objectives.  These efforts appear to have contributed to some improvement in short-term funding markets.  We will continue to monitor financial developments closely.

As part of its ongoing commitment to improving the accountability and public understanding of monetary policy making, the Federal Open Market Committee (FOMC) recently increased the frequency and expanded the content of the economic projections made by Federal Reserve Board members and Reserve Bank presidents and released to the public.  The latest economic projections, which were submitted in conjunction with the FOMC meeting at the end of January and which are based on each participant's assessment of appropriate monetary policy, show that real GDP was expected to grow only sluggishly in the next few quarters and that the unemployment rate was seen as likely to increase somewhat.  In particular, the central tendency of the projections was for real GDP to grow between 1.3 percent and 2.0 percent in 2008, down from 2-1/2 percent to 2-3/4 percent projected in our report last July.  FOMC participants' projections for the unemployment rate in the fourth quarter of 2008 have a central tendency of 5.2 percent to 5.3 percent, up from the level of about 4-3/4 percent projected last July for the same period.  The downgrade in our projections for economic activity in 2008 since our report last July reflects the effects of the financial turmoil on real activity and a housing contraction that has been more severe than previously expected.  By 2010, our most recent projections show output growth picking up to rates close to or a little above its longer-term trend and the unemployment rate edging lower; the improvement reflects the effects of policy stimulus and an anticipated moderation of the contraction in housing and the strains in financial and credit markets.  The incoming information since our January meeting continues to suggest sluggish economic activity in the near term.

The risks to this outlook remain to the downside.  The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further.

Consumer price inflation has increased since our previous report, in substantial part because of the steep run-up in the price of oil.  Last year, food prices also increased significantly, and the dollar depreciated.  Reflecting these influences, the price index for personal consumption expenditures (PCE) increased 3.4 percent over the four quarters of 2007, up from 1.9 percent in 2006.  Core price inflation--that is, inflation excluding food and energy prices--also firmed toward the end of the year.  The higher recent readings likely reflected some pass-through of energy costs to the prices of core consumer goods and services as well as the effect of the depreciation of the dollar on import prices.  Moreover, core inflation in the first half of 2007 was damped by a number of transitory factors--notably, unusually soft prices for apparel and for financial services--which subsequently reversed.  For the year as a whole, however, core PCE prices increased 2.1 percent, down slightly from 2006.

The projections recently submitted by FOMC participants indicate that overall PCE inflation was expected to moderate significantly in 2008, to between 2.1 percent and 2.4 percent (the central tendency of the projections).  A key assumption underlying those projections was that energy and food prices would begin to flatten out, as was implied by quotes on futures markets.  In addition, diminishing pressure on resources is also consistent with the projected slowing in inflation.  The central tendency of the projections for core PCE inflation in 2008, at 2.0 percent to 2.2 percent, was a bit higher than in our July report, largely because of some higher-than-expected recent readings on prices.  Beyond 2008, both overall and core inflation were projected to edge lower, as participants expected inflation expectations to remain reasonably well-anchored and pressures on resource utilization to be muted.  The inflation projections submitted by FOMC participants for 2010--which ranged from 1.5 percent to 2.0 percent for overall PCE inflation--were importantly influenced by participants' judgments about the measured rates of inflation consistent with the Federal Reserve's dual mandate and about the time frame over which policy should aim to attain those rates.

The rate of inflation that is actually realized will of course depend on a variety of factors.  Inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect.  Upside risks to the inflation projection are also present, however, including the possibilities that energy and food prices do not flatten out or that the pass-through to core prices from higher commodity prices and from the weaker dollar may be greater than we anticipate.  Indeed, the further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month.  Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well anchored.  Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future.  Accordingly, in the months ahead, the Federal Reserve will continue to monitor closely inflation and inflation expectations.

Let me turn now to the implications of these developments for monetary policy.  The FOMC has responded aggressively to the weaker outlook for economic activity, having reduced its target for the federal funds rate by 225 basis points since last summer.  As the Committee noted in its most recent post-meeting statement, the intent of those actions has been to help promote moderate growth over time and to mitigate the risks to economic activity.

 A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures.  In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects.  Monetary policy works with a lag.  Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation as well as the risks to that forecast.  Although the FOMC participants' economic projections envision an improving economic picture, it is important to recognize that downside risks to growth remain.  The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.

Finally, I would like to say a few words about the Federal Reserve's recent actions to protect consumers in their financial transactions.  In December, following up on a commitment I made at the time of our report last July, the Board issued for public comment a comprehensive set of new regulations to prohibit unfair or deceptive practices in the mortgage market, under the authority granted us by the Home Ownership and Equity Protection Act of 1994.  The proposed rules would apply to all mortgage lenders and would establish lending standards to help ensure that consumers who seek mortgage credit receive loans whose terms are clearly disclosed and that can reasonably be expected to be repaid.  Accordingly, the rules would prohibit lenders from engaging in a pattern or practice of making higher-priced mortgage loans without due regard to consumers' ability to make the scheduled payments.  In each case, a lender making a higher-priced loan would have to use third-party documents to verify the income relied on to make the credit decision.  For higher-priced loans, the proposed rules would require the lender to establish an escrow account for the payment of property taxes and homeowners' insurance and would prevent the use of prepayment penalties in circumstances where they might trap borrowers in unaffordable loans.  In addition, for all mortgage loans, our proposal addresses misleading and deceptive advertising practices, requires borrowers and brokers to agree in advance on the maximum fee that the broker may receive, bans certain practices by servicers that harm borrowers, and prohibits coercion of appraisers by lenders.  We expect substantial public comment on our proposal, and we will carefully consider all information and viewpoints while moving expeditiously to adopt final rules. 

The effectiveness of the new regulations, however, will depend critically on strong enforcement.  To that end, in conjunction with other federal and state agencies, we are conducting compliance reviews of a range of mortgage lenders, including nondepository lenders.  The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of, and improved enforcement for, all categories of mortgage lenders.

The Federal Reserve continues to work with financial institutions, public officials, and community groups around the country to help homeowners avoid foreclosures.  We have called on mortgage lenders and servicers to pursue prudent loan workouts and have supported the development of streamlined, systematic approaches to expedite the loan modification process.  We also have been providing community groups, counseling agencies, regulators, and others with detailed analyses to help identify neighborhoods at high risk from foreclosures so that local outreach efforts to help troubled borrowers can be as focused and effective as possible.  We are actively pursuing other ways to leverage the Federal Reserve's analytical resources, regional presence, and community connections to address this critical issue.

In addition to our consumer protection efforts in the mortgage area, we are working toward finalizing rules under the Truth in Lending Act that will require new, more informative, and consumer-tested disclosures by credit card issuers.  Separately, we are actively reviewing potentially unfair and deceptive practices by issuers of credit cards.  Using the Board's authority under the Federal Trade Commission Act, we expect to issue proposed rules regarding these practices this spring.

Thank you.  I would be pleased to take your questions.

 

February 2008 Monetary Policy Report

Governor Frederic S. Mishkin

At the Third National Summit on Economic and Financial Literacy, Washington, D.C.

February 27, 2008

The Importance of Economic Education and Financial Literacy

As an educator myself, it's a pleasure to be here today to take part in this important event that brings people together from educational organizations all over the country, with the common goal of educating students and citizens in the fundamentals of economic and financial literacy. As many of you know, the Federal Reserve has had a long and fruitful relationship with the National Council on Economic Education (NCEE), through our many Reserve Bank collaborative efforts around the country, and through leadership at the national level. This leadership is evidenced, in part, by the involvement of my former and present colleagues on the Federal Open Market Committee, Cathy Minehan and Gary Stern, who currently serve as NCEE board members. Cathy, of course, is the former president of the Federal Reserve Bank of Boston, a bank that under her leadership has played a key role in furthering economic education in our New England states. Gary is president of the Federal Reserve Bank of Minneapolis, from where he has served not only as a long-time member on NCEE's board, but also as its chair. And they are just two of the many Federal Reserve Bank presidents and officials who have worked to foster and improve economic education with the National Council over the years.

There can hardly be a better time to make the case for economic and financial literacy than right now. Others have doubtless stood before an audience like you in years past and made the same case, but now we face a downturn in our housing industry fueled, at least in part, by unwise mortgage borrowing and, at times, abusive lending practices. Improving consumers' knowledge of the home mortgage process will better equip them to avoid unsuitable mortgages in the future. Our national economy has been strained by this housing slowdown and other forces, causing policymakers and others to debate what response is necessary. Also, during this election season, we are reminded of the importance of economic issues. Just a brief consideration of these three cases shows that a better-educated citizenry can not only contribute to a better functioning economy, but also to a more-effective government.

On the first point, many lessons can be drawn from the downward swing in the housing industry, ranging from those that individual consumers can learn at the micro level, to those that financial companies can learn about investment and oversight. In that regard, the Federal Reserve has proposed new rules to strengthen regulatory oversight and to protect consumers in the future, and we continue to assess this episode to determine what more can be done to help homebuyers and homeowners. Of course, one of the most effective ways to help consumers is to empower them with information. And this gets to our first case for economic and financial literacy: Improving consumers' economic decision making will enhance the effectiveness of new rules and regulations. And while we at the Federal Reserve are charged with regulatory duties, we certainly see the value of education and the positive impact it can have on the broader economy. While the current troubles in the housing industry stem from a number of causes, a better-informed citizenry would likely have resulted in more-prudent decision making and, consequently, less harm to the economy.

In the matter of the national economy, here the call for economic education is based on the idea that a better-informed citizenry makes for better economic policymaking. This is a subtle argument, but its logic is no less clear. As my friend Alan Blinder, the noted Princeton economist and textbook author, as well as the former vice chairman of the Federal Reserve's Board of Governors, has said, an uneducated citizenry can lead to simplistic policy solutions, and those solutions are usually suboptimal. "The fact that the basic level of economic literacy in the country, indeed in the world, is so low," Alan has said, "is one of the things that leaves the political process so vulnerable to this malady."¹ Now, even Alan would admit that it's difficult to draw a direct line from economic literacy to economic policymaking, but politicians listen to their constituents at home, just as they are supposed to do. And at a time when our elected officials are confronted with a myriad of options to address a slowing economy, or when they consider the increasing fears about a globalizing economy, it's fair to ask whether they are getting good economic counsel from their constituents. This is not to say that there is only one valid answer for these complicated questions, but it does mean that we get a better answer when we are all better informed. Let me reinforce this point by sharing this quote from Ben Bernanke, Chairman of the Federal Reserve's Board of Governors:

The Federal Reserve's mission of conducting monetary policy and maintaining a stable financial system depends upon the participation and support of an educated public. Accomplishing this mission involves trade-offs and tough decisions. As the Fed pursues the monetary policy objectives that have been set out for us by Congress--to pursue price stability, maximum employment, and moderate long-term interest rates--it is essential that the public understand our objectives and our actions. Educating the public about the reasoning behind our decisions helps build confidence in our economic system--another critical factor in keeping our economy running smoothly.²

Chairman Bernanke made those comments nearly two years ago, but the message is no less relevant today.

Let's now consider our third case for economic and financial literacy--the role of citizens as voters. Americans elect a president every four years and we also send representatives and senators to Washington. As is so often the case, the pundits and the opinion polls tell us that the top issues on voters' minds this year are those relating to the economy. What do the candidates have to say about how, if at all, the federal government should address the lagging national economy? How about issues relating to trade? Taxes? Income inequality? Even issues that are not often described as economic--such as health care, education, and the environment--are informed by an understanding of economic principles. All these issues are better understood by an appreciation of tradeoffs, cost-benefit ratios, and opportunity cost, to name just a few core economic tools and principles.

Finally, as we are so often told, people vote with their pocketbooks. And not only do they vote with their pocketbooks, they also make a lot of pocketbook decisions every day that have an impact on the health of the economy, such as whether to take on a particular mortgage, how much to save and invest, whether to lease or buy a car, and how to manage credit cards. This brings us back to the importance of financial literacy. The choices we make as individuals--as consumers, investors, and even voters--are linked to the broader economy in ways that we don't always appreciate. However, one thing is certain--we make better decisions if we are better informed, and the whole economy benefits. That's the promise of economic education--to get back to the title of this session--that it not only improves the lives of individual consumers, but that it also makes for more-effective policy and a better economy. Delivering on that promise is the hard part, of course, but that's where the National Council comes in. We at the Federal Reserve are proud of our relationship with the National Council and with other educational organizations around the country, and we look forward to continuing this important work. The task at hand is not easy, as all of you know, but the returns are high.

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Footnotes

1.  Blinder, Alan S, (1994), "Interview with Alan S. Blinder," The Region, Federal Reserve Bank of Minneapolis, December, Return to text

2.  Bernanke, Ben (2006), "A Message from Chairman Bernanke," Federal Reserve Bank of Dallas, July, Return to text

Release Date: February 28, 2008

For immediate release

The Federal Reserve Board on Thursday requested public comment on proposed changes to its Payments System Risk (PSR) policy that are intended to loosen intraday liquidity constraints and reduce operational risks in financial markets and the payments system.  The Board is proposing a new strategy for providing intraday credit to depository institutions and would encourage these institutions to collateralize their daylight overdrafts.

The Board has spent several years reviewing long-term developments in intraday liquidity, operational risk, and risk management in financial markets and the payments system, including the increased use of daylight overdrafts at the Federal Reserve Banks and increased Fedwire funds transfers late in the day.  The Board published a consultation paper on these issues in 2006 and received public comments.  As a result of this review and the comments, the Board is proposing changes to the Federal Reserve's current strategy for providing intraday credit to the banking industry to help ease intraday liquidity constraints and reduce operational risk.

Specifically, the Board proposes to adopt a policy of supplying intraday balances to healthy depository institutions predominantly through explicitly collateralized daylight overdrafts.  To avoid significantly disrupting the operation of the payments system and increasing the cost burden on a large number of institutions that incur small amounts of daylight overdrafts, the Board would allow depository institutions to pledge collateral voluntarily to secure daylight overdrafts.  The proposed policy would encourage the voluntary pledging of collateral to cover daylight overdrafts by providing collateralized daylight overdrafts at a zero fee and by raising the fee for uncollateralized daylight overdrafts to 50 basis points (annual rate) from the current 36 basis points.  In developing this proposal, the Board has sought to minimize the effect of the proposed policy changes on institutions that use small amounts of daylight overdrafts by increasing substantially the biweekly fee waiver to $150 from $25.  The proposed policy would also involve changes to other policy provisions, including adjusting net debit caps, streamlining procedures for the expansion of daylight overdraft capacity for certain foreign banking organizations, eliminating the current deductible for daylight overdraft fees, and increasing the penalty daylight overdraft fee for ineligible institutions to 150 basis points (annual rate) from the current 136 basis points.  The Board expects that a revised PSR policy could be implemented approximately two years from the adoption of a final rule. 

To assist depository institutions in assessing the impact of the proposed changes on their institution, the Board has developed a simple fee calculator that will allow institutions to estimate their daylight overdraft fees under the proposed policy.  The fee calculator is located on the Board’s website at https://www.federalreserve.gov/apps/RPFCalc/.

Comments are requested by June 4, 2008.

The Board's notice is attached.  The Board also requested public comment today on a proposed change to the daylight overdraft posting rules under its PSR policy.

Attachment (366 KB PDF)

Payments System Risk Policy Fee Calculator

Having savings and an emergency fund helps you manage your personal finances and achieve your short- and long-term goals. The following resources provide information and links to agencies and organizations that may be able to help you.

• Department of Labor
  • Top 10 Ways to Prepare for Retirement

• Federal Citizens Information Center
  • 66 Ways to Save Money
  • Savings Fitness: A Guide To Your Money and Your Financial Future

• Federal Deposit Insurance Corporation
  • Certificates of Deposit: Tips for Savers

• Federal Reserve System
  • 4 Steps to Your Financial Freedom
  • ABCs of Figuring Interest
  • Bank Products: What's Insured and What's Not
  • Building Wealth
  • Get Financially Fit
    • The Warm Up: Get Ready for the Financial Fitness Challenge! Volume 1 (67 KB PDF)
    • The Work Out: Take the Financial Fitness Challenge! Volume 2 (90 KB PDF)
    • The Big Weigh In: Take Financial Charge! Volume 3 (85 KB PDF)

• Federal Trade Commission
  • Saving Money at the Gas Pump: Tips from the Federal Trade Commission
  • Saving Starts @ Home: The Inside Story on Conserving Energy

• Internal Revenue Service
  • Divide and Prosper: Refund Splitting Creates Asset-Building Opportunities for Direct Deposit Filers

• Securities and Exchange Commission
  • An Introduction to 529 Plans
  • Calculators for Investors
  • Get the Facts: The SEC’s Roadmap to Saving and Investing