The Fed, Prime Rates and the Financial Crisis

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The Fed, Prime Rates and the Financial Crisis

Postby dtcochrane » Tue Mar 31, 2009 8:45 pm

The trigger for the recent financial crisis was the jump in defaults among subprime mortgage holders. In particular, those with adjustable rate mortgages (ARMs), began to default. This was set off by rising Fed Fund rates that added insult to injury for those with backloaded interest rates (pay low rates for the first three years or so). The Fed began to increase its lending rate in July of 2004. By late 2005, early 2006 foreclosure and delinquency rates for subprime ARMs began to increase [1]. The Fed Fund rate hit its peak (5.25%) in July, 2006 and remained there for a year.

My question to you: Why did the Fed begin increasing the Fed Fund rate at this time?

[1] Mortgage Bankers Association. 'National Delinquency Survey.' (June 30, 2008).
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Re: The Fed, Prime Rates and the Financial Crisis

Postby TwinkleStarrs » Tue Mar 31, 2009 9:51 pm

Absolutely no clue whatsoever! But it must be a good story!
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Re: The Fed, Prime Rates and the Financial Crisis

Postby DanielRose » Sat Apr 04, 2009 7:38 am

My guess is that it was due to fear of inflation. Take a look at the CPI from 2000 to 2008, and you'll see a jump around 2002 or so, happening mostly due to the rise in the price of oil and the artificially-low interest rate. Greenspan, like the good monetarist he is, tried to kill inflation in its cradle by boosting the prime rates. With the result of a danger of a recession, and a wave of mortgage defaults.
Also, as you note, some of the mortgages were formed as Adjustable Rate Mortgages, meaning they were programmed to start with "teaser" rates, and then "resetting" upwards a few years later.
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Re: The Fed, Prime Rates and the Financial Crisis

Postby dtcochrane » Sat Apr 04, 2009 8:31 am

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Re: The Fed, Prime Rates and the Financial Crisis

Postby DanielRose » Sat Apr 04, 2009 8:56 am

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Re: The Fed, Prime Rates and the Financial Crisis

Postby dtcochrane » Sun Apr 05, 2009 8:58 am

Could the banks really not have foreseen what the interest rate boosts would do to their assets - the subprime mortgage holder? Did they drink their own Kool-Aid and accept that the bundled and rebundled derivates, despite being based on B risk assets now somehow deserved A ratings?

This really makes me think that despite the current turmoil, Big Finance may not consider the current situation so tragic and dire and may emerge the ultimate beneficiaries. Or at least, they may have had this longer-term view without properly judging how deep the impact of the crisis would be. Nonetheless, the survivors could very well come out on top. I'm curious as to what's going on with the in-house finance arms of various members of dominant capital. I know GE Capital has been swinging GE about. Have any large corporations dropped their financing arms, seeking to get back to the 'real'?
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Re: The Fed, Prime Rates and the Financial Crisis

Postby Aaron_Muchelle » Tue Apr 07, 2009 4:38 am

Increasing inflation may have been the underlying reason for an increase in interest rates, the following, I think, ought to be pointed out:

Albeit the impact of rising prices and lowering volume on profit is non-linear, the subject of analysis ought not to be, as Nitzan & Bichler put it, not prices, but rather inflation and its impact not on profit but differential profit. 'Although inflation is never uniform and thus never neutral, this is exactly the point - inflation redistributes and is a permanent process.

Inflation is always present and always increasing. Capitalism, from the 20th Century onwards, is an inflationary concept. Why, pray tell, do central bankers guard against inflation?

Answer: Inflation is very risky.

Since inflation is re-distributional and re-distributon brings about conflict and instability, inflation then, by definition, arises with crises. Although the relationship between the rate of inflation and GDP ought to be positive - the data show the reverse. The relationship is actually negative. Inflation, it seems, tends to appear with low growth, whilst price-stability tends to appear in periods of deflation.

As Nitzan & Bichler write, 'stagflation intensifies as growth declines and inflation rises and it recedes when growth increases and inflation falls' (2002: 69). Stagflation then, is the heart of capitalism - it is the norm.

Now, if, as is assumed, the Federal Reserve essentially tightened policy in order to control inflation, the consequence of this tightening is exaclty the opposite: the economy slows, as it has done so presently.

Although it is technically possible for stagflation to sustain differential accumulation, ad infinitum, this is politically untenable as stagnation and re-ditrbution by inflation have a tendency to heighten social conflict, as seen at least here in the UK and the continent.

Given that dominant capital needs to continusiously grow and 'break envelopes' the subsequent crises will be harder to manage - as the current crisis patently illustrates.
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Re: The Fed, Prime Rates and the Financial Crisis

Postby dtcochrane » Tue Apr 07, 2009 9:51 am

Aaron,
I think you raise some pertinent and valuable points. I think we need to recall another feature of capitalism that emerges the Nitzan and Bichler's analysis, and to which you allude: the differential interests of capital. I believe this is one of the most important elements of capitalism, and one that gets glossed over or entirely eliminated in the standard critical analyses. There is competition on the one hand, which is rational, ultimately restricted to price competition, and rewards efficiency and then there is the standard, and universal logic of capital tout court on the other - accumulation. When we consider the complex processes of power that underlie the accumulatory process we see that it is not so cut and dried. When the divergent and conflicting interests of capital come to bear on government and quasi-government agencies like the Fed, there are often mutually exclusive possible outcomes which inevitably favour one capitalist coalition over another.

When we realize that the assets of lenders is the borrower, not the object that the borrowing funded, we can begin to understand a differential interest on the part of financial intermediaries as concerns interest rates and wages. When the intermediaries are able to borrow at lower rates they can lend at lower rates, effectively reducing the cost of borrowing for consumers. Both mortgage and consumer debt have risen over the post-war era, with mortgage debt exploding since the start of the new millenia (relative to earnings). At the same time, financial obligations have only risen slightly, meaning the cost of borrowing has declined[1]. Rather than seek to accumulate on increasing interest rates, Big Finance has expanded the number of debtors. In other words, it has used a breadth, not depth process. Therefore, it has a clear interest in the on-going solvency of its 'assets' - the borrower. So while the standard assumption concerning capital's mechanism in its antagonistic relationship to labour is pushing down its earnings and using the heavy-hand of layoffs to achieve this, the financial intermediaries do not share in this relationship. Their interest is, if anything, increased wages, which means a greater possibility of extending the indebtedness of the labouring masses.

Aaron is absolutely correct that stagflation is inherently unstable. But, if Big Finance had any indication that increased interest rates would have this effect on their assets - make borrowers unable to meet their financial obligations, then they would undoubtedly have preferred the risk of inflation. It would seem possible that the Fed adhered to ideology - fight inflation at all costs - over any please to maintain low interest rates, at which point the masking justification of mainstream economics becomes a burden to some of its greatest proponents.

[1]Data from the Federal Reserve Bulletin Statistical Supplement.
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