While talk today of the 2008 subprime mortgage crisis that touched off the Great Recession tends to center mainly around the failure of regulators or bad individual actors at the level of banks and lenders, we should not forget that it was Fed policy from 1993 to 2005 that created the crucial conditions for the ultimate collapse.
Put simply, the Fed kept monetary policy too loose for too long. Viewed charitably, it likely did this in response to several potential exogenous shocks that could have negatively impacted on the US economy and financial sector. In a rapid succession of years the Mexican peso, East Asian, and Russian debt crises caused the Fed to lower rates. The Y2K computer scare also prompted a cash infusion.
Predictably, flushing the system with so much cash caused multiple asset bubbles, most notably in technology and housing. The Fed’s policy also caused yield compression, bringing expected payouts from riskier and thereby more profitable investments closer to that of traditionally safe assets. Money managers who had promised their clients high rates of return were thereby forced to pursue even riskier investments in the hopes of making their promised profits.
This, of course, is where subprime mortgage-backed securities (MBS) comes in. Because apart from the role Fed policy played in setting the monetary conditions for the crisis, massive government involvement in the subprime market created a moral hazard, whereby the banks and lenders selling mortgages were not ultimately on the hook for any of the risk in exchange for their profit.
As Powell backtracks from his tepid taper talk of last month, it is worth drawing attention to the role the Fed has again played, and is continuing to play, in blowing up bubbles in housing and technology—this time even directly buying MBS, in violation of its own charter. Reflecting back on the previous cycle, noting the continued explosion in housing prices, and examining the gapping P/E ratios of the stocks of the major tech indexes, the similarities to its run-up are obvious, worrying, and plainly illustrate the continued failure of the Fed.
