Federal Reserve Mortgage
Macro-economics
The Role of the Federal Reserve in a Mortgage Crisis
The Federal Reserve System has been around for many years. It was established in the year of 1913. The Federal Reserve System was created to have more secure and stable economic structure. There are three primary functions of the Federal Reserve System. Promotions of safe and sound banking practice by a controlled system. Acts as the bankers' bank hence establishing a system whereby banks can attempt to borrow from the Fed. The third primary function is to establish monetary policy, guided by the Federal Open Market Committee (FOMC); which basically control and regulates money supply. The Federal Reserve System is known for being the central banking system in thee United States. It consists of twelve regions and twenty five branches. Currently, Ben Bernanke holds the position of the chairman.
Commercial Banks and lending institution are financial intermediaries that accept deposits from the public and use these deposit as source of finance for prospective investors that lacks the funding to implement projects, at an interest to these borrowers.
These functions expose them to too two major risk namely; credit risk and liquidity risk. Credit risk involves the possibility for borrowers to default on loans while liquidity risk involves the possibility for banks not to have enough liquid assets to cover withdrawals by depositors. Both risk are correlated, banks primary means of earning revenue is through lending depositors money to borrowers where a large percentage of borrowers are defaulting on loans this will result in the bank not having enough liquid assets to cover withdrawal by its depositors. Occurrence of such situation can and has lead to bank run and detrimental financial meltdown in society's that have had such fall out in their banking system. The ripple effect of Bank run has been known to cause major crisis in numerous economies, to date it is still blame as the major cause of the great depression in the United States economy in the nineteen thirties. This event revolutionize the Federal Reserve System which reacted by putting in safe guards that would prevent the panic that cause economic collapse from being repeated in us history. Some of the safeguards includes; I) the establishment of the federal deposit insurance corporation, 2) the implementation of the required reserve system requiring banks to keep a portion of depositors money in reserve where its accessible to depositor , 3) providing a cushion to commercial bank through being a lender of last resort to lend emergency cash to banks that are low on reserve and 4) subjecting Banks to close inspection by the federal deposit insurance corporation and the office of the comptrollers of currency. Not withstanding these safeguards, banks insatiable appetite for large profit has often lead to them disregarding these safeguards. The sub prime mortgage crisis that now plagues the United States banking and investment sector is a classic example of this. Recently, Banks in their quest to capitalize on the soaring price of real estate over has being offering loans to person, many of whom had questionable credits, at low teaser rate, sometimes as low as 1% through their adjustable rate mortgage scheme. These rates were charged for a time before higher market based rates kicked in. Over the last year and a half sub prime borrowers made up one out of every five new mortgages and ten percent (10%) of all mortgage debt. As the market based interest rates starts to kick in about thirteen percent of sub prime borrowers were behind on their payments. In the meantime banks were turning these mortgages both sub prime and mainstream into securities. Lenders no longer needed to keep these loans on their books but could sell bundles of them to investment funds at home and aboard. Rating companies in the meantime was misleading the market into believing that these securities were full proof. Therefore many local financial institution and European financial institution purchased these securities. Since then local institution such as merril lynch has announced write downs of $7.9 billion dollars on their mortgage holdings while Citigroup has lost million already and is set to loose even more. European financial institution such as France BNP Paribus and Germany' s IKB Deutsche Industrie bank was only saved from bankruptcy by their local central bank.
Care full analysis of this financial fiasco will reveal even conventional rules of economics were breached by commercial bank and lending. For example in a market where money supply is controlled by the Federal Reserve System and discount rates are set as a yard stick for financial institution to set their own. Financial institutions were guilty of setting artificial interest rates to encouraging more borrowers, many of who had very questionable credits to try and access loans. As the graph labeled figure 1 will show, as more person try to access loans the aggregate demand for money or loans will increase. As aggregate demand for money increase then interest charged to access that money will also increase as bank has to charge the new rate set by the market. As the new interest rate kick in the lending institution found them selves in a massive credit meltdown. This credit meltdown became of interest to the Federal Reserve System when it started to affect the stock exchange and where the situation creates an imminent chance for a bank run on the institutions facing the credit meltdown. The federal deposit insurance corporation policy of ensuring that depositors fund up to one thousand dollars will probably reduce the event of depositors making a bank run on the institution. However the back lash on the stock market and the economic importance of having a vibrant banking sector will no doubt propel the Federal Reserve System policy makers to act. A growing Stock market and a vibrant banking sector will automatically lead to more investment in the economy. Increase investments will naturally lead to expansion and growth in the economy. The main goal is to implement policies that will stimulate expansion, reduce inflation and prevent recession within the economy. In order to achieve this in the current crisis the policy makers has two choices they can either allow the current situation to play out and the economy regulates itself in the long run or intervene however the United States law after the great depression make it compulsory for the federal reserve system to intervene in any matter threatening the economy. Therefore in tackling this crisis as the graph labeled figure 2 the central bank policy makers are likely to increase money supply thereby lowering the rates of interest. By lowering the rates of interest the Banks and mortgage institutions currently at the brink of bankruptcy can access cheaper loans to keep them selves afloat. In addition to this these cheaper rate of interest can be past on to sub prime mortgage holders whose adjustable rate mortgage was at unaffordable high rates. Saving these credit portfolios means increase revenue to financial institution struggling to stay afloat. In the mean times investment will increase as financial institution can now disperse much cheaper loans to investors. This will stimulate growth in the economy. The Federal Reserve policymakers are likely to use the interest rate monetary tool because it is the easier monetary tool to implement. However if banks insist on not putting in the protective measure in place to safeguard depositors money then the central bank can take the proactive approach of increasing the reserve requirement thereby boasting depositors confidence in the system and averting the event of a bank run. This policy is very difficult to implement as it creates disruption and confusion in the system. However where financial institutional failure to follow establishes guidelines becomes as widespread as to threaten the economy the Federal Reserve System policy holders do reserve the rights to take even the above mentioned draconian measures to ensure economic stability.
In concluding, one should not overlook that the lessons learnt from the great depression and the safeguards put in during that period has being very instrumental in preventing this current sub prime mortgage crisis from descending to the magnitude of causing a recession. The assurance given to depositors that they will get up to one hundred thousand of their money if the institutions go under and that the central banks will act as lenders of last resorts to these institutions has being the main reasons for this.
However economic trends has always shown that any fall out in the economic system no matter the size has and can affect the economy and has always require the central bank making adjustments to its monetary policy. Many thought that the economic health of the United State economy would not require the central bank to try to save these institution by reducing the interest rate however failure to do so would mean banks facing the prospect of bankruptcy that would ultimately result in closure in operation since other commercial banks were even hiking rates to these banks requesting loans from them. Closure of these institutions on the other hand would obviously lead to the lost of jobs for employees and Hugh losses for depositors who had deposited Hugh sums of money for safekeeping. The multiplier effect would be almost as devastating as a recession.
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