Bernanke conundrum is Obama’s problem

September 9, 2010

In the wake of Institutional Risk Analytics’ comment last week about the lack of ideas inside the Obama Administration for resolving the economic mess, President Obama suggested new tax credit and infrastructure spending. Neither of these ideas is likely to become real, however, since the Republicans are expecting to take control of at least one house of the Congress in two month’s time.

Over at the Federal Reserve Board, a different kind of policy gridlock persists. The Federal Open Market Committee thinks low interest rates are helping the economy, but the opposite is the case. The monetary policy mechanism that provided liquidity to households when the Fed lowered the cost of credit is broken. Both the central bank and the White House need to recognize this fact and act to address it with effective policy.

Offit Capital Advisors noted in an August 1, 2010 commentary entitled “The Invisible Tax” that the zero rate policies by the Fed are draining hundreds of billions of dollars in income each year from the U.S. economy. Offit estimates that $350 billion per year is being foregone by investors in state and federal obligations and transferred to the government due to Fed low rate policy. The income foregone by individual and corporate savers and transferred to the banks is something closer to $600 billion annually or nearly $1 trillion in total.

When theses subsidies from low interest rates are added to the huge mortgage banking profits being taken by the top four banks from Fannie Mae and Freddie Mac, the largest U.S. banks are literally draining a large portion of the income from the American economy. The fact that these large banks and GSEs are refusing to refinance many residential mortgages in order to preserve their profit margins only adds insult to injury, a political fact that will be made clear at the polls in November.

The chart below, which is inspired by a chart used by David Zervos at Jeffries & Co in a research note on this same topic, illustrates the problem. MTGEFNCL is the yield of the par 30-year FNMA mortgage backed security. USMIRATE is the effective rate for all outstanding mortgages in the US from the Bureau of Economic Analysis. In days gone by, you could add 50 bp to the FNMA yield to get the zero point mortgage rate to homeowners, but not today with banks adding points to the effective cost of mortgages. The Fed target rate is the federal funds rate.


Note how the progression of Fed interest rate cuts from the 1980s to today resulted in a significant reduction in average mortgage borrowing costs for households. This is the case until 2008, when mortgage rates implied by the bond market fell significantly but households were not able to refinance.

What is preventing a refinancing wave today? Fees charged by Fannie Mae and Freddie Mac (Loan Level Pricing Adjustments and Adverse Market Development Fees) and a mortgage origination industry that is highly concentrated in the big four banks, who are working for 4-5 points on new origination loans. Those frictions, which can add up to 7 to 10% of the face value of the loan, raise mortgage rates to borrowers by hundreds of basis points. Banks and the housing GSEs, however, saw significant benefits in declines in funding costs thanks to low Fed rates.

The banks, of course, do not exist in a vacuum. As JPM and the other money center’s desperately fight to survive, they are actually making conditions worse in the real economy, for consumers and business alike. As this reality comes more sharply into focus and the forward growth prospects for the U.S. economy are revised lower, the final blow to consumer confidence will come in the form of higher interest rates by the Fed.

Now into year three of the Fed’s quantitative easing, with visible duration on all first mortgages is already 2x 2005-2006 levels, the party is over for the largest zombie banks. And federal regulators cannot claim that they were not warned. The table below is from a presentation by Alan Boyce, CEO of Absalon, given at an FDIC-sponsored mortgage conference organized by Professional Risk Managers International Association in 2009 and shows the changes in the duration of the US mortgage system:




% ARMs


Market Size

Total OAD



5.0 est





5.0 est











































Source: Absalon

Notice in the table that the option-adjusted duration (OAD) of the mortgage sectors has roughly doubled during the period of Fed zero rate policy – this due to the steepness of the yield curve, a flight from adjustable rate mortgages to fixed rate loans, and high interest rate volatility. As the central bank is slowly forced to allow rates to rise in order to restore income to savers (or perhaps defend the dollar), the OAD for all manner of U.S. securities will explode. This interest rate trap illustrates the key policy error made by the Fed under Alan Greenspan and with the complicity of Ben Bernanke.

“From September 2003 to September 2006, the Federal Reserve Board (“FRB”) directly reduced the total mortgage market OAD by doing three things: they flattened the yield curve, they talked down options volatility and they encouraged homeowners to take out ARMs,” notes Boyce. “This sucked out a huge amount of OAD from the mortgage system despite increasing the outstanding amount of mortgages by $3 trillion. If the FRB had not driven down the OAD, we would never have made all those loans. The change in OAD was $3.6 trillion dollar duration years. To put it in perspective, the Chinese bought $600 billion of Treasuries and Agencies during that time period, with an aggregate duration of $1.2 trillion. The latter is 1/3 the “weight” of the former but is well understood and is the commonly accepted explanation of the Greenspan Conundrum.”

There are many things that need to be done in order to correct the immediate and structural problems in the U.S. economy. But one of the top priorities for President Obama and Chairman Bernanke is to press the banks and the GSEs to immediately accelerate efforts to refinance performing loans in their portfolios to lower rate mortgages now, before interest rates begin to move.

We cannot undo the decisions made by the Fed in past years, but we can recognize at long last that there is no free lunch. The low rates policies of 2002-2006 created a distortion in the financial markets, a shift we are still struggling to deal with a decade later. The first step to fixing the problem is to lighten the load on households now so that today’s homeowner is not tomorrow’s loan default event.


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Chris is right. The only question is when are the higher rates going to come. The yield curve is starting to flatten ever so slightly.

Remember, when gold went up from 1977-1980, the prime rate went UP from 6.25 to 15.25 when gold peaked in Jan. 1980. Prime rate continued to rise to 20.50 by May 1981.

The latest prime rate I have is 3.25%.

The banks won’t refinance performing loans, despite Chris’ plea, because they are going to go right off the cliff – they will go as far as they can, then let the whole thing collapse and ask for the second bailout.

Posted by Fazsha | Report as abusive

If that is done, then what is the effect on banks? It seems that it might just move the problem from one place to another.

Posted by dyllman | Report as abusive

Backstopping the mortgage market to give the economy the appearance of not really flat-lining is plain wrong on a number of levels. There is nothing uniquely messianic about Bernanke, Summers or Geithner requiring their sainted presence at their current jobs. Probably the opposite is true ..

Posted by Woltmann | Report as abusive

[…] Christopher Whalen of Institutional Risk Analytics has written a very helpful piece over at Reuters which fleshes out the problem we have with zombie banks sucking capital out of the US economy. […]

Posted by On the Zombie Bank Problem « The Market Navigator | Report as abusive

I agre. Obama conundrum is that helicopter Ben has mutated with “bluffing comments” last week that market took by the bulls lifted wall st. now I call him Poker Ben!

Posted by 007james | Report as abusive

Capitalism. So passe

Posted by DavidAKZ | Report as abusive