Federal Reserve and Monetary Policy: Federal Reserve's Challenge

The greatest challenge faced by the Fed is the carry trade. A negative real interest rates (fed funds target – inflation rate) means that the carry trade can effect prices (speculation). It is a certainty that the removal of the carry trade will result in volatility of both US bonds and dollar index. The new financial instruments are going to be stress tested in the coming months.

The 2 financial instruments I'm going to discuss are the credit issued to the sub-prime market through both the consumer loan institutions and through the secondary mortgage market as represented by the GSE's Fannie Mae and Freddie Mac. I will point out the mechanisms that I feel will cause these markets to fail and in turn, affect the entire US and the global market to the status of becoming non-functional.

The credit issuer use credit derivatives and the secondary mortgage institutions uses a form of risk management call dynamic hedging. Both of these risk management strategy requires that both the bond and currency market remain stable and predictable. The removal of the carry trade has always been a dramatic event in the international financial markets. Russia's default, Long Term Capital Management's collapse and Orange County, Cal default are just some of the well know failures.

The major issues that will determine if there is a collapse of the US financial markets can be enumerated:

• How much of the debt is backed by some sort of a hedging strategy.
• How many consumers are at risk of default. Notice I stated on the quantity not the quality of income. It is uncertain on how the resulting instability will affect the job market.
• What is the perceived wealth of the US consumer from the foreign investor's point of view.
• What will the response of the international market to the removal of the carry trade. Herding mentality will increase the volatility of the financial markets.
  
  A starting point to gain some knowledge of the levels of various debt level in the mortgage market can be retrieve from the following: Remarks by Governor Edward M. Gramlich At the Financial Services Roundtable Annual Housing Policy Meeting, Chicago, Illinois May 21, 2004 Subprime Mortgage Lending: Benefits, Costs, and Challenges
  
  The risk to the sub-prime financial system can be gleaned from this paper: MORTGAGE BROKERS AND THE SUBPRIME MORTGAGE MARKET
  Amany El Anshasy
  George Washington University
  Gregory Elliehausen
  Credit Research Center, Georgetown University
  and
  Yoshiaki Shimazaki
  George Washington University
  May 2004
  
  The following is going to be a problem:
  The retail price is the combination of points and contract rate that the broker quotes to the borrower. The borrower typically can choose from a menu of different points and contract rates. The wholesale price is from a menu of loan prices (expressed as a percentage of the loan amount) that the creditor is willing to pay for different contract rates with specific lock-in terms, which is based on the value of the loan in the secondary mortgage market. The broker’s spread is equal to the loan price less 100 plus the number of points paid by the borrower.
  
  After the carry trade; “ What will the value of the loan in the secondary mortgage market be”? A large quantity of delinquencies can effect the mortgage's value on the secondary market. Also, a high delinquency rate is associated with sub-prime mortgages.
  
  The perceived wealth of the US consumer is reflected in the dollar index. A large portion of that wealth is tied up in homeowners equity.
  
  A primer on financial engineering: Remarks by Vice Chairman Roger W. Ferguson, Jr. At the Annual Conference on the Securities Industry, American Institute of Certified Public Accountants and the Financial Management Division of the Securities Industry Association, New York, New York
  November 20, 2002
  Financial Engineering and Financial Stability