Spread Between Fed Funds Rate and Mortgages: History Doesn't Support Greenspan

by: Thomas Tan, CFA

Courtesy of Lugwig von Mises Institute

There are two interesting charts shown above produced by the Mises Institute. They were produced to respond to the bogus defense of Alan Greenspan, who has been trying very hard to exonerate himself from the housing boom and bust.

Specifically, Greenspan said, “U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.”

Any statisticians would argue this statement is very misleading. First of all, when you use a long period of data, in this case 30 years, to compare with a 3 year self-selected period of data, you are really comparing apples to oranges. Statistically they are not at all comparable and have no meaning and significance. It is more his excuse than anything else.

Secondly, the behavior between mortgage and fed fund rates during period of 2002-2005 is hardly anything abnormal. If you look at the spread between them at the 2nd chart above, it had happened many times in recent history, twice under Greenspan’s early era as a Fed chairman, both in late 1980s and early 1990s. What happened in 2002-2005 is not the first time for Greenspan. Why would he suddenly forget about them? Maybe he has a selective memory lapse?

The truth about influencing long term rate by manipulating short term rate is always that they only make recessions much worse and longer in the future. Sometimes it is better just to leave things alone and let them run naturally. If Greenspan didn’t drop the interest rate to 1% in 2004 to “rescue” us, we wouldn’t have been in such a bad depression now.

Mr. Mayo is right that this is much worse than the great depression, as also voiced by former Goldman chairman John Whitehead last November. The total bad loans could be at the range of $7 - $11 trillion, or 3.5 - 5.5% of all loans, as estimated by Mr. Mayo, worse than the 3.4% ratio during the great depression. We have written off only about 2% so far, about 3rd or 4th inning of a 9 inning game. There is still a very long and dark night to go.

A lesson from the past rate manipulation for today is that we should just let banks fail, including several big ones, like WaMu, the largest bank in the US that failed last year. Let subordinate bondholders get wiped out and let a few senior bondholders get some residual money back through a “pre-package” bankruptcy process. Similar to shareholders, if bondholders make bad decisions by investing in toxic banks, why doesn’t the government allow them to share some of the losses? Why should shareholders be totally wiped out but not bondholders? Why should the taxpayer's money be placed at risk before the bondholders?