TROUBLED ASSET RELIEF PROGRAM

 The Troubled Asset Relief Program, known as TARP, was the cornerstone of the United States program to address the U.S. financial crisis that began in 2008. It came into being in October 2008 with the enactment of the Emergency Economic Stabilization Act of 2008. The legislation was commonly billed as a $700 billion bailout for banks.

The TARP plan evolved over time but originally its purpose was to buy bad loans, mortgage-backed securities, and collateralized debt obligations from banks. These assets went by the term “toxic assets” because they had no market value, and amounted to a severe threat to solvency of the banking system. At first it was thought that the government might be able to recover its investment because it would be purchasing these assets at bargain basement prices, and selling them for a profit later when the financial crisis had passed. Further consideration brought the realization that purchasing these assets at low prices undercut the capitalization of the banking system. Two weeks after the program’s enactment, the secretary of treasury shifted the focus of the program to emphasize the purchase of preferred stock in banks and guaranteeing troubled assets. If a bank recovers with the benefit of the government’s help, and its stock climbs, the government can sell its stake and recover at least some of the taxpayers’ investment.

Citigroup was one of the large banks that benefited from the program. The United States Treasury first purchased $25 billion in preferred stock in Citigroup, and later another $20 billion. The United States government in addition guaranteed troubled loans and securities on Citigroup’s balance sheet on the order of $306 billion. In return for the guarantees, the government received another $7 billion stake in Citigroup (Curran, November 25, 2008). The government forced the top banks to participate in the government bailout. Otherwise, banks that elected not to participate would appear financially stronger, which might give a competitive advantage over the banks that did participate. For smaller banks, participation was voluntary. In the beginning, many smaller banks worried that participation in the program was equivalent to a confession of financial weakness. Once the government let it be known that it would not let banks that were fundamentally unhealthy participate in the program, perceptions changed. Banks began to fear that not applying for participation might be regarded as financial weakness.

TARP drew criticism from the outset.

The government did not seem to be doing enough to track how banks were using the infusions of government capital. Homeowners facing foreclosures received no relief from TARP funds. People wondered why it was more important to bail out Wall Street than to bail out families facing bankruptcy and home foreclosure. None of the TARP funds helped homeowners refinance mortgages that they could not pay. In December 2008, President Bush used his executive authority to make TARP funds available to U.S. automobile manufacturers. Both General Motors and Chrysler received TARP funds. The most controversial beneficiary of TARP funds was American International Group, a large insurance company. In January 2009, the new administration of President Obama vowed to revise the TARP plan to alleviate the rate of home foreclosures.

Bank bailouts became a global phenomenon in 2008. The United Kingdom established a plan similar in strategy and scale to the one in the United States. The Royal Bank of Scotland was the largest beneficiary of government bailout money in the United Kingdom. In 2008, Sweden announced a sweeping bailout plan to save its banking system. Belgium bailed out a large bank in October 2008. Germany and Iceland both bailed out financial institutions. Switzerland, eager to protect its status as global banking center, put together a massive recapitalization of the United Bank of Switzerland.

See also: Savings and Loan Bailout

References

Cimilluca, Dana. “The Financial Crisis: Swiss Move to Back Troubled UBS; Under Plan, as Much as $60 Billion in Toxic Assets to be Taken Off Balance Sheet.” Wall Street Journal (Eastern Edition), October 17, 2008, p. A3.

Curran, Rob. “Large Stock Focus: Citi Jumps on Bailout; B of A, Goldman Follow”, Wall Street Journal (Eastern Edition) November 25, 2008, p. C6.

Kessler, Andy. “What Paulson Is Trying to Do.” Wall Street Journal (Eastern Edition) October 15, 2008, p. A19.

Solomon, Deborah. “U.S. News: Obama Works to Overhaul TARP—Team Tries to Meld Some Paulson Ideas with Aid to Borrowers Facing Foreclosure.” Wall Street Journal (Eastern Edition), December 17, 2008, p. A3.

Williamson, Elizabeth. “U.S. News: Rescue Cash Lures Thousand of Banks.” Wall Street Journal (Eastern Edition), November 3, 2008, p. A3.

UNIVERSAL BANKS

 In addition to the traditional commercial banking activities of holding deposits and extending loans, universal banks offer a full range of financial services, including underwriting, issuing new offerings of stocks and bonds, and brokering stocks and bonds. Some universal banks provide insurance. Banks that only engage in underwriting new securities, floating new offers of securities, and brokering securities are called “investment banks.” Universal banks combine deposit banking of traditional commercial banking with investment banking.

In the 1800s, banks in continental Europe and Germany in particular developed along the lines of universal banks, whereas in Britain deposit banking and investment banking tended to remain separate. In the United States, financier moguls such as J. P. Morgan introduced universal banking in the United States in the last decades leading up to World War I. Congress cut short the development of universal banking in the United States with the enactment of the Glass–Steagall Banking Act of 1933. Aimed at restoring public confidence in banks, this act prohibited commercial banks from investing in the stock market or providing investment bank services. In the German model of the 19th century, universal banks purchased corporate stock for customers. In exchange, customers yielded to banks proxies entitling banks to vote the customers’ shares in shareholder votes. The banks also purchased corporate stock on their own accounts. The control of a large piece of shareholder power ensured that the banks held positions on corporate boards of directors. The universal banks were also lenders to corporations. By holding seats on boards of directors, the banks had a voice in the management of companies that owed them money. In addition, they had an incentive to watch out for mismanagement at the expense of stockholders and creditors. It was an arrangement that put a large amount of power in the hands of banks.

In the post–World War II era, universal banks enjoyed the greatest legal acceptance and experienced the fullest development in Germany. German universal banks hold large equity positions in corporations, have representatives on their boards, and exercise proxy votes for customer shareholders. Japan and Switzerland also followed the universal banking model. The economic success of these countries, and particularly the rapid economic growth in Germany and Japan, began to restore confidence in universal banking. Banks in these countries help to minimize conflicts between debt and equity holders and keep corporate management under tighter rein. By ensuring access to long-term financing, universal banks shield corporate managers from short pressures from fluctuations in stock market prices.

Particularly in Germany, critics raised the issue of universal banks dominating the German stock market. It is said that rather than earning high dividends, banks were more interested in making loans to corporations on whose boards they had representation. In the 1990s, Germany experienced several corporate failures. In 1998, the German government enacted the Control and Transparency in Corporate Field Act. This act prohibits a bank holding more than 5 percent of a company’s shares from controlling the proxy voting rights for its bank customers who also own shares in the company.

In the 1990s, momentum began to build to approve universal banking in the United States. Critics worried that universal banks would choose riskier investments because under a system of FDIC insurance the cost of funds to a bank does not vary with the riskiness of its investments.

In 1999, the U.S. Congress lifted the ban on universal banking with the passage of the Financial Services Modernization Act of 1999. Replacing the Glass–Steagall Act of 1933, this act allowed the integration of banking, insurance, and stock-trading. By 2007, the United States boasted three large universal banks, Citigroup Inc., JPMorgan Chase & Co., and Bank of America Corp (Wall Street Journal, September 6, 2007). As the subprime financial crisis of 2008 unfolded in the United States, some observers felt the financial woes stemmed directly from dismantling the wall between deposit banking and investment banking. They were referring to the repeal of the Glass–Steagall Act. At first, the universal banks seemed to fare better than the investment banks. The financial crisis could be interpreted as a symptom of the shake-out and consolidation that analysts expected from the enactment of the Financial Services Modernization Act of 1999. As the financial crisis widened, however, the stock values of Citigroup, JPMorgan Chase, and Bank of America crashed, and the future of the institutions was very much in doubt. All three of the banks received large infusions of preferred stock investments from the United States Treasury.

See also: Glass–Steagall Banking Act of 1933, Troubled Asset Relief Program

References

Esen, Rita. “The Transition of German Universal Banks.” Journal of International Banking Regulation, vol. 2, no. 4 (2001): 50–57.

Fohlin, Caroline. “Relationship Banking, Liquidity, and Investment in the German Industrialization.” Journal of Finance, vol. 53, no. 5 (October 1998): 1737–1758.

Sidel, Robin. “Do-It-All Banks’ Big Test; Universal Model So Far Weathers Credit Crunch, Remains Controversial.”

Wall Street Journal (Eastern Edition, New York) September 6, 2007, p. C1. Wall Street Journal (Eastern Edition). “Glass and Steagall Had a Point.” May 31, 2008, p. A10.


FEDERAL OPEN MARKET COMMITTEE (FOMC)

 The Federal Open Market Committee (FOMC) is the chief policy-making group within the Federal Reserve System. It makes the key decisions for monetary policy in the United States. Monetary policy has to do with interest rates, credit conditions, and growth in the money supply.

The FOMC consists of 12 members. All seven members of the board of governors of the Federal Reserve System serve on the FOMC. The president of the Federal Reserve Bank of New York is also a permanent member of the FOMC.

The presidents of the 11 other regional Federal Reserve Banks hold the remaining four seats on a rotating basis. The seven presidents of regional Federal Reserve Banks who do not hold a seat attend meetings of the FOMC as nonvoting members. The chair of the board of governors of the Federal Reserve System also serves as chair of the FOMC. The president of the Federal Reserve Bank of New York serves as vice-chair. The seven members of the board of governors wield a powerful sway over monetary policy. They hold the majority of the voting seats on the FOMC and are permanent members. FOMC decisions are made either by consensus or near consensus. The president of the Federal Reserve Bank of New York owes his precedence over the other presidents to the special role played by the Federal Reserve Bank of New York. The Trading Desk at this bank carries out the day-to-day operations required to implement the policies decided by the FOMC. The account manager for the FOMC is the chief supervisor of the New York bank’s Trading Desk. That person is in daily contact with members of FOMC subcommittees. Normally, the FOMC meets eight times per year to assess monetary policy and make adjustments. If developments in the economy warrant quicker action, the FOMC holds additional meetings either in person or by conference call. Immediately after a meeting, the FOMC announces its decisions to an eagerly awaiting Wall Street and financial media. Financial markets often react within minutes of an announcement from the FOMC. Financial markets may react right before a meeting as speculators try to make money by betting on what action the FOMC will take.

The wording of the formal instructions to the New York Trading Desk is decided at the FOMC meeting. Once the FOMC decides to change policy, the new policy is implemented immediately. The policies are implemented through the purchase and sale of U. S government securities. The Federal Reserve’s trading in U.S. government securities are called “open-market operations.” The New York Trading Desk decides the amount of securities to buy or sell to carry out the instructions handed down by the FOMC.

The main interest rate the FOMC aims to influence is the Federal Funds Rate, which is the rate of interest commercial banks charge each other for overnight loans. The FOMC decides on a target for the Federal Funds Rate and instructs the New York Trading Desk to conduct the open-market operations necessary to maintain the targeted rate. To ease monetary policy, the FOMC lowers the targeted rate, and to tighten monetary policy, the FOMC raises the targeted rate.

See also: Announcement Effect, Open Market Operations

References

Meade, Ellen E. “The FOMC: Preferences, Voting, and Consensus.” Review, Federal Reserve Bank of St. Louis, March 2005, pp. 93–101.

Thornton, Daniel L. “When Did the FOMC Begin Targeting the Federal Funds Rate? What the Verbatim Transcript Tells Us.” Working Papers, 2004-015, Federal Reserve Bank of St. Louis, 2005.

ANNOUNCEMENT EFFECT

 Central banks publically announce intentions of maintaining a key policy interest rate at a certain level called the “target rate.” The practice of announcing targets is relatively recent, and represents a sharp departure from the confidentiality and secretiveness that was once thought to be a necessary part of monetary policy and open market operations. The “announcement effect” refers to a central bank’s ability to control a key interest rate merely by announcing its intentions.

In the United States, the key policy interest rate targeted by the central bank is the federal funds rate, and the central bank is the Federal Reserve System. The federal funds rate is the interest rate at which commercial banks can borrow funds from each other overnight. The federal funds rate reflects the market tightness for these funds. The Federal Reserve can ease tightness in this market by purchasing U.S. government bonds, and can tighten this market by selling U.S. government securities. Buying U.S. government securities injects additional funds into the banking system, allowing banks to increase lending and enlarge the money supply in the process. Central bank purchases and sales of government securities are called “open market operations.” In the Federal Reserve System, a policy-making group called the Federal Open Market Committee (FOMC) formulates the policy for open market operations.

Until 1994, the Federal Reserve kept directives involving open market operations a secret until 45 days after an FOMC meeting, keeping current financial market participants unaware of the Federal Reserve’s policy stance at a given point in time. In 1976, the Federal Reserve successfully defended itself against an inquiry filed under the Freedom of Information Act to obtain copies of the minutes of FOMC meetings without the 45-day delay. Federal Reserve cited an “announcement effect” that might lead to volatility and uncertainty in financial markets, and maintained that secrecy was a necessary part of monetary policy.

On 4 February 1994, the FOMC, amidst a two-day meeting, announced that it planned to apply slight pressure to commercial bank reserve positions, and that short-term interest rates could be expected to rise, breaking the Federal Reserve’s long stance policy of secrecy in these matters. It was an experiment in clearly communicating policy decisions to financial markets, and using public announcements as a method of communication. The experiment had none of the dire consequences that the Federal Reserve cited in its 1976 defense against a Freedom of Information inquiry. The practice of publically announcing policy decisions and targets became a standard part of central banking in the United States and in numerous other countries. What became known as the “announcement effect” enabled central banks to control a targeted interest rate with fewer interventions in the open market. It gave central banks the ability to control a targeted interest rate merely by announcing its intentions and taking little or no immediate action.

See also: Federal Open Market Committee, Open Market Operations

References

Belongia, Michael T., and Kevin Kliesen. “Effects on Interest Rates of Immediately Releasing FOMC Directives.” Contemporary Economic Policy, vol. 12, no. 4: 79–91.

Demiralp, Selva, and Oscar Jorda. “The Response of Term Rates to Fed Announcements.” Journal of Money, Credit, and Banking, vol. 36, no. 3 (June 2004, part 1): 387–405.

LIQUIDITY TRAP

 A liquidity trap is a macroeconomic condition in which injecting additional money and liquidity into an economy exerts very little impact on overall price levels, output, or employment. It is a macroeconomic phenomenon, meaning that it applies to the economy as a whole and not to industries individually. Only an economy at a low point in a business cycle is at risk of developing a liquidity trap. During a recession, a liquidity trap can become a major hindrance to economic recovery, considerably complicating the task of designing an effective economic policy.

The liquidity trap at first seems more of a puzzle than a trap. It seems paradoxical that the money stock can grow without commiserate growth in spending. Theories of inflation assume that money stock growth does lead to comparable growth in spending, and the growth in spending drives inflation. Only economies experiencing deflation or near deflation seem to be at risk of developing a liquidity trap.

A liquidity trap becomes possible because money, particularly bank balances, can act as a substitute for stocks and bonds, and may even become an attractive substitute if interest rates drop to very low levels. Money pays little or no interest, but it is the most liquid of all financial assets. Liquidity confers certain advantages. It puts one in a position to exploit speculative opportunities or handle financial emergencies. To offset the advantages of liquidity, stocks and bonds pay dividends and higher interest. The danger of a liquidity trap occurs when interest rates reach very low levels, probably lower than 1 percent. Unusually low interest rates of this order occurred in the United States during the 1930s, and again in Japan in the 1990s. Extremely low interest rates, coupled with fear of deflation, makes bank balances a highly attractive financial asset compared to much less liquid stocks and bonds. Low interest rates involve the expectation that interest rates will be higher in the future. Investors do not want to lock in a low interest rate by purchasing longer term financial assets when interest rates are low.

The practical significance of a liquidity trap is that it leaves the monetary authority powerless to stimulate the economy by increasing the money supply. The main ingredient of a monetary stimulus is the purchase of government bonds with newly printed money. Called “open-market operations,” this action makes the bond market more of a seller’s market, meaning bond sellers can sell bonds at lower expected yields. In other words, interest rates fall. In a liquidity trap, the preference for holding bank balances over bonds becomes so strong that open-market operations can no longer reduce interest rates. Falling interest rates no longer accompany above average growth in the money supply.

As a recession unfolds, the market for used capital goods is likely to see severe deflation, which will undercut the prices of new capital goods. Businesses become hesitant to purchase capital goods if they come to expect that capital goods can be purchased at lower prices in the future. Falling demand for finished goods further undermines the willingness to purchase capital goods. With the liquidity trap acting as a floor under interest rates, openmarket operations cannot push interest rates low enough to stem the tide of falling investment spending. The economy sinks deeper into recession.

The cure for a liquidity trap involves a high level of government deficit spending to compensate for the absence of business investment spending. In the 1990s, the Japanese government baulked at enlarging the public debt on the scale needed to lift Japan out of the liquidity trap. The Japanese economy languished in recession during much of the 1990s.

See also: Open Market Operations

U.S. FINANCIAL CRISIS OF 2008–2009

The U.S. financial crisis of 2008–2009 owed its origins to a failure of institutions to adjust to rapid innovation in the home mortgage industry. The size and importance of the United States in the global economic and financial system left little doubt that the outcome would take on global dimensions.

The roots of the U.S. financial crisis go back to the aftermath of the 1990s economic prosperity. The 1990s saw the longest economic expansion recorded in U.S. history. The long expansion received its thrust from an investment boom in information technology industries. Easy credit fed the investment boom for a time. When the United States started tightening credit, a high-tech stock bubble burst, the investment boom ended, and the United States entered into recession. In a bid to resuscitate the United States economy, the government again turned to easy credit and bargain basement interest rates.

Low interest rates and easy credit between 2002 and 2005 sparked a boom in housing, creating a housing bubble comparable to the high-tech stock bubble of the 1990s. A housing bubble posed special risk to the financial system because houses are one asset that can be purchased with small down payments. Compared to purchasers of corporate stock, purchasers of houses can put in a much smaller share of their own money.

Dodd and Mills (June 2008) lay out every step in the development of the crisis. A long upswing in house prices had put creditors at ease about the risk of home mortgages. A house seemed to be bullet-proof collateral. Lenders began granting riskier loans and being less thorough in verifying the income, jobs, and assets of borrowers. Some mortgage originators went so far as to offer interest-only loans and negative amortization payment options. Negative amortization meant the borrower’s monthly payment was not even covering all the interest charges, much less paying down the principal. Lenders felt that escalation in house prices assured that a house could always be refinanced for larger amounts, or sold to pay off a mortgage. Rising house prices should translate into falling loan-to-value ratios for creditors.

Another weak link in the stability of the financial situation was in the process of packaging home mortgages into financial securities. Investors buying these mortgage-backed securities had to rely on the same credit rating agencies that rated bonds. Well-established and reputable rating agencies such as Standard and Poor’s and Moody’s had performed well in rating bonds but had little knowledge or experience in mortgage-backed securities. Since mortgage-backed securities were new, no historical data existed to estimate past performance and risk. These agencies awarded top ratings of AAA to over 90 percent of the mortgage-backed securities based on subprime loans (Dodd and Mills, June 2008).

Investors purchased mortgage-backed securities with borrowed funds and counted on being able to trade out of these investments in a hurry to cut losses. Mortgage-backed securities, however, were sold in an over-thecounter market, and no dealers committed themselves to making a market for them. As the poor quality of the mortgages became evident, no dealers came forward willing to maintain an inventory of these securities. The market for mortgage-backed securities became a market where everybody wanted to sell and nobody wanted to buy.

The magnitude of investor losses from mortgage-backed securities would have been easily manageable if the problem had not had wider implications. Mortgage delinquencies and home foreclosures began to mount in 2006 and 2007 amid an otherwise expanding economy. It became clear that many homeowners could only make their mortgage payments if home prices continued to escalate, allowing them to refinance their homes before the teaser interest rates on their existing home mortgages expired. It was equally obvious that many loan applications had inflated measures of borrowers’ income and house appraisal values. Falling home prices triggered a wave of foreclosures. Upward interest rate adjustments on adjustable-rate mortgages worsened an already bad situation.

A related casualty of the mortgagebacked securities market debacle was investor confidence in the credit ratings agencies such as Standard and Poor’s and Moody’s. These agencies were forced to downgrade the credit ratings of mortgage-backed securities at a much faster pace than had ever been seen for corporate bonds.

The month of July 2007 saw a significant round of ratings downgrades for mortgage-backed securities. Wall Street hedge funds began trying to liquidate large positions in these securities. In August 2007, the French bank BNP Paribas suspended withdrawals from some money market funds that were heavily invested in U.S. mortgage-backed securities. The bank claimed it had no way of putting a value on these assets. Expecting a wave of customer cash withdrawals, other money market fund managers shifted these portfolios from medium- and long-term bank deposits and commercial paper to overnight deposits. The strong demand for liquidity drained the supply of funds for short-term commercial credit instruments. The market for what was called “asset-backed commercial paper” collapsed.

The collapse of the asset-backed commercial paper market brought to the surface the role of the structured investment vehicles that a number of banks sponsored as off-balance sheet entities. Banks sponsored these off-balance sheet entities to skirt banking regulations. They amounted to a hidden banking system. These structured investment vehicles raised funds by selling asset-backed commercial paper and invested the funds in longer-term assets that paid higher interest rates. Part of the arrangement was that the sponsoring banks were obligated to provide credit to the structured investment vehicle when necessary. When the market for asset-backed commercial paper collapsed, sponsoring banks had to meet unwanted and inconvenient loan commitments.

Banks, unable to raise funds by selling loans and fearful of depositor withdrawals, set to hoarding liquidity. They were caught in a squeeze between keeping loans on their books that they had planned on selling, and honoring loan commitments to hedge funds and corporate entities, commitments that they wished they had not made.

In March 2008, the Wall Street firm of Bear Stearns saw a run on its deposits that would have ended in bankruptcy if the Federal Reserve had not assisted in its acquisition by JPMorgan Chase. In September, the United States government announced a takeover of Fannie Mae and Freddie Mac, two government-sponsored enterprises concerned exclusively with the home mortgage market. Later in September, the Wall Street firm Lehman Brothers failed. The United States Treasury refused to bail out Lehman Brothers but did encourage other firms to acquire it. When no buyers appeared, Lehman Brothers went into liquidation.

Another important industry found itself drawn in to the mortgage-backed security debacle. Bond insurers usually provided investors with default insurance against municipal and infrastructure bonds. The firms had begun selling default insurance for the mortgagebacked securities. Rising mortgage delinquencies and foreclosures hammered the stocks and credit ratings of bond-insuring companies and left in doubt the ability of these companies to honor default insurance claims in the municipal bond market and the student loan market, making these investments much less attractive.

The outcome of these developments was a banking system less willing and able to make loans and demanding U.S. Financial Crisis of 2008–2009 | 415 Media and pedestrians gather in front of the Lehman Brothers headquarters in New York on September 15, 2008, the day the 158-year-old financial firm filed for bankruptcy. (AP Photo/ Louis Lanzano) tighter criteria of credit worthiness. A seizing of credit markets hobbled private initiative among producers and consumers. The forces of recession gathered strength as firms across industries reported falling earnings. October 2008, stock markets around the world entered a steep slide. The world braced for a global recession. Economic policy makers assumed that the economic situation in the United States was developing along the lines of a liquidity trap. The Federal Reserve System, the central bank of the United States, pushed its policy interest rate to near zero and allowed banks to use a wider range of assets to borrow funds. The U.S. government met the crisis with plans for massive increases in deficit spending. In a liquidity trap, massive government spending is needed to offset the combined effects of strong liquidity preference and pessimistic expectations.

See also: Liquidity Trap

ADJUSTABLE-RATE MORTGAGES

An adjustable-rate mortgage (ARM) provides for varying interest rates over the life of the mortgage. It forces the borrower to shoulder some of the risks that fixed-rate loans place on the lender. Key to the rationale for ARMs is the almost one-to-one relationship between short-term interest rates and inflation rates. Over the life of a 30-year, fixedrate mortgage, inflation ranks among the biggest enemies that a lender faces. Increases in the inflation rate reduce the real (inflation-adjusted) rate of interest that a mortgage pays to a lender. Higher inflation reduces the real purchasing power of each monthly payment while pushing up the real operating cost of a lender. If the inflation rate happens to rise above a mortgage interest rate, the lender ends up earning a negative real interest rate.

The high inflation rates of the 1970s taught lenders the damage that inflation can wreak on the interest income earned from mortgages. Lenders began demanding higher interest rates on 30-year mortgages as insurance against a wave of inflation wiping out the profits and capital of mortgage holders. Adjustable-rate mortgages developed as a way to get home buyers into houses without paying the high interest rates attached to 30-year, fixed-rate mortgages.

Under an ARM, the mortgage interest rate at any given time is linked or indexed to a short-term interest rate. Two short-term, benchmark interest rates commonly used for setting ARM interest rates are the London Interbank Offered Rate (LIBOR) and the one-year, constant maturity treasury bond rate. The interest rate on an ARM is adjusted periodically to reflect changes in a benchmark interest rate. The home buyer benefits because short-term interest rates are usually lower than long-term interest rates, since short-term rates have less inflation risk. The disadvantage to the home buyer lies in the risk that short-term interest rates go up, probably because of rising inflation or anti-inflation policies. If short-term interest rates go up, the monthly payments on ARMs go up. With ARMs, the burden of accelerated inflation is born by the borrower instead of the lender. In turn for bearing the risk of accelerated future inflation, the home buyer stands a chance getting by with lower interest rates. If inflation never drives up short-term interest rates over the life of the loan, the home buyer comes out ahead.

Adjustable-rate mortgages come in several varieties. In some mortgages, the monthly payment can change every month, depending on the benchmark interest rate. Other mortgages allow changes in monthly payments as infrequently as every five years. The time frame between rate changes is called the “adjustment period.” A mortgage with a one-year adjustment period is called a one-year ARM.

Many ARMs put a cap on the amount that a mortgage interest rate can change from one adjustment period to the next. This provision protects home buyers from large jumps in interest rates and monthly payments. Other contracts put a limit on the amount that monthly payments can increase from one adjustment period to the next. If interest rate adjustments call for a 10 percent increase in monthly payments, but the contract only allows monthly payments to go up 5 percent, then the unpaid interest will be added to the balance of the mortgage. By law, nearly all ARMs have a cap on how high interest rates can go over the life of a mortgage.

One version of the ARM allows the home buyer to pay an initial interest rate well below the benchmark interest rate used for setting an ARM interest rate. The home buyer enjoys the low interest rate, often called a teaser rate, for an initial period, such as a year. Then the interest rate is adjusted upward according to the indexing formula tied to the benchmark interest rate. If shortterm interest rates happen to be rising at the same time that a homeowner is transitioning from the teaser rate to the fully indexed, benchmark rate, then the home owner may experience “payment shock.” The large increase in monthly payment may leave a home owner unable to make a house payment. The practice of offering teaser rates contributed to the severity of the subprime mortgage crisis in the United States. 

See also: U.S. Financial Crisis of 2008–2009

Mexican peso crisis of 1994

The sharp depreciation of the Mexican peso in December 1994 marked one of the swiftest macroeconomic reversals in the history of developing economies and currency crises. President Ernesto Zedillo had barely been in office three weeks when, on December 19, 1994, his administration asked the Banco de Mexico to undertake roughly 15 percent devaluation of the peso, adjusting the pegged exchange rate from 3.45 pesos per dollar to 4.00 pesos per dollar (Sharma, 2001). It was a modest devaluation, but it undercut the confidence of foreign investors and touched off a wild speculative run against the peso. On December 22, 1994, the Banco of Mexico, unable to defend the peso against stampeding, panic-stricken foreign investors, allowed the peso to float. The peso immediately sank another 15 percent (Sharma, 2001). By February 16, 1995, the peso had depreciated 42 percent against the U.S. dollar (Torres, February 1995). The peso reached its nadir at 7.65 pesos per U.S. dollar (Sharma, 2001).

The outgoing President Carlos Salinas and the soon-to-be President Zedillo met on November 20, 1994, to discuss the currency situation. The Friday before, Mexico had lost $1.7 billion in a run on the peso. The two leaders agreed that devaluation on the order of 10 percent was needed, but the outgoing officials refused to devalue the currency on their watch (Wessel, July 1995).

The peso crisis caught many observers and investors by surprise. Mexico had become the darling of Wall Street. Mexico’s economic policy seemed to have all the right ingredients. It emphasized privatization and deregulation of state-owned enterprises, restrictive monetary and fiscal policies, and a pegged exchange rate relative to the U.S. dollar. The ratification of the North American Free Trade Agreement (NAFTA) in January 1994 opened Mexico’s economy to the largest consumer market in the world. Between 1989 and 1994, Mexico’s gross domestic product (GDP) growth averaged 3.9 percent (Sharma, 2001). Mexico’s inflation rate, which raged as high as 160 percent in 1987, sank to single-digit territory in 1993 (Sharma, 2001). Government indebtedness as a percent of GDP shrank from 15 percent in 1987 to 1 percent in 1992 and 1993 (Sharma, 2001). Between 1987 and 1994, government spending as a percent of GDP shriveled from 44 percent to 24.6 per cent (Sharma, 2001). In February 1994, Mexico’s foreign exchange reserves stood at $28 billion, well above the $6.3 billion level held in 1989 (Sharma, 2001). With the dawn of NAFTA, Wall Street saw no limits to Mexico’s potential.

In hindsight, one economic statistic signaled trouble. Mexico’s current account deficit steadily climbed from $6 billion in 1989 to $20 billion by the end of 1993 (Sharma, 2001). Mexico’s imports were growing much faster than its exports. Current account deficits reflect either a high level of government deficit spending, high levels of private investment spending relative to savings, or some combination. In 1994, government deficit spending in Mexico was minimal, and the high level of private investment spending seemed to reflect Mexico’s bright future under NAFTA. Foreign portfolio investments in Mexican stocks and short-term bonds made possible the high level of investment spending. It also left Mexico vulnerable to a sudden outflow of foreign capital.

In 1994, foreign investors began to get jittery over the size of Mexico’s current account deficit. Mexico tamed inflation, but did not eradicate it. Under a pegged exchange rate, inflation increases the prices of domestic goods, but does not affect the price of imported foreign goods unless the peg is adjusted. Mexico failed to adjust the pegged exchange rate to compensate for domestic inflation, encouraging Mexico’s consumers to purchase more imported goods at the expense of domestically produced goods. As long as foreigners exhibited a strong appetite for Mexican stocks and bonds, the Mexican government felt no pressure to devalue its currency. The peso appeared to be in high demand at the current exchange rate.

In 1994, the strong foreign demand for portfolio investments in Mexico began to diminish over worries about Mexico’s rising current account deficit. Rising current account deficits often lead to a devaluation of a currency. If a currency depreciates 25 percent, foreign investors immediately see the value of their investment depreciate by 25 percent.

Part of the attraction of Mexican stocks and bonds had to do with low interest rates in the United States. Throughout 1993, the U.S. federal funds rate remained at 3 percent. In 1994, the Federal Reserve System started raising the federal funds rate, pushing it up to 5.5 percent by November 1994 (Sharma, 2001). As interest rates rose in the United States, investors became less willing to chase higher interest rates in developing countries and emerging markets. When the Mexican government announced a devaluation of the peso in December 1994, foreign investors decided it was time to get out of Mexico.

After the peso crisis, Mexico’s economy sank into steep recession. Inflation soared as devaluation lifted the prices of imported goods. In the United States, President Bill Clinton put together a nearly $50 billion rescue package (Greenwald and Carney, 1995). Without the rescue package, the Mexican government would have defaulted on a large amount of dollar-denominated government bonds. (In 1994, the Mexican government had started issuing dollar-denomniated bonds to ease investor fears about devaluation of the peso.) The rescue package helped calm markets and limited the damage inflicted on other Latin American countries.

See also: East Asian Financial Crisis, Currency Crises

Current account

The current account summarizes transactions that fall within the categories of imports or exports of good and services, income earned abroad, domestically generated income belonging to foreigners, and unilateral transfers. The common denominator behind all these transactions is the involvement of an inflow or outflow of currency. Unilateral transfers include foreign aid and gifts of money from residents of one country to family members living in another country. Cross-country investments, such as buying and selling foreign stocks and bonds, also involve currency inflows and outflows, but are summarized in another account called the capital account. A third account, the official reserves transactions account, summarizes central bank transactions that involve an inflow or outflow of currency and that change official reserve holdings. A Federal Reserve purchase of gold with dollars is an example of the type of transaction covered by the official reserves transactions account. These three accounts make up the balance of payments.

The current account balance is considered a significant indicator of the economic and monetary health of a country. It is among the handful of indicators that the Economist magazine reports for major countries of the world. The Economist reports the current account balance both in absolute numbers and as a percent of gross domestic product (GDP).

On the current account, transactions that involve an outflow of currency are a debit item, and transactions that involve an inflow of currency are a credit item. Exports of goods and services are a credit and imports are a debit. The foreign expenditures of a U.S. family visiting Greece count as an export on the U.S. current account. The interest income that a resident earns on a foreign bond counts as a credit. The interest income that a domestic bond pays to a foreign owner is a debit. Money residents send to family members living abroad counts as a debit. If the money value of the debits outweighs the money value of the credits, then the outflow of currency outruns the inflow of currency, and a country has a current account deficit. If the credits exceed the debits, the country has a current account surplus.

Persistent current account deficits is often regarded as an indication that a currency is overvalued and therefore faces a heightened risk of future depreciation. The largest component in the current account balance is net exports (exports minus imports). A current account deficit is nearly always an indication that imports exceed exports. As the value of a country’s currency goes up in foreign exchange markets, foreign imports into that country become less costly while exports from that country become costlier in foreign markets. An excess of imports over exports suggests that a domestic currency is too strong and likely to weaken in the future. A current account deficit indicates that the currency outflow on the current account exceeds the inflow. If the excess outflow of currency from a current account deficit is not offset by an excess inflow on a capital account surplus, a currency will depreciate unless a government is able and willing to take action. Governments usually hold sufficient official reserves to defend domestic currencies against speculative attacks, but not against long-term downward trends driven by market forces.

Currencies can remain strong in foreign exchange markets for extended periods of time in situations where a large current account deficit is offset by a large capital account surplus. A capital account surplus indicates that the inflow of foreign capital exceeds the outflow of domestic capital to foreign countries. A net inflow of capital equates to a net inflow of currency. Countries with persistent current account deficits often maintain elevated interest rates. The high interest rates encourage the inflow of foreign capital, offsetting the tendency of a current account deficit to undermine the value of a currency.

Even with strong capital inflows, a current account deficit is regarded as a risk factor in foreign exchange markets. The components in the current account are not tightly linked to the volatility and varying psychology of financial markets whereas capital flows are tightly linked to conditions in financial markets. Capital flows are much more sensitive than exports and imports to changes in expectations, and can therefore be more volatile. A net capital inflow can quickly change to net capital outflow, leading to almost certain currency depreciation and crashing financial markets for a country with a current account deficit. Currency speculators are always closely watching countries using elevated interest rates to sustain current account deficits offset by capital account surpluses. If these speculators see signs that elevated interest rates are pushing a country with a current account deficit into recession, they will dump the currency of that country. The value of the currency will crash in foreign exchange markets, domestic financial markets will crash, and the country will likely undergo a full-blown economic collapse.

For several years, the United States has been able sustain current account deficits with little difficultly. That is because the United States holds a reputation as a safe haven for foreign capital. United States’ investments are considered among the safest in the world. Over the last 30 years, however, the Japanese yen has gained strength relative to the dollar, reflecting the fact that Japan usually has current account surpluses and the United States usually has current account deficits.

See also: Balance of Payments, Currency Crises, Foreign Exchange Markets

East asian financial crisis

 n 1997, a financial crisis threw the East Asian economies into a financial chaos that threatened to derail the East Asian economic miracle and engulf the global financial system. In the 1990s, East Asia had become the scene of a new group of economic miracles. From the mid1990s until the outbreak of financial crisis, East Asian countries such as Thailand, Singapore, Indonesia, South Korea, and Malaysia posted real gross domestic product (GDP) growth rates in the 8 percent range or higher (International Monetary Fund, 1997).

Until the East Asian financial crisis, currency crises were often the domain of countries suffering from high inflation, slow growth, large government budget deficits, low savings, and political instability. Unlike the usual candidates for currency crises, the East Asian countries had what economists call “sound macroeconomic fundamentals.” They had high savings rates, low public debts, fast growth and low inflation—the very qualities that win the confidence of foreign investors.

One crack in the foundation involved the structure of corporate finance. Enterprises had relied too heavily on debt financing as opposed to stock issuance. Enterprises do not face bankruptcy when the value of company stock plunges, but they do face bankruptcy when they cannot pay debts. An equally important vulnerability stemmed from the balance sheets of East Asian banks. These banks borrowed foreign capital on a short-term basis to underwrite long-term loans. The short-term nature of the foreign capital inflows left these banks open to a sudden and unexpected reversal from a foreign capital inflow to a foreign capital outflow. A sudden reversal of foreign capital flows made these banks and enterprises illiquid. Much of the foreign debt was denominated in dollars. When the exchange rates of local currencies fell, the real value of foreign debt in local currencies skyrocketed.

The East Asian countries practiced an economic policy that pegged the value of their local currencies to a basket of currencies in which the U.S. dollar played a highly dominate role. The rate at which a local currency could be converted into dollars remained almost constant. This policy shared in making East Asia an attractive haven for foreign capital, but it also was the undoing of these economies. In the late 1990s, the value of the U. S dollar went up, probably because of strong global demand for U.S. financial assets. As the value of the dollar climbed, the values of currencies linked to the dollar, such as the East Asian currencies, also climbed. The appreciation of a country’s currency leaves the exports of that country more expensive in foreign markets. It also makes foreign imports into that country less costly. Falling exports and rising imports left the East Asian economies with current account deficits that needed to be financed by an inflow of foreign capital. East Asian companies began to feel the pain as sales fell off in foreign markets, and domestic sales faced greater completion from imports. In addition, East Asian central banks raised interest rates to increase the attraction for foreign capital. The policy of keeping the local currency exchange rates pegged to the dollar required that current account deficits be financed by foreign capital inflows. Otherwise, the value of the local currency relative to the dollar would sink.

The economic and financial situation in Thailand sparked the crisis. Many currency traders believed that the baht, Thailand’s currency, traded too high, higher than the central bank of Thailand could support.

Thailand’s economy was already suffering from double-digit interest rates and depressed stock prices. Currency traders launched billions of dollars of sell contracts on the baht. Fears of currency depreciation excited a broad outflow of foreign capital, putting more pressure on foreign exchange reserves. In a single day, the central bank spent $500 million dollars of its dollar reserves to keep the baht from falling below its pegged level (Daniels and VanHoose, 1999, 441). In 1997, Thailand’s central bank let the baht float, free to depreciate, which it did.

The depreciation of the baht triggered foreign capital outflows from other East Asian economies. By the end of 1997, Thailand, Indonesia, and South Korea had watched local currencies depreciate about 40 percent relative to the U.S. dollar (Daniels and VanHoose, 1999, 36). 

See also: Currency Crises