Straight Story: The Fed knows best

Marketplace Staff Mar 23, 2007

TESS VIGELAND:
It’s time once again for our economics editor, Chris Farrell, to help you sort out what is smart, what is stupid and what’s the straight story. Hey, Chris.

CHRIS FARRELL:
How are you doing?

VIGELAND:
We’re doing all right. So here is something we’ve been reporting on a lot these days, the problems in the subprime housing market.

FARRELL:
Subprime, all the time.

VIGELAND:
Subprime, all the time, that’s right. Home foreclosures are up. Millions of new homeowners could find themselves out on the street. And tell me if I’m wrong that the big worry seems to be that all this could trigger a full-blown recession.

FARRELL:
No, you’re absolutely right. Stephen Roach, chief economist at Morgan Stanley, he’s a good economist. He compares the subprime market to the dot-com bubble…

VIGELAND:
Uh-oh.

FARRELL:
…seven years ago. And as you remember, when that bubble burst, the stock market tanked and the economy sank into recession.

VIGELAND:
But you don’t think that’s gonna be the case this time around?

FARRELL:
You know, you got it. With all the usual caveats that go with predicting the future.

VIGELAND:
Of course.

FARRELL:
But here is a straight story. The Fed has a lot of experience handling housing and mortgage market crises. So my bet, and it is a bet, that this is not another dot-com bubble.

VIGELAND:
Well, hopefully, I don’t have to take your money. So, first, let’s lay out Roach’s case. How could these problems in the subprime market spill over to the rest of the economy?

FARRELL:
When the dot-com bubble burst, you know, there’s a lot of story saying, look, that’s six percent of the overall stock market. It’s a tiny part of the stock market. The problems with dot-com, companies, everyone got over enthused. But market is gonna continue to do okay, and so will the economy. Well, what happened is the problems in the dot-com exposed more problems in the overall text sector, the stock market fell by 49 percent. Consumers lost a lot of confidence, so did business. He’s arguing something similar will happen with the subprime market. Yes, it’s a small part, but as it spills over, it will have a bigger impact on the overall housing market. And then consumers, who have been keeping this economy going, will pull back. And therefore, we will see a tank through a spillover effect.

VIGELAND:
And why do you think that that’s not gonna happen?

FARRELL:
Well, part of it is, I do think, let me just give you one comparison.

VIGELAND:
All right.

FARRELL:
When the dot-com bubble burst, $9 trillion in corporate equity vaporized. In the subprime market, we’re talking somewhere probably around $300 billion. Now, that’s still a lot of money, and as you mentioned, a lot of paying, a lot of suffering. But I’m a little bit skeptical that it’s gonna have the same spillover effect for this very important reason. Mortgage rates in the prime market are going down.

VIGELAND:
Yeah. They’re still really, really low.

FARRELL:
Back, beginning of February, 6.34 percent for your classic 30-year mortgage, fixed rate mortgage. You know, it’s down to 6.14 percent. So my guess is that the prime homeowner, which is most people, will do okay. I also think, as I said, this is the kind of financial crisis that the Fed does have a lot of experience dealing with.

VIGELAND:
What do they do in this case?

FARRELL:
They do two things. And they, actually, what they’re doing is just classic. It’s coming right out of the textbook. Part of it is they’re tightening up standards. And, by the way, they actually want some of these subprime lenders to go out of business.

VIGELAND:
Sure. Sure.

FARRELL:
And quite a few have already gone out of business. The last count I saw was about 36.

VIGELAND:
Now, when you say tightening up lending standards, essentially, they’re making less money available for people to use to buy a house?

FARRELL:
That’s right. And, for example, you know, a lot of the problems are concentrated in the no-money-down, the so-called NINJA loans?

VIGELAND:
NINJA loans?

FARRELL:
NINJA loans, you know, No Income, No Job, No Assets. So that’s not going on right now. At the same time, they’re watching very carefully. Now, let’s say that the tightening of credit standards goes too far. And all of a sudden, it starts infecting the prime market and all kinds of other aspects of our market.

VIGELAND:
People can’t, can’t buy anything.

FARRELL:
Can’t buy anything. Well, at that point, what they do is, you know, back to 19th century, Walter Bagehot, founder of The Economist magazine, he wrote a famous book called Lombard Street. And he’s sort of like the, the god of central bankers. And he said, you flood the system with money at that point. I do think that the Fed does know how to deal with this crisis. And it didn’t really know how to deal with the dot-com bust. There was a lot of question marks and turmoil. And then you had the additional tragedy of 9/11. I think this is a little more of a classic situation. They can always cut their benchmark interest rate, and that will help out the situation.

VIGELAND:
All right. Our man, Chris Farrell. Chris, thanks for more subprime, all the time.

FARRELL:
Maybe in a year we’ll, we’ll see who won the bet.

VIGELAND:
You’re on.

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