Independent monetary policy

What is interesting about the banks raising their mortgage rates independently of the Reserve Bank moving the cash rate? It’s a symptom of a shift that could ultimately be more important than the immediate cause, the global credit crunch.

It’s the first time such a rise has happened in ten years. But movements the other way have been more common, narrowing the gap between the cash rate baseline and the banks’ lending rates. The reason was the entry of all the new mortgage broking firms. These firms started the securitisation trend we now hear so much about. They lent to home-buyers, but offloaded the loans as soon as possible onto third parties. They did this by issuing securities (i.e. bonds) tied to the payments from the mortgages. This meant that their own money was tied up for only the short period between signing the mortgage and selling the mortgage-backed security. So smaller companies could muscle in on the banks’ business. Of course the banks got in on the action and issued their own asset-backed securities. This competition lowered the margin between the cash rate and the rate mortgage borrowers pay.

Another effect was to change the nature of mortgages. Previously, a mortgage tied up a single organisation’s funds for decades. The availability of mortgages was thus limited by the amount of funds that could be tied up like that. But with a market for mortgage-backed securities, no individual organisation’s funds were committed for so long. If they needed cash, they could sell the securities. Now mortgages could be funded out of a broader pool of funds – they could sit alongside bonds and shares in portfolios of instruments that can be sold at will. They were more liquid than old-school mortgages, in other words. I imagine this development was partly responsible for the housing binge and bubble of the 2000s.

But there’s another thing. These markets were quite international. Mortgages in Sydney, Auckand, Perth, etc, could be funded by securities sold on markets in New York, London, Tokyo – at the interest rates prevailing on those markets, exchange rate risks hedged off with derivatives. The fact that interest rates were lower there than in this part of world for the whole decade so far made it profitable for firms to do this. But of course the Reserve Banks of Australia and New Zealand had no influence on those interest rates. In fact a couple of years ago in New Zealand the central bank was extremely frustrated that its hikes of the base rate did not flow through into mortgage rates. It wanted to cool the housing market, but the gears of the monetary policy machine were slipping.

Now things have gone into reverse in the credit markets. Pressure is going the other way. But the point is the same – that bank interest rates are less closely tied to the national central bank. Although central banks have been forced to bail out the markets, they are less in control than they seemed to be – in fact the forced pumping of liquidity into the market is itself a loss of control.

Australia did not have the same issue as New Zealand in the housing boom, probably because it is that much larger. But New Zealand could be a sign of things to come. The point is not obvious now, because it just so happens that the private banks’ de facto policy tightening is moving in the same direction the central bank wants to go. The private tightening may in fact take the place of a public tightening. But there is no particular reason why the effect will always go the way the central bank wants.

Most of the story above about securitisation is in the past tense, because the crunch has stopped it almost dead for now. But chances are, once this all blows over – even if that’s on the other side of a major recession – securitisation will be back to stay, and continue to grow. Plenty of once-novel instruments – like commercial paper – have been implicated in financial crises and then come back as part of the wallpaper. Central banks being forced to intervene to stop a meltdown in fact reassures the markets in the long run that such instruments, and the institutions that issue or hold them, will not be allowed to fail. New markets make themselves indispensable.

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