E LIBOR Destroyed Subprime. But The Fed Deepened The Great Recession

Chart 2

Chart 3

Chart 1 refers to the GDP decline, starting in 2004-2005 but really picking up in early 2007, compared to inflation, which kept steady until late 2008. Massive layoffs also occurred in late 2008. Was that not a random coincidence? Chart 1 shows Fed inaction in the face of a major NGDP crisis.

Chart 2 refers to LIBOR interest rate exploding and crossing the Swaps rate, the blue line, making swaps unprofitable for banks, causing bank subprime lending to slow. Swaps were insurance against bad real estate loans. And when that insurance was no longer safe for the banks, lending slowed. Also, when LIBOR rose, adjustable mortgages became unprofitable. Bernanke speaks of this 2007 LIBOR explosion as if it caused the decline of interbank lending. So it is necessary to look at chart 3 to show that was not quite true.

Chart 3 refers to interest on reserves paid to the banks by the Fed. The interbank lending started to dive in late 2008 as the crisis hit, and Lehman failed September 15th, which is the first vertical line, but rebounded slightly until Bernanke started paying IOR.

George Selgin quotes Bernanke as saying:

The skyrocketing cost of unsecured bank-to-bank loans mirrored the course of the crisis. Usually, a bank borrowing from another bank will pay only a little more (between a fifth and a half of a percentage point) than the U.S. government, the safest of all borrowers, has to pay on short-term Treasury securities. The spread between the interest rate on short-term bank-to-bank lending and the interest rate on comparable Treasury securities (known as the TED spread) remained in the normal range until the summer of 2007, showing that general confidence in banks remained strong despite the bad news about subprime mortgages. However, the spread jumped to nearly 2-1/2 percentage points in mid-August 2007 as the first signs of panic roiled financial markets. It soared again in March (corresponding to the Bear Stearns rescue), declined modestly over the summer, then showed up when Lehman failed, topping out at more than 4-1/2 percentage points in mid-October 2008 (pp. 404-5).

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Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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Joe Economy 5 years ago Member's comment

Its questionable whether the Fed's raising rates by 0.25% has had such a drastic effect on the economy. Other major factors combine together to make a recession. The overly strong dollar which hurts exports, the decline of oil, and the fall of China's economy and the knock on effect globally are likely more likely to blame. You never know, if things get bad, maybe Yellen will decide to reverse her decision and lower rates again. Stranger things have been known to happen!

Gary Anderson 5 years ago Author's comment

Rising rates would not be a problem if the Fed did other things to loosen.

Joe Economy 5 years ago Member's comment

Do you foresee the US following Japan and going negative on rates?

Gary Anderson 5 years ago Author's comment

It doesn't seem to concern the Fed if that happens. I will have a new article, hopefully, out on that today, Joe.