At the recent Federal Open Market Committee meeting, Federal Reserve Board Chairman Ben Bernanke signalled that he plans to keep interest rates effectively at zero for as long as possible, and that he’s ready to stand by with more quantitative easing (i.e. printing money) if necessary. But if the Fed’s blaming the last recession on the financial meltdown from the subprime mortgage market, why is it so committed to recreating those same credit conditions that spawned Wall Street’s worst-ever post-Depression crash?

There is no shortage of people to blame for the subprime mortgage fiasco: wayward rating agencies that ranked the risk of mortgage default as comparable to the risk of a US Treasury default; unscrupulous lenders who eagerly approved mortgages and then quickly resold them to financial institutions; over-leveraged banks that used depositors’ money to play Russian roulette in the financial derivatives market; and asleep-at-the-wheel regulators (like the Securities Exchange Commission), who were either blind or indifferent to Wall Street’s systemic risk to the subprime mortgage market. However, the real culprits behind the subprime mortgage crisis were the incredibly low interest rates that sustained the bubble. All the greed in the world could not have done what the Fed’s easy-money policy made so simple.

Was it not the desperate search for yield that threw many an otherwise cautious pension fund into the arms of seemingly safe CDOs (collateralized debt obligations)? Beneath the AAA-rated vanilla wrapping paper were pools of subprime mortgages just waiting to go bust. The measly extra basis points they offered over government-funded AAA bonds may not seem like much when Treasury yields are 5 to 6 per cent, but they meant a lot more to return-starved pension plans when government bond yields fell to near-record lows.

Similarly, was it not the ridiculously low cost of credit that allowed banks to become so leveraged—hence exposed—to the subprime mortgage market? And of course, it was the same low cost of capital that allowed interest-free mortgages (negative amortization types) to be given out to anyone who would take them in the first place.

Neither the demand for financial products like CDOs that were funded by subprime mortgages, nor the supply of subprime mortgages themselves would have been possible in a world of normal interest rates. When the federal funds rate rose to 5 per cent, an historically average setting, the subprime mortgage market collapsed, creating an insolvency crisis for financial institutions whose vaults were filled with reeking CDOs.

Of course it won’t be subprime mortgages and CDOs next time, but if the Fed keeps rates at zero for long enough, you can count on financial markets’ insatiable desire for yield to invent something just as toxic.

  • Kevin Cobley

    The ratings agencies are right the risk of a housing mortgage default is comparable to the risk of US treasury default. True treasury will not default it can print to reimburse bond holders but the printed money will be worth less than the original debt, so treasury will default by stealth.

  • Velolover2

    What is really the cost of the Canadian banking system? Canadians pay the price for the ability to buy real estate with 5% down by having their mortgages insured. The insurance premium is strictly for the benefit of the bank so that they (the banks) are paid out any losses in the event of default. We pay the premium, and usually interest on top of that premium, and then are subject to strict qualifying guidelines to even obtain the financing. THEN the banks turn around and invest in the sub prime market for the Return On Investment. They incur the losses, and it is Canadians that suffer the consequences with even more conservative lending policies, and a slumping economy. Then there are the penalties charged when we need to break the interest rate contract; the Interest Rate Differential has been responsible for thousands of Canadians to lose money upon sale of their homes…money from your equity straight into the banks' hands. They've made it harder to qualify to go with short term or variable rate financing, forcing people into “locking in” for 5 year terms. The banks win with the penalties they charge when someone needs to get out early. Since when does their crystal ball work better than anyone elses? No one can control where interest rates will be…it is no business of theirs to dictate how long someone should have to “lock in” for. Our government works hand in hand with policy setting, and law making, and entirely for the banks' benefits. I wish that Canadians did not have to be at their complete mercy.

  • Fraser Harris

    Jeff – you blame the low fed rates for driving down return. What about the role of China pushing $1 trillion into US government & corporate debt from 2002 – 2008? Can you quantify the effect that had in driving down returns across bonds?

  • Rojelio

    Is there any chance at all now to prevent a collapse of the currency? It seems like the amount of debt & liabilities can never be paid back at this point.

  • Bob

    Jeff's right we will see more clever schemes .Remember there are basically two players the chislers and the suckers ,and given half a chance the sucker would be a chisler.Schemes are all we have left a bubble here and a bubble here but the patient is harder to rally steroids have taken their toll.

  • Nipon

    Could Jeff or anyone tell me if the current rise in the price of gold is due to the expectation of inflation or a speculative bubble?

  • Peter Breedveld

    I think the next bubble might be in mergers and acquisitions. Business is not investing in expanding their production because they don't see increased demand from debt ridden consumers for their products.

    Right now businesses are sitting on trillions in cash. Once the ball starts rolling I can see a stampede of money into mergers and acquisitions.

  • jbb

    I once read a decent chunk of a book called “Competition in Currencies” by someone at the Cato Institute. It might be the only way to have an emergent systemic process deal with the issue of the appropriate level faith in the future/debt/money, which are all the same thing, and such a system is the only thing that will work anywhere close to optimally, even as compared to the great wisdom of our central bankers. In pre-Christian times, all debt was declared void every seven years, a bit draconian, but it would sure be effective at shaking out all the bad debtors, a mechanism for which our current system of government “guarantees”, insurance (including social programs and pension liabilities), bail-outs and “stimulus” (one really can't help but laugh) desperately lacks. As we now see with the States, our governments can easily become the worst credit risks of all, if we let them. Ooops, we are they.

    Jeff, I think you are right that there may be a bubble coming in paper assets, but the “bubble” in precious metals, as many will attempt to portray it, will in fact be wealth seeking out that precious third function of money, the store of value function. If the giant naked short positions of HSBC et al and the kiting of customers allocated gold on the LBMA is in fact true – which is seeming increasingly likely to me, though I would value your opinion – then the currency fireworks have just begun. There certainly doesn't seem to be much on it in the mainstream press, but watch the three parts of

    Because gold is becoming the only money-like store of wealth that wealthy people can trust, it is in fact becoming money once again, for “them”. I found much of the history and insight here illuminating:

    I think I can count on the market's insatiable desire for yield, but just as much also count on the financial market-makers to invent toxic things, but bubble-icious ones. The trick to understanding if you are making “money” will be to divide by the price of gold.

    Thoughts? Thanks for reading,

  • trkiehl

    Here is the reason why QE2 (or 3…) may not work and may actually be counterproductive. Loss of confidence in the US$ may result in a flight of capital into commodities. More QE may thus actually cause the next recession and result in deflation.

    Oil prices above $80 are probably not compatible with economic growth in the U.S. And this number (above which economic growth in the US stalls) may actually be declining over time. It may have been $85 going into the last recession but may now be less than $80. If so, this is deflation right then and there.

    Related: (ZeroHedge) Guest Post: $100 Oil Could Sink The Fed’s QE2

  • Johnmorelli

    I think low interest rates have also encouraged consumers to take on excessive debt (and similarly discouraged savings) thus creating greater risk for our economy during an economic downturn. I can't imagine what would happen if interest rates were to increase sharply for some reason!

  • Enquirica

    Ultimately, the question is not how high gold can go, its how low fiat currency can go. While the debate about whether gold is in a bubble or whether we are in a deflationary or inflation environment continues, the monetary authorities in the developed world have embarked on a well-publicized campaign of currency devaluation via low interest rates. Central banks can control interest rates or exchange rates – not both – and they are opting for record low interest rates with little concern for the debasing consequences. There should be no debate on this matter – central banks have a perfect track record in one area and that alarmingly is in currency devaluation. The US and Canadian currencies have suffered a greater than 95% loss in purchasing power since the inception of their respective central banks. Enquirica Research has published a report – “Guide to Inflation Hedging 101″ go to and signup for access.