Positive Economic Commentary

Why Does Fed Chairman Greenspan Have To Keep Interest Rates Low?
May 15, 2003

To prevent more problems from developing in the mortgage market. I emphasize "more" because, as shown in Chart 1, the MBA has reported that the mortgage foreclosure rate hit a 30-year high in the last quarter of 2002. And the latest data from federal bankruptcy courts show that cumulative four quarter personal bankruptcy filings hit a record high in the first quarter of this year (see Chart 2). This bankruptcy record would seem to point toward higher mortgage foreclosures in the first quarter.

So what if folks can't pay their mortgages? If more and more mortgages go bad, U.S. commercial banks will start to have major problems. Although U.S. banks did a good job of off-loading their corporate credit risk to unsuspecting entities, such as insurance companies and foreign banks, in this past cycle, they have assumed record high exposure to mortgages. Chart 3 shows that direct and indirect exposure to mortgage debt by U.S. chartered commercial banks reached 57.2% of total bank credit in the fourth quarter of 2002. Included in this 57.2% are holdings of mortgages, mortgage pool securities (both government sponsored agency- and privately-issued), collateralized mortgage obligations (both government sponsored agency- and privately-issued), and direct obligations of government sponsored agencies (e.g., Fannie Mae and Freddie Mac). So, if more problems were to arise with regard to the creditworthiness of mortgages or mortgage-related debt, U.S. commercial banks would not be able to dodge this bullet.

In the past three years, households have suffered unprecedented declines in their net worth in the post-WWII era because of the vicious bear market in stocks (see Chart 4). In 1999, at the height of the bull market in stocks, corporate equities dominated the net worth of households at a postwar record of 40.8% (see Chart 5). As the bear market in stocks took hold, residential real estate regained its dominance in households' portfolios, reaching a postwar record high of 34.8% at the end of 2002. So, a house is not just a home for households. It is once again their single biggest element of net worth. If housing were to falter, households would suffer yet another blow to their retirement nest eggs.

Just to show you how important low mortgage interest rates are to keeping housing activity and home prices levitated, take a look at Chart 7. In it you will see that the value of residential real estate is at a postwar record high in relation to disposable personal income - over 170%. That would seem to make the purchase of a house out of reach for a typical household. Yet, also as shown in Chart 7, the index of housing affordability remains at quite high levels. How can this be?

The lowest mortgage rates in 40 years, that's how. If Greenspan fails to keep mortgage rates at extremely low levels, housing could take a tumble. And if housing takes a tumble, so do banks and household net worth. I have no doubt Greenspan will do all in his power to keep interest rates in general, and mortgage rates in particular, low. I just wonder what will happen to U.S. interest rates and/or inflation if the rest of the world decides to cut back on its lending to the U.S. on the same favorable terms it is now. After all, 3-1/2% on 10-year Treasury paper is not a lot, especially when the keeper of the currency printing press has openly said that he thinks U.S. inflation is in danger of getting too low.

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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