Your humble blogger would like to thank Mr. Hilsenrath and the Fed for confirming a prediction that I made in late 2007 has come to pass. At the time, I said that the economy would be in a downward spiral until such time as structured finance provided current information on the underlying collateral.
To date, structured finance securities do not provide current information and the market for these securities is substantially smaller than it was pre-financial crisis.
This is important as banks have a limited capacity to hold loans on their balance sheets. Naturally, the banks are using this capacity to hold loans to borrowers with the best credit ratings. Due to zero interest rate policies, the spread between excellent and troubled credit is so small that the extra yield does not merit the risk to banks to hold the loans for troubled credits.
While the banks are handling the credit needs of the most creditworthy borrowers, the absence of structured finance means there is a huge shortage of capacity to handle the credit needs of the less creditworthy borrowers. As a result, the credit channel for the transmission of monetary policy is blocked.
Opening this credit channel is simple: require that all structured finance securities provide observable event based reporting. Under observable event based reporting, each activity, like a payment, involving the underlying collateral is reported before the beginning of the next business day.
With access to observable event based reporting, market participants can independently assess the risk and value of each security and make buy, hold and sell decisions based on the prices shown by Wall Street.
With structured finance functioning closer to pre-financial crisis levels, the credit channel is unblocked.
Shrunken access among credit have-nots is triggering more than personal plight. It has weakened the influence of the Fed—one of the best hopes for spurring stronger economic growth—and raised doubts within the central bank about whether it is doing much to reduce unemployment.
The debate is especially important now. Fed officials are weighing new steps at their policy meetings Tuesday and Wednesday, following a period of disappointing jobs growth and financial turbulence in Europe.
The credit divide factors into their thinking. Fed officials have been frustrated in the past year that low interest rate policies haven't reached enough Americans to spur stronger growth, the way economics textbooks say low rates should.
By reducing interest rates—the cost of credit—the Fed encourages household spending, business investment and hiring, in addition to reducing the burden of past debts.
But the economy hasn't been working according to script.
After surviving a crisis caused partly by loose lending, banks remain reluctant to extend credit to households with even a hint of financial problems. Fannie Mae and Freddie Mac, the two government-backed mortgage finance firms, tightened their own standards after the crisis. Banks worry Fannie and Freddie will return any troubled mortgages.