Courtesy of Aaron Klein, Brookings Institute
This paper analyzes economic policy responses to the COVID-19-induced recession, focusing on the American policy response. Despite widespread political distrust between the two parties sharing control of the government and the timing of the upcoming presidential election, America’s political system was able to enact a massive policy response that reduced the severity of the recession.
Download the full report here.
This political response happened faster than any automatic policy response would have, based on the delays in data reporting. The economic policies enacted continued America’s trend toward financialization of fiscal policy. The Federal Reserve and America’s private banking and financial systems were heavily relied upon to deliver general macroeconomic assistance to households and businesses, particularly small businesses.
The immediate result was that households and businesses that have stronger ties to the financial system received greater economic support. Those with less strong ties to the financial system received aid more slowly and, in some instances, not at all. The long-term consequences of relying on the Federal Reserve to distribute recession assistance through the financial system blurs the lines between engaging in monetary and fiscal policy.
This response is a continuation of the trend that began in America from the prior recession and appears likely to continue, potentially impacting the central bank’s independence and raising concerns regarding the role of the Federal Reserve in society.
Research by Boston Fed economist finds borrowers and lenders incentivized to take more risk
September 15, 2022 — In 2010, researcher Mattia Landoni obtained access to data on thousands of short-term loans known as “repos” that were issued in the three years before the 2007-2008 financial crisis. But like many of his colleagues, Landoni assumed that data on repos would be boring since they were generally thought of as safe. He did not take a closer look at it until 2014, at the urging of fellow researcher Jun Kyung Auh.
He quickly realized he was wrong: Repos were not boring. In fact, the lack of transparency into how they are made or how lenders manage risk has implications that could impact the economy’s fragility, said Landoni, now a senior financial economist at the Federal Reserve Bank of Boston.
“We need to understand what we are seeing here, or we could be just as blindsided by the next financial crisis as we were in 2007,” said Landoni, who works in the Bank’s Supervision, Regulation & Credit department.
Landoni and Auh teamed up on a paper that examines risk-taking associated with repos, “Loan Terms and Collateral: Evidence from the Bilateral Repo Market,” which is forthcoming in The Journal of Finance. The researchers find that repo loans against low-quality collateral are riskier than those against high-quality collateral. But they also find that there are incentives for both lenders and borrowers to continue engaging in these riskier loans.
The researchers said lenders appear to take more risk and receive more compensation when collateral quality is lower, and loans against low-quality collateral are cheaper for borrowers.
Quality, transparency of securities used as collateral varies widely
“Repo” is short for “repurchase agreement,” a short-term, collateral-backed loan. A “bilateral” repo is between two parties. The firm acting as the borrower agrees to sell securities – such as stocks and bonds – to another firm, and then repurchase those same securities at a higher price. The securities act as collateral, meaning the buyer keeps them if the seller breaks the agreement.
But the quality of the collateral varies widely. The researchers observed two main types of securities used as collateral: mortgage-backed securities and collateralized debt obligations.
Landoni said mortgage-backed securities have some degree of transparency because they are backed by real estate loans.
“You can list each mortgage by zip code, so you know exactly what is going into that (security),” he said.
Collateralized debt obligations are backed by a pool of loans and assets, and are, in theory, no more or less risky than mortgage-backed securities. But the researchers found that they are less transparent and more complex, making it harder to assess their value. And, Landoni said, “They were of lower quality, on average.”
Paper: Loans against lower-quality collateral are riskier, but attractive
For their paper, Landoni and Auh created a dataset of more than 13,000 “uncleared” repo loans – meaning they were made directly between two parties. The loans were made between a large hedge fund and major financial institutions from 2004-2007.
The length of the loans spanned one day to six months, and their principal amounts ranged from about $30,000 to more than $700 million, with a median of about $10.5 million.
The researchers analyzed the data and studied the prices of securities being used as collateral. They also created a model to determine what was causing patterns they observed in the dataset.
They found that, despite their higher margins, repo loans against lower-quality collateral were riskier than loans against higher-quality collateral. But both lenders and borrowers had incentives to engage in these riskier loans.
Why? The researchers said it relates to lender optimism and a behavior called “reaching for yield:” Lenders offer a relatively cheaper loan to a borrower with lower-quality collateral in exchange for the chance to take more risk and potentially earn more money.
Since borrowers can get cheaper loans using low-quality collateral, they have an incentive to continue buying it. And that gives the firms that produce securities used as low-quality collateral an incentive to keep creating them.
The researchers said it is critical to continue learning more about this market as the risks lenders take there could have significant impacts on the overall economy.
Landoni said efforts are ongoing to gather more information about the bilateral repo market. He added that he hopes the study helps inform a pilot program in the U.S. Treasury’s Office of Financial Research that is focused on establishing data collection and disclosure protocols.
Courtesy of Amanda Blanco, Federal Reserve Bank of Boston
June 29, 2022 — When credit risk is on the rise, such as during an economic downturn, credit card companies may look at reducing consumers’ available credit limits to prevent against losses. Credit card line decreases are an industry practice where a company cuts a consumer’s credit limit on an existing account. A consumer’s available credit can disappear, sometimes without warning or subsequent explanation.
A new CFPB report describes how credit card companies increasingly used credit line decreases during both the Great Recession and at the start of the COVID-19 pandemic. Due to the critical role credit plays in financial resiliency, especially during a downturn, we sought to examine the importance and impact of these decisions by credit card companies.
The impact of limiting available credit lines
The following highlights our key findings:
Majority of decreased credit lines were not linked to recent credit card delinquencies
Credit line decrease actions were four times as common if a consumer had a recent credit card delinquency. However, approximately 67 percent of consumers who experienced declines in their credit line showed no evidence of a recent credit card delinquency.
For these consumers, the decision may be driven by other changes in their credit profile, internal account performance data, or by changes in institution risk management unrelated to their credit standing. Credit reports don’t currently indicate whether the action was driven by the consumer’s risk or the lender’s internal decision-making.
Credit line decreases led to dramatic reductions in available credit
Our research showed that line decreases resulted in a dramatic reduction in credit available on a consumer’s impacted credit card. For consumers across different credit score tiers, the median amount of credit decreased by approximately 75 percent. Median available credit was often reduced to less than $400 for all consumers except those with superprime credit scores (generally a superprime score is 720 or greater compared to deep subprime of 579 or less).
We also showed that a credit line decrease on a consumer’s highest balance card significantly affects a consumer’s total access to credit card lines. The impact of a line decrease may be more acutely felt for consumers in lower score ranges who are less likely to have as many cards as their prime counterparts and may find it more challenging to access new credit.
Rates of credit utilization went up
The credit utilization rate – or the amount of credit used against the available credit limit – also significantly increased, with most consumers essentially “maxing out” the card.
When their available credit decreased, median deep subprime, subprime, near-prime, and prime consumers reached 94 percent of their available credit. Even for super-prime consumers, their utilization rate more than doubled from 37 percent to 78 percent. We also showed that total combined utilization also increased after a credit line decrease for all but deep subprime scored consumers. This can have an impact on their credit scores – when utilization goes up, consumer credit scores tend to go down.
Credit line decreases tend to coincide with decreasing credit scores
Credit scores declined around the time of a line decrease, and this was felt by consumers of different credit scores. The decline, however, was significantly greater if a consumer had a recent credit card delinquency. During the analysis period, median credit scores for consumers with a recent card delinquency on any card decreased between 33 and 87 points. For consumers without a recent card delinquency on any card, median scores decreased between 1 and 12 points.
Credit balances remained depressed for subprime borrowers
While prime consumers may have used other credit cards or new accounts to offset the line decrease and return to previous total card balance levels, subprime and deep subprime balances remained depressed three quarters later, meaning that subprime borrowers are likely less able to return to previous card use.
This research is part of a series looking at consumer credit trends using a longitudinal sample of approximately five million de-identified credit records maintained by one of the three nationwide consumer reporting agencies.
Read the report, Credit Card Line Decreases .