International Capital Flows and the Return to Safe Assets in the United States, 2003-2007

43 Pages Posted: 12 May 2011

See all articles by Ben S. Bernanke

Ben S. Bernanke

Board of Governors of the Federal Reserve System

Carol C. Bertaut

Board of Governors of the Federal Reserve System

Laurie DeMarco

Board of Governors of the Federal Reserve System

Steven B. Kamin

Board of Governors of the Federal Reserve System

Date Written: April 11, 2011

Abstract

A broad array of domestic institutional factors – including problems with the originate-to-distribute model for mortgage loans, deteriorating lending standards, deficiencies in risk management, conflicting incentives for the GSEs, and shortcomings of supervision and regulation – were the primary sources of the U.S. housing boom and bust and the associated financial crisis. In addition, the extended rise in U.S. house prices was likely also supported by long-term interest rates (including mortgage rates) that were surprisingly low, given the level of short-term rates and other macro fundamentals – a development that Greenspan (2005) dubbed a "conundrum." The "global saving glut" (GSG) hypothesis (Bernanke, 2005 and 2007) argues that increased capital inflows to the United States from countries in which desired saving greatly exceeded desired investment – including Asian emerging markets and commodity exporters – were an important reason that U.S. longer-term interest rates during this period were lower than expected.

This essay investigates further the effects of capital inflows to the United States on U.S. longer-term interest rates; however, we look beyond the overall size of the inflows emphasized by the GSG hypothesis to examine the implications for U.S. yields of the portfolio preferences of foreign creditors. We present evidence that, in the spirit of Caballero and Krishnamurthy (2009), foreign investors during this period tended to prefer U.S. assets perceived to be safe. In particular, foreign investors – especially the GSG countries – acquired a substantial share of the new issues of U.S. Treasuries, Agency debt, and Agency-sponsored mortgage-backed securities. The downward pressure on yields exerted by inflows from the GSG countries was reinforced by the portfolio preferences of other foreign investors. We focus particularly on the case of Europe: Although Europe did not run a large current account surplus as did the GSG countries, we show that it leveraged up its international balance sheet, issuing external liabilities to finance substantial purchases of apparently safe U.S. "private-label" mortgage-backed securities and other fixed-income products. The strong demand for apparently safe assets by both domestic and foreign investors not only served to reduce yields on these assets but also provided additional incentives for the U.S. financial services industry to develop structured investment products that "transformed" risky loans into highly-rated securities.

Our findings do not challenge the view that domestic factors, including those listed above, were the primary sources of the housing boom and bust in the United States. However, examining how changes in the pattern of international capital flows affected yields on U.S. assets helps provide a deeper understanding of the origins and dynamics of the crisis.

Keywords: global saving glut, interest rates, capital flows, mortgage-backed securities

JEL Classification: F3, G1

Suggested Citation

Bernanke, Ben S. and Bertaut, Carol C. and DeMarco, Laurie and Kamin, Steven B., International Capital Flows and the Return to Safe Assets in the United States, 2003-2007 (April 11, 2011). FRB International Finance Discussion Paper No. 1014. Available at SSRN: https://ssrn.com/abstract=1837780 or http://dx.doi.org/10.2139/ssrn.1837780

Ben S. Bernanke

Board of Governors of the Federal Reserve System

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Carol C. Bertaut (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th and C Streets, NW
Washington, DC 20551
United States

Laurie DeMarco

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Steven B. Kamin

Board of Governors of the Federal Reserve System ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-3339 (Phone)
202-736-5638 (Fax)

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