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2006 Economic Outlook Roundtable:
Scenarios for the Next U.S. Recession

Questions and Answers

MR. BROWN: You've heard from the experts about the economic outlook. You've heard that the U.S. economy is performing well. The banking industry also has been performing well. But both are very dependent on housing, very dependent on the consumer sector, and, clearly, there are some issues to consider there.

I'd like to turn it over to you, the audience, now and start taking your questions directed to the panel. Please stand up if you want to ask a question and identify yourself, and we'll direct it to the panel.

MR. NOTHAFT: Hi. I'm Frank Nothaft with Freddie Mac. I have a couple of questions for Kathleen. You had mentioned investment from China in U.S. fixed-income assets helping to keep interest rates low, and that would continue to keep rates low. I was wondering if you could quantify that. How much lower are rates now because of it? And what's the risk to U.S. interest rates if foreign investment funds pull out of the dollar?

My second question is about the steepness of the yield curve. You were talking about the 3-month T-bill to a 10-year spread, and you mentioned the market is expecting a rate hike on January 31, and perhaps another one in the spring. So if we have another rate hike at the end of the month, that will pretty much give us flat yield curve. And if there is another one in the spring, we'll have the inverted yield curve. How does that tie in, then, with your outlook for economic growth?

MS. CAMILLI: Thanks—two great questions. As to the first one, on China, I have no idea how much it [China's investment in U.S. fixed-income assets] is influencing the long end of the yield curve. I don't think even policymakers have an idea. The reason I borrowed Catherine Mann's analysis on co-dependency is because, in reality, our trade deficit and our current account in trade deficit have expanded because we are just importing large amounts of goods from China.

We are offshoring manufacturing to produce goods there. They are exporting to us, we are importing from them, and we are in a co-dependent relationship with them, which is causing our trade deficit to expand.

We had a tiny revaluation of the yuan this summer. We probably will have a few more revaluations of the yuan. But the fact is that the Chinese have large dollar reserves. Those dollar reserves have to be invested in the U.S. Treasury market.

I can remember back in the 1980s when there was a big fear that the Japanese would divest themselves of U.S. Treasuries. Instead, the Japanese went on not only to own U.S. Treasuries in their portfolio, but then to own U.S. corporate bonds and U.S. mortgages.

So I suspect that the same thing will happen with the Chinese, that they will eventually go on to diversify the portfolio into other U.S. fixed-income assets, and then also to diversify into other markets. I'm not anticipating that that will be a big problem for the dollar.

Your second question was on the shape of the yield curve. Yes, I really found Tim Geithner's speech last week to be fascinating on this. The speech was predominantly on asset prices and the impact of asset prices and the feedback loop on monetary policy. I think he was in some way telegraphing what the Fed plans to do here using the recent UK example. And in the UK, they did end up inverting the yield curve. They raised rates to 4 ¾ percent before the housing market really started to roll over and roll over rapidly, at which point they backed away from the tightening and lowered rates a quarter of a point, and then left them there and left the yield curve inverted.

So when I read Tim's speech, and I thought about the UK example, I thought to myself, the Fed is doing the same thing. This is why Greenspan keeps saying, "We can invert the yield curve, and it doesn't mean that a recession is coming."

We can invert it, and maybe we need to invert it, to stop the acceleration in home prices, but it won't necessarily be a signal of a recession. And I think that may be accurate, because my other indicators don't indicate a recession. The S&P 500 doesn't indicate a recession. The University of Michigan does not indicate a recession.

So I think that may be what's happening. It would not be my preferred course of action, and I said so in my remarks. My preferred course of action would be to just pause right here at the January 31st meeting, put some language in the text that says we've decided to pause here to assess the outlook, and then, if it turns out that the economic numbers don't show some moderation in growth, then I would proceed with the tightening. But that might not be their preferred course.

Thank you for the questions.

MR. BROWN: Kathleen, does the dependence on foreign capital, the effect that it's having on long-term interest rates, and, presumably, home prices, does that represent a possible source of instability in the housing market if long-term interest rates should suddenly shoot up? What effect would that have on our housing market?

MS. CAMILLI: Well, I can't imagine what a challenge it has been for the Fed to conduct monetary policy in this environment, where normally when you start raising interest rates you get a backup in long rates, as the premium for inflationary expectations gets built in and causes long rates to rise.

That didn't happen this time around. Instead, long rates have stayed low, and I believe they've stayed low because of the perception of a low inflationary expectation, as well as the impact of foreign capital flows.

So I imagine it's especially trying for them, and it is with great difficulty that they're conducting monetary policy, which may be why they feel they need to invert the yield curve, to bring about the desired result of moderation in home prices.

MR. BROWN: Other questions?

MS. MARCUSS: Rosemary Marcuss, Bureau of Economic Analysis. This is a question for Mr. McMahon. I found your point that the local housing markets often reflected the job market a very interesting one. As we're trying to measure the GDP, we're always asked, "Well, where are the effects of Hurricanes Katrina and Wilma? We know they're sort of in there somewhere."

I'm wondering whether, through the banking system, you've been able to perceive any noticeable effects of such a large destruction of house values that occurred such an unusual way.

MR. McMAHON: I think when Katrina first hit there was an expectation that it would be a big drag on economic activity, and it certainly destroyed a lot of wealth in the area, which is slowly being rebuilt.

But in terms of housing activity, it probably extended the housing boom a little bit, by creating more demand for home construction in that region. And certainly one would imagine that would lead to a bidding up in the cost of resources, which are already pretty fully employed in home construction, and, therefore, would be positive for home prices, at least temporarily, as contractors bid construction workers and others away from Florida and other places to come to the Gulf and start to rebuild.

I'm not sure that the rebuilding in New Orleans, for example, has started yet on a big scale. I'm also not so sure about southern Mississippi, but I think that Katrina will end up being a positive for housing for a while, although, obviously, the wealth destruction is a negative on so many other fronts. But my general sense is that most of the forecasts I saw were expecting a bigger impact from Katrina, in the third quarter at least, than actually occurred.

MS. CAMILLI: I also made an error in my forecast. I took down GDP for the third and fourth quarter, thinking it would have a bigger impact, and that turned out not to be correct.

MR. SEIBERG: Jaret Seiberg with the Washington Research Group. I have a question for Mr. McMahon and Mr. Brown. When you look at what a decline in housing prices could mean to the banking industry, do you explore how many of these exotic mortgages banks are keeping on their books, and how many they are selling off to the secondary market? And how does that affect your analysis?

MR. McMAHON: Well, first of all, it's not easy to get a complete account from looking at the numbers that are actually available, because while you get originations, and you get information on securitized loans, it's hard to get a really accurate picture of everything that's going on.

Clearly, banks are securitizing a lot of their mortgage assets. We have to get information about banks' exotic mortgage activities from our examiners in the banks, and we get that for the larger institutions. It's harder to collect it on the smaller institutions.

One thing I would say about exotic instruments, I think you do tend to see a concentration of activity here in the larger institutions and the more sophisticated institutions. And, one would believe that they have more sophisticated tools at their disposal to manage the risks. While we've talked about the increase in residential real estate exposure generally, we haven't spoken about the distinction between large and small banks.

And a lot of the increase in the one-to-four book, as opposed to the home equity book, has been in the large institutions. I think if you look at the growth rate of one-to-four lending at smaller institutions, it's going to trail significantly behind larger institutions. And I think for the exotic instruments, that's certainly the case.

And we have people in each of the large banks. The OCC has a resident team in there looking at what they're doing, looking at the risk management, looking at how they're handling these things.

MR. SEIBERG: Do you have any sense as to whether they are actively trying to securitize these?

MR. McMAHON: They are clearly doing a lot of securitization, and securitization decisions are based on a lot of factors, including the need for liquidity, whether the bank wants to make some other loans and is anxious to securitize a portion of its portfolio to get some funds to do that.

And I think there are different strategies among the banks about the kinds of instruments that they keep on the books, and the kind of instruments they securitize. But, clearly, there has been a pick-up in securitization that has contributed to the expansion of residential real estate financing, availability, and to activity generally, because while banks have increased their loan book by the amounts we've shown you, they've also securitized a lot of other assets, a lot of loans that they've originated. And so the risk is spread out. But I'm not sure I can tell you precisely what percentage of the exotic stuff goes off the books. I think that does vary bank by bank.

MR. BROWN: The large institutions are certainly active in originating the new mortgage products. Seven out of the top 10 mortgage originators are at FDIC-insured institutions or their affiliates, and they are very active also in the innovative mortgage products. This is also an area where mortgage brokers have been very active, and they have also been pushing the envelope as far as the terms of these loans.

The ability to securitize those has been, I think, one of the factors that has led to some of the growth in the market. The private-label MBS market has been shown to have a surprising appetite for these innovative structures.

Again, they have performed really admirably in what has been a fairly benign economic environment. I think there is some uncertainty about what the extent of payment shock would be under some higher interest rate scenarios, and I think that's one of the things that is going to test the marketplace going forward.

I'd like to throw out a question to Meredith about this also. You mentioned the possibility of liquidity shocks, and, clearly, the appetite for risk in the private-label MBS market has been something that has fueled mortgage lending. What do you think some of the triggers could be for cutting off some of these sources of private-label financing in the mortgage-backed markets?

MS. WHITNEY: For the originators, it will be the higher capital levels required, and this is insisted upon largely by S&P and other ratings agencies. So to get a deal rated you're going to put more capital against the deal.

All of this ties back to a prolonged environment of very low, long-term interest rates. In my analysis, China is less of a factor than many people would have you believe. Japan and Europe together represent over 70 percent of the buying power, and they've been very consistent sources of capital. And China has been very consistently 15 percent of the buying power.

So there's nothing that erratic about what China is doing, and there's nothing that erratic about what Europe and Japan are doing. But because rates are so low—for example, 10-year yields in Japan are around 1.5 or 1.6 percent—of course you're going to go where your money is better rewarded, to the U.S. market.

Everyone is looking for yield, so people are taking on more risk, and will take on these crazy exotic mortgage products, or at least portions of them, such as a senior sub-piece that they wouldn't have taken on otherwise, because they are so desperate for yield.

The rates we're seeing in Argentina, for example, are crazy. Throughout Latin America, we see interest rates and capital availability that we thought we would never see. The cost of accessing capital in Greece is virtually at parity with some of the leading European nations.

But it is difficult for investors to make some of these distinctions in this environment of very low rates when they are going after yield. People sometimes think, okay, things can't be that bad, and the greed almost overshadows anything else in terms of the buyer's demand for these assets.

What will place a limit on the issuance of debt is a more onerous capital requirement. It makes the deal that much less profitable.

MR. BROWN: Do you think it's more likely that a market event or a regulatory event will end this cycle?

MS. WHITNEY: A regulatory event.

Let's go back to the late 1990s. A former colleague of mine is in the audience, and we used to cover these somewhat shady mortgage companies that lent on home equity, which used to be a four-letter word, by the way. In the 1990s, this was considered the lowest-of-low type of product. It was almost like one of these Japanese loans that you get at a kiosk that no one wants to talk about.

What happened after the collapse of Long-Term Capital Management was that you had a systemic risk event that flooded the market, and credit spreads widened so dramatically that it became so much less profitable to originate these loans. And it basically shuttered over 50 companies that did this type of lending.

So it gets back to what happens with the rating agencies and the credit markets. And this is a very different environment now compared to the late 1990s. Then, we were going into a budget surplus, and so maybe more Americans were buying securities, and that's why long-term rates were lower. In this environment, it's because we're really in a global economy.

So I don't want to say it can't happen. That would be foolish. But I don't see an exogenous market event being as likely as I do a change in which the rating agencies continue to require more capital. That may mean fewer business failures, but it could bring a real slowdown in lending. And that could be a real Goldilocks-type of environment for the regulators.

MR. GABRIEL: Steve Gabriel with the FDIC. I'd like to address this to Kathleen. Do you expect that the U.S. economy will be able to continue to sort of shrug off future energy price spikes as it has in recent months, and especially in light of the fact that there is the expectation that we may be facing years, and maybe decades, of increased hurricane activity in the Atlantic?

And if your answer is yes, could you come up with a scenario where we would need a confluence of events in combination with an energy price spike in order to cause some problems for the economy?

MS. CAMILLI: Typically, energy price spikes in the past have had an impact on consumer spending. And I'm not so sure that they aren't having an impact now, given what we see is happening in fourth quarter GDP. Again, we don't need to look at the report.

To date, everyone has been impressed with the fact that energy has seemed to have had an impact on spending, but that could just be because housing prices has been going up so dramatically that they're offsetting whatever negative impact is coming from energy.

So I imagine once you take the price acceleration away in homes, and you're left with just $70-a-barrel oil, you may have more of a negative impact. And you would only conclude that from looking at prior price spikes, because they usually do have a negative impact on consumption.

Now, with that said, how are they impacting the way businesses operate? Well, businesses seem to have built it in. I'm not talking about airlines, but businesses seem to have come to accept the fact that we may be dealing on a sustained basis with higher energy prices for the foreseeable future, and they're building that into their models.

But I actually think the consensus has been that energy prices would subside to about $50-a-barrel oil this year. And, if anything, in the last couple of weeks it has proved not to be the case. So I think they do have an impact, yes.

MS. SCHTEVIE: Hi. I'm Helly Schtevie with CNBC. This question is for Ms. Whitney. I just want to clarify, how concerned are you by that 5 percent of the new homebuyers? Do you think they could have a ripple effect on the economy if the housing market were to cool significantly?

MS. WHITNEY: They will have a ripple effect on the economy vis-à-vis consumer spending, clearly. Is it as severe as it would be if it were a higher net worth demographic? As I said, the top 20 percent of earners spend 40 percent of discretionary spending.

I don't think it's going to have a profound effect on the economy, but I think it will certainly put pressure on bank earnings. This may raise another issue in terms of how difficult it is for you guys to analyze what percentage of banks are exposed to these exotic products. They don't want to admit it. They don't want to admit the exposure to subprime. It is a dirty word, particularly after what happened in the late 1990s.

So it will have an impact. I think it will ultimately slow down consumer lending, and it will put pressure on consumer spending. And as Kathleen could tell you, most economists are expecting a slowdown in consumer spending for 2006 anyway.

And I would imagine that at least some portion of it will be picked up by an increase in corporate spending, which I expect to be very robust. But I don't expect it to send seismic waves through the economy.

MR. BROWN: I would just add that I see somewhat of a parallel between the democratization of consumer credit that we saw in the mid-1980s where everyone got credit cards for the first time. What you saw there was a quintupling of personal bankruptcy filings between 1985 and 1994. And after that you saw a much higher loss rate on credit cards.

On the other hand, the credit card companies were able to manage and price that risk reasonably well. They managed to make a lot of money during that period of time.

It's not unreasonable, if you take that parallel, to think that this availability of credit that is now being given to residential borrowers, and the flexibility you're giving them to skip payments, could ultimately result in a higher loss environment in mortgage lending.

Again, we've seen low losses in recent years with this very benign set of conditions that we don't think is going to last forever. But the idea of moving to a higher loss environment seems to me to make sense.

Now, can the risk dispersal mechanisms of mortgage securitization help keep the risks manageable? Can the lenders and mortgage investors continue to make money during this environment? I think there's a good case to be made there, but I think it ultimately remains to be seen.

MS. WHITNEY: It seems to me that rational pricing only comes after an event. People have to start losing a lot of money. You start with very aggressive credit card teaser rates, and then there is some type of credit blowup.

You saw credit card issuers aggressively marketing teaser-rate programs in the late 1990s into 2000. This tends to lead to a credit bubble, and then you finally have rationalization of pricing. And that is the cycle that we know very well.

Most of the credit card lenders at the time that you're speaking of were diversified banks. So they managed.

MR. KLUMPNER: Jim Klumpner, Senate Budget Committee. I wanted to go back to something that Kathleen Camilli said about the impact of energy price increases on firms as opposed to consumers. And you said they are factoring it into their models.

But it goes beyond just factoring it into your models. There was a real income loss somewhere there, for every firm in the United States uses energy, and so they saw their costs go up and may see further cost increases if the price of oil stays high. Somebody has to bear that income loss, whether it's a hit on profits, whether there's less hiring and wage growth, or whether it's passed on in the prices of non-energy goods, and, therefore, borne by consumers.

And what I'm trying to puzzle out is: Who took that income loss? A lot of people have focused on the consumer and the direct impact of the energy price increases on consumer spending, but was it profits? Was it wages? And I don't think you can make the case that it was passed through into non-energy goods prices.

So it seems like it should be either profits or wages. And what's the effect of that going to be?

MS. CAMILLI: Well, I think it's all of the above. I think if you look at the airline industry, it has been adversely affected; their profits have been affected. Last week I went to Phoenix, and I spent some time talking to two of the flight attendants. Their wages and income have been severely adversely affected by everything that has happened to the airline industry as a result of higher energy prices.

I was flying American, and they were telling me how American didn't hedge their exposure to higher oil prices. And so I think it's all of the above. I think profits have been affected and wages have been affected, and in some cases, in service businesses, prices have been affected. It has been passed through. It may not be passed along in a generalized way that we're used to seeing when oil price shocks impact profits, but it has had an effect.

There are really two tiers of price inflation, and I think sometimes when we listen to the press we get this impression that everything is all lumped together, because we look at the overall price measures as CPI and PCE and the GDP deflator. But if you're in a service business, you've been adversely affected. You take that energy increase, and if you can pass it along in the final price of your product, you're doing that.

There's a whole other tier of prices—what I would call commodities or the Wal-Marts of the country—where they've either hedged it or they've figured out a way not to pass it on. So you have to put those two forces together. One is almost a deflationary force, and one is an inflationary force, and you put them together and you just don't get that much effect, at least in the price indices.

In real life, I think it's a different story. But in the price indices, because of the weightings, you just don't get much of an acceleration in inflation. But I think it is falling out in profits. And, certainly, people who operate at a minimum wage have been affected by higher energy prices. I don't think we couldn't conclude that.

MR. GONZALEZ: Hi. I'm Oscar Gonzalez with the FDIC. I have a question for Ms. Whitney. I've been analyzing the impact of Rita and Katrina over the population of the Gulf Coast that was affected. One of the findings is that, if you take the counties that were most affected by it, approximately 173 zip codes, the population there only earns about 65 to 70 percent of the average income for the United States. So it's a relatively poor population. So I think in analyzing exogenous shocks, you make a very good point in terms of understanding the segmentation that occurs as well.

The question I had is: When looking at events like the hurricanes in the Gulf Coast, for example, let's say the population that is low income is 10 percent—in numbers, that's a big number of people. But what percent of GDP would this group represent? I am wondering what the impact of future hurricanes in the Gulf Coast might be with a population that lags the rest of the country in terms of income as well.

MS. WHITNEY: To start off with, I'm not an expert on regional economies or regional demographics. I suppose I know a good deal to the extent that I spend a lot of time researching these issues. What I have found, particularly with Katrina, was that the city of New Orleans had a 20 percent unemployment rate. Fifty percent of the residents of New Orleans didn't have bank accounts. That's extraordinary.

And if you look at these facts you might conclude that the state of Louisiana has been the single-worst state for lenders in the country. Most major lenders don't have a large presence in Louisiana. Even so, a lot of the large banks have taken charges related to Katrina, which makes you scratch your head and say, "Wait a second—you weren't even in Louisiana, and California wasn't affected by Katrina. How do you come up with a $500 million charge?”

But, anyway, that's just conjecture. You have to look at the segmenting and income levels to see who qualifies for credit anyway, and that's why you have to break down your 100 percent based on income levels. And I think the kimono was opened in terms of how incredibly poor that region was. What you see is that the bulk of the wealth resides on the two coasts. And then, as you move in, you see poorer and poorer areas. This was a dirty little secret that has not changed in a hundred years.

Many of the residents were government-subsidized and incredibly poor, and your analysis would have to ask who was borrowing there. A very small percentage of people in that area had actually borrowed or had any access to credit. And I would say that would be pretty consistent through the area. But the state of Louisiana is like a different country in terms of lending and regulation, and that's why many of the bigger lenders aren't there.

MR. GONZALEZ: So do you think this is why the effect of Katrina was not seen in the GDP figures? Do you think there is a time lag maybe that will show when insurance claims come up? Do you think it was because the population was low-income and didn't participate as much in the larger economy?

MS. WHITNEY: One guess on that. Look at the folks who did business in the state of Louisiana. Many of them were petrochemical companies, which have had amazing tailwinds behind them. They do business in Louisiana at least in part because it has the most relaxed environmental standards of any state in the United States.

So your one anomaly for that region might be in terms of what the commodity industries have contributed to overall GDP. Certainly the commodity companies have been the biggest stock market performers and have had the most extraordinary profitability across corporate America.

The other suggestion I would offer is that because you didn't have an enormous consumer buying capacity from that region, it didn't make a major impact. Let's suppose that Manhattan were closed down for that period of time, or Los Angeles or Chicago. Then you would see a bigger impact on GDP.

You're looking at really a very, very poor segment of consumers in New Orleans. A lot of those folks didn't leave town because they had no car or because they couldn't even afford a bus ticket. That limited the impact on the economy from a consumer perspective.

MR. BROWN: I would just point out also, the FDIC released earlier this month a preliminary analysis of the effects of Hurricane Katrina on FDIC-insured institutions. And while there are large U.S. institutions that do business in the Gulf Coast region, it's probably not a very big part of their portfolios.

There are 120 institutions that are headquartered in the most heavily damaged regions as designated by FEMA, and there are 87 institutions that get 100 percent of their deposits in those counties in southern Louisiana and Mississippi.

Those institutions have been really impacted in terms of facilities. We still had 100 institutions as of the beginning of this month that still had offices closed. They've been working very hard to get the operations back into swing there.

Going forward, I think these institutions are going to be critical as far as turning around the economic environment there. There is going to have to be a lot of small business lending to get that region back on its feet.

So I think the financial sector down there may not be a big part of the national picture, but it's vitally important to that region. And I think those institutions are going to be playing a leading role in the recovery process.

MS. KAPER: Hi. This question is for Mr. McMahon. I'm Stacy Kaper with American Banker newspaper. There has been a great deal of emphasis today on the real estate market, and I was wondering, what would be the first signs of change in that market that could negatively affect the earnings for banks? And if they start to see that, what should they do?

MR. McMAHON: Looking at the recent data, I think you'll see a mixed picture on housing. And, Kathleen, you may want to supplement my comments on this.

What you see is very strong housing starts. You see home prices rising. You see some slowing in home sales, and a little bit of an increase in inventories. But we're still at a very high level of activity in housing. So I think to see a slowing there, you would want to look to see if there was slowing in sales and a big backup in inventory of homes available for sale.

In terms of the impact on the banks, I think the first thing you would see would be a decline in loan volume. The question really is: How do banks make up for any reduction in demand for new mortgages or for refinancing mortgages? And we are seeing some tailing off in that activity.

Where will you see banks go with their funds to offset the loss of that loan volume, to make up for that in terms of their earnings? That would be the key question. Because if we have the kind of economic environment that Kathleen and other analysts have been talking about, home price changes will continue to be positive, but activity will be slow. Typically, you will need to see some prolonged period of stress, really, before you see a negative movement in overall home prices.

In that environment, the issue is going to be a volume issue and where banks go to offset slowdown in the volume of real estate lending. That would be what I would look to—whether there is enough growth in C&I lending demand. As has been pointed out, the corporations have a lot of alternatives for bank financing, and C&I lending has declined as a share of total bank financing.

And so the question is going to be whether there is an adequate pick-up in other demand for loans to offset the weakness in real estate demand, if that's what happens. Does that answer your question?

MS. KAPER: Yes. I guess just the second part would be: What do you see as the most important economic sector that banks should be concerned about in the near future?

MR. McMAHON: Well, certainly, housing is one, not just because of the risk of loss on housing loans, but because of its integration into the rest of the economy and its potential impact on other loan types, in terms of credit losses.

But given the financial strength of the banks right now, it would really take a dramatic slowing in economic activity or some other external shock that we're not anticipating at the moment to really create an earnings issue for banks. They're in a very strong position at the moment.

MR. BROWN: With regard to the housing markets, we do track some of the measures of inventory. One of them is months supply on the market, which has recently risen from below four months to up around five.

Given the activity that we've had—and housing has been red hot for about four years now—we're going to have to wait until the spring to really see how it starts to shake out. And then, I think we'll get a clearer picture about just how much slowdown there is.

I think we would agree that a slowdown is inevitable. It's a question of whether it's an orderly or a disorderly slowdown, and I just don't think we're going to see that until we get to the spring, or maybe even beyond.

MR. DeYOUNG: I'm Bob DeYoung here at the FDIC. I have two quick questions. They are unrelated.

The first has to do with exotic mortgages, and my question is: Do we have any data on which households are getting these? I seem to recall seeing that the vast majority of exotic mortgages are made to households with FICO scores above 660, and with loan-to-value ratios well below 80 percent. That's my first question.

The second question is unrelated. It has to do with the growth of the economy. We know there's two reasons—and two reasons only—why economies grow. One is that the economy gets more resources. The second is that the economy learns to use those resources better

We've talked about how productivity growth has been one of the keys to growth in the current expansion, and we've talked about an influx in capital from abroad. That's more resources. No one has mentioned the increase in labor. There has been a huge influx of labor, much of it undocumented. And that, of course, is fuel for the economy to grow.

Do any of you have any comments about what might happen if policy interrupts that flow of labor into the economy?

MR. McMAHON: I'll start with the first question if I can. I think there are lots of ways to look at the data, and there are lots of different sources of data on this stuff. But what I've seen is consistent with the point you made, that if you look at the exotic instruments, and you look at the FICO scores and you look at the loan-to-values, they look reasonable. They're above subprime.

Now, if you look at the subprime category by itself, you may see that a growing number of these may be in exotic instruments. But if you look at the total pool, I think you'll get a slightly different picture.

The other thing I would say, though, is that there has been some erosion over time. Though the FICO scores are high, and the loan-to-values are relatively low, you do see over time a bit of an erosion in those characteristics, even though they still are fairly robust.

MS. WHITNEY: Of course, due to the law of large numbers, the larger percentage of adjustable-rate mortgages are going to be higher FICO. You look at a company like Golden West—it has done prime mortgages and simple adjustable-rate mortgages for 50 years or so, and there is a big portion of borrowers who want adjustable-rate mortgages.

But just looking at a segment of what I estimate to be 15 million households, the vast majority of those are subprime borrowers and are in adjustable-rate mortgages. That's how I would explain it.

And looking at it from a corporate analysis standpoint, it is productivity gains that will offset everything else. Aside from unions, which I would say had more of a negative impact on the airline industry than oil prices, you've see enormous productivity gains in the United States.

MR. DeYOUNG: But my question with labor has to do with the quantity of labor, and the 10 million or so undocumented folks that have come into the economy since…

MS. WHITNEY: So if we build a wall to Mexico, that…

MR. DeYOUNG: No. My question is, that's an increase in quantity, that's an increase in resources, and the economy grows because of that. And my question is: Does anybody have any idea of the magnitudes of that and what might happen to economic growth if we staunch that flow of labor?

MS. CAMILLI: I don't have an estimate of that. There are many, many underemployed white-collar workers. I doubt they would be willing to do the jobs of the immigrant labor. But it's a good question.

MS. WHITNEY: If you look at the largest percentage of unemployed, they are the folks who are below high school–level education. The undocumented worker technically wouldn't factor into the unemployment numbers.

MR. BROWN: Part of what you're talking about, Bob, may be reflected in the relatively slow growth in the labor force itself during this expansion. Payroll growth has been slower than usual, but also the job force has been growing relatively slow, slower than you would expect. Usually, an expansion draws people back in.

A lot of jobs are being taken by immigrants who don't have the proper paperwork, so maybe that is affecting the statistics. It's certainly worth taking another look at.

MS. WHITNEY: I would doubt it, though, because if you look at the largest demographic of undocumented workers, they would come from Mexico. There are large amounts of undocumented funds that go back to Mexico from undocumented workers in the United States. It is even larger than the dollars from tourism.

But much of that is going to be in California, and I don't know that California could single-handedly represent all of the growth in the United States. That makes no sense.

MS. CAMILLI: Just one other point that I thought of as you were asking the question. It's very rarely talked about, and involves the huge amounts of wealth that were created in the last decade and how this may relate to the number of people who have exited the labor force. This also may be a reason why the labor force is growing so slowly, because they have accumulated wealth and they don't need to work and are living off of portfolio income. That's not really talked about very much.

MR. BROWN: I'm sure we could go on longer, but our time is just about up. We have really enjoyed the chance to have this back and forth, and have enjoyed answering your questions. I hope you will join me in thanking these experts for coming and sharing their views with us today.

Last Updated 02/20/2006 communications@fdic.gov