From The Ridiculous To The Subprime
A reader suggested a topic on the Federal Reserve 2007 transcripts. “How about a discussion of why top economic policy makers have such a hard time seeing what at least some mere mortals have trouble missing.”
The New York Times. “When Federal Reserve policy makers convened in August 2007, one of the nation’s largest subprime mortgage lenders had just filed for bankruptcy, and another was struggling to find the money it needed to survive. Officials decided not to cut interest rates. The Fed did not even mention housing in a statement announcing its decision. That was on a Tuesday. By Thursday, the European Central Bank was offering emergency loans to continental banks, the Fed was following suit.”
“The transcripts show that the Fed entered 2007 still deeply complacent about the housing market. By the early August meeting, Fed officials had moved from denial to puzzlement. American Home Mortgage, a leading subprime lender, had filed for bankruptcy the previous day. Countrywide Financial, another lender, was looking for a lifeline. The investment bank Bear Stearns had liquidated a pair of mortgage-focused hedge funds.”
“‘It is an interesting question why what looks like $100 billion or so of credit losses in the subprime market has been reflected in multiple trillions of dollars of losses in paper wealth,’ Mr. Bernanke said at the meeting, referring to the decline of global financial markets.”
From Bloomberg. “Originations of non-prime mortgages rose to $1 trillion in 2006, up from $395 billion in 2003, according to data from Inside Mortgage Finance. Delinquencies on the loans to borrowers with damaged or limited credit histories rose to 17.3 percent of total loans by the fourth quarter of 2007, up from 13.7 percent in the first quarter, according to data from the Mortgage Bankers Association. They jumped to 27.2 percent in the first quarter of 2010 after home prices fell by about a third from their 2006 peak, according to a home price index tracked by CoreLogic Inc.”
“The Financial Crisis Inquiry Commission’s 545-page report said regulators took ‘little meaningful action’ against the threats of financial calamity. ‘The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudential lending standards,’ the report says.”
“Participants at the first FOMC meeting of 2007, on Jan. 30- 31, saw signs the economy was improving and recession risk diminishing. The transcripts mention the word ‘recession’ four times in January, three times in June, once in August, and 27 times in December.”
The Washington Post. “Richard Fisher, the president of the Dallas Fed, expressed confidence during the October 30/31, 2007 meeting that investors were waking up to problems in the subprime market. He quoted a Financial Times article where an investor said, ‘Corporate treasurers are no longer buying things they don’t understand,’ prompting laughter around the room.”
“Fisher continued: ‘Imagine that. Investors are coming home from lala land. To be sure, we’re not out of the woods quite yet, as President Plosser and President Rosengren mentioned. The situation remains real, but we’ve gone beyond suspended reality. If you will forgive me, you might say we have gone from the ridiculous to the subprime.’”
The Atlantic. “Richard Fisher, December 11, 2007: ‘I’d like to address the inflation situation more thoroughly, Mr. Chairman. The CEO of Wal-Mart USA said that, for the first time in his career at that firm, they have approved a plan in which purchase costs will increase 3 percent in ‘08. He hadn’t seen that before in his experience and said, “I’m totally used to deflation. Deflation is finished.” In terms of the suppliers to Wal-Mart, this was verified. I think on food prices we have to be extremely careful. Frito-Lay is seeking a 51⁄2 percent price increase for next year. Wal-Mart has acquiesced.’”
The New Yorker. “Perhaps the most interesting thing about the transcripts is what they tell us about how policymakers thought before the full scale of the crisis became clear. Like the European politicians who blundered into war in 1914, most people at the Fed simply couldn’t conceive of the catastrophe that was to ensue. Lured into a false sense of security by more than two decades of economic prosperity, they suffered from what the economists Jack Guttentag and Richard Herring term ‘disaster myopia.’”
“It wasn’t as if Bernanke and the rest were ignorant about the downturn in the housing market. But the Fed policymakers, like their Edwardian forebears, believed they had things under control. The problems in the subprime market wouldn’t spill over into the broader economy, they thought. Indeed, the general view at the Fed (and in the markets) was that economic growth was picking up.”
“On June 27, 2007, when Bernanke turned the discussion over to his colleagues on the F.O.M.C., they also made upbeat comments, and so did he: ‘I agree with the general view around the table that, except for housing, the economy looks to be healthy.’ In retrospect, this was a bit like saying that, apart from the huge tumor in his abdomen, the patient was doing fine.”
“But my point here is not to berate Bernanke, or his colleagues: they were merely parroting the collective wisdom of economists on Wall Street, in academia, and at other central banks. The interesting question is why they didn’t know better. In terms of behavioral economics, the Fed policymakers succumbed to the ‘representative heuristic’—the tendency to assume that the future will look like the past.”
“Many of them were defrocked academics relying on a theoretical framework—modern macroeconomics—that paid little attention to institutional features, such as developments in the banking system. According to the theories that Bernanke helped develop during his days in academia, as long as the Fed carefully adjusted interest rates to keep inflation under control, and also kept an eye on the money supply, it couldn’t go too wrong. In terms of maintaining a healthy rate of economic growth, the things that mattered most were tangible inputs and outputs: the labor supply, unemployment, productivity growth, and inflation. The financial sector was merely a ‘veil’—except, in this case, the veil almost strangled its wearer.”
“Finally, folks at the Fed may have been reluctant to recognize their own mistakes. For several years, they had kept interest rates artificially low to stimulate the economy. In terms of G.D.P. growth, the results had been pretty modest, but the impact on the housing market had been dramatic. Many parts of the country had experienced an unprecedented bubble. Tens of millions of homeowners were delighted. For a time, Bernanke and his colleagues were lionized.”
“By the summer of 2007, the party was over, and the inevitable hangover was beginning. It is really any wonder that the Fed was disinclined to consider such an outcome?”
