Federal Reserve documents 13 page

Ideally, the whole Committee would have agreed on the projections. Policy committees in several countries, the United Kingdom being one leading example, publish collective forecasts. But we could not count on the diverse (and geographically dispersed) Federal Open Market Committee, with its nineteen participants when all positions are filled, being able to agree on a single forecast. Instead, following existing practice, we asked each individual participant to submit his or her own projections for economic growth, inflation, and unemployment, assuming that their preferred monetary policy was followed. We publicly reported both the full range of projections for each variable and the “central tendency” of the projections (the range of projections with the three highest and three lowest projections excluded).

The first set of projections under the new system would show most FOMC members forecasting inflation in three years (in 2010) to be between 1.6 percent and 1.9 percent. Most expected an unemployment rate at the end of 2010 of 4.7 percent to 4.9 percent. It wasn’t unreasonable to draw the conclusion that the Committee was aiming for inflation a little less than 2 percent and that it thought unemployment couldn’t dip too much below 5 percent without running the risk of overheating the economy. For this purpose it didn’t much matter whether the forecasts were accurate—the purpose of the longer-term forecasts was to disclose the direction in which, ideally, the Committee would like to steer the economy.

Now all that remained was to announce the new system. In mid-September Tim Geithner—ever the pragmatist—had urged me to consider postponing the launch of the new framework until my semiannual testimony before Congress in February. He argued that a period of financial fragility wasn’t the best time to introduce a new monetary policy regime, and that the staff shouldn’t be distracted from crisis fighting. And, he said, there was “a real risk this will get lost in the noise of other stuff.” After some thought, I decided that the fall of 2007 was as good a time as any.

Our announcement options narrowed when Greg Ip published a story containing the gist of our plan in the Wall Street Journal on October 25. I decided that we would announce on November 14, and that I would follow our press release with a speech the same morning to the Cato Institute, a libertarian think tank.

Before we announced, we needed to touch base with Barney Frank and Chris Dodd, the chairs of our oversight committees. I believe strongly in central bank independence when it comes to the implementation of monetary policy, but the proposed changes had implications for the goals Congress had established by law. Consultation was entirely appropriate. I called Barney myself. Laricke Blanchard, then head of our legislative affairs office, reached out to an economist on the staff of Dodd’s committee. Barney was concerned that any step toward an inflation target would downgrade the Fed’s employment objective. But he at least provisionally accepted my argument that the changes were aimed primarily at achieving greater clarity. With those boxes checked, I proceeded to lay out my case for greater openness in monetary policy at the Cato Institute.

The new communications practices for monetary policy played to generally favorable reviews in the

newspapers and among economists, but, as Tim Geithner had predicted, it soon was “lost in the noise of

other stuff.”

CHAPTER 9

The End of the Beginning

The markets continued their roller-coaster ride through November as investors tried to assess the worsening crisis. Much of their concern focused on major financial companies. Sharp declines in the prices of mortgage-related securities and other credit products continued, forcing many firms to report large write-downs. Meanwhile, funding costs continued to rise in both the United States and Europe.

The losses were large. Citigroup revealed on November 4 that it was preparing to write down its subprime-related holdings by $8 billion to $11 billion. It also said that its chief executive, Chuck Prince, had “elected to retire.” Prince had in 2003 succeeded Sanford Weill, who in 1998 had reinvented Citi as a financial services supermarket by merging the insurance conglomerate Travelers Group Inc. with the bank holding company Citicorp. Prince was the second CEO of a financial behemoth, after Merrill’s O’Neal, to fall to the crisis. In light of the size of the losses, he said that “the only honorable course” was to step down. Just four months before his ouster, in an interview with a Financial Times reporter in Japan, Prince had uttered words that would become emblematic of his industry’s complacency on the eve of the crisis: “When the music stops . . . things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

As would become clear over the next few months, Citi had compounded its problems by conducting a substantial portion of its operations through separately incorporated off-balance-sheet entitles called structured investment vehicles (SIVs), which collectively accounted for more than a third of its holdings. SIVs, which Citi invented in 1988, were similar to other types of off-balance-sheet vehicles, though somewhat more conservatively structured. SIVs didn’t have much capital to absorb losses, but their funding was typically more stable than other vehicles, with less reliance on asset-backed commercial

paper and relatively greater use of longer-term debt, with maturities of up to five years. They also held a wider range of assets. Many SIVs had little or no exposure to subprime loans, and, typically, they held considerable amounts of easily sold (liquid) assets, such as Treasury securities. It’s perhaps not surprising, then, that, up until this point, SIVs had performed reasonably well. Between 2004 and 2007, the SIV sector tripled in size, and, just prior to the crisis, thirty-six SIVs held almost $400 billion in assets.

However, in the second half of 2007, SIVs started coming under pressure. Unsurprisingly, the first to run into trouble had substantial subprime holdings. But investors soon began withdrawing funds from SIVs with minimal or no subprime assets as well, an indication of just how deep investor mistrust was becoming. As their funding dried up, the SIVs had to sell assets rapidly to repay investors. By the end of November 2007 SIVs had liquidated 23 percent of their portfolios, on average. Over the following year, virtually every SIV would default, be restructured, or be taken back on its sponsor’s balance sheet.

But that wasn’t the end of the story. The faltering SIVs also had direct effects on banks, like Citi, that had served as their sponsors. Sponsors advised SIVs and sometimes extended backup credit lines. On paper, the sponsors recognized no potential loss exposure other than through the credit line. Indeed, SIVs and other off-balance-sheet vehicles appealed to banks because the supposed reduction in loss exposure meant the banks could hold less capital against SIV assets. However, the sponsoring banks (and their regulators) hadn’t counted on “reputational risk.” As outside funding became unavailable and SIVs threatened to collapse, sponsoring banks found that it wasn’t so easy to separate their reputations from those of their progeny. In many cases, the sponsors scrambled to prop up their SIVs, for fear that the collapse of those vehicles would hurt the parent bank’s public image and reputation with investors. But propping up off-balance-sheet vehicles meant taking responsibility for their losses.

On November 5, the day after Citi announced its write-downs, Fitch Ratings said it was reviewing the financial strength of the so-called monoline insurers. These nine U.S. firms, including MBIA Inc., Ambac Financial Group, and Financial Guarantee Insurance Company (FGIC), were little known outside the industry but played an important role. They insured bonds and other securities, paying off policyholders in the event of a default; they were called “monolines” because this was essentially their only business. Their traditional business had been insuring corporate and municipal bonds, but over time they had expanded to offering insurance on securities backed by mortgages and other types of credit. Just as a property insurer suffers losses when a major earthquake or hurricane destroys thousands of properties, the monolines experienced large losses due to losses on subprime and other securities. That is what had prompted Fitch’s review.

If the ratings companies took away the monolines’ triple-A ratings, as seemed likely, it would affect not only the insurers. Firms that had purchased insurance from the companies would have to recognize the reduced value of that insurance by writing down the values of insured securities on their own books. Here was another familiar feature of classic financial panics: contagion. Weak firms infect other firms that have

lent to them or that rely on them for guarantees or other forms of support. Trouble in the monolines consequently led to sharp drops in the stock prices of many financial firms.

A few days after the Fitch announcement, Boston Fed president Eric Rosengren reported several conversations with hedge fund managers. They were particularly concerned about the potential effect of monoline downgrades on the municipal bond market, which had so far been relatively untouched by the crisis. Of the $2.5 trillion in securities insured by the monolines, about $1.5 trillion were municipal bonds, used to finance the construction of schools, roads, and bridges. Even with no change in the financial conditions of the issuing states and cities, municipal bond ratings could slip if the ratings of the monolines were downgraded.

Morgan Stanley, the white-shoe investment banking firm and an inheritor of the legacy of financier J.P. Morgan, added to the prevailing gloom with an announcement on November 7 that it, too, would write down its subprime holdings—by $3.7 billion. It would more than double that figure, to $9.4 billion, in a subsequent announcement on December 19. Wachovia and other large firms followed with more losses and write-downs.

On a positive note, many firms raised capital, much of it from abroad, which at least partially filled the holes in their balance sheets. In October, Bear Stearns had initiated a partnership with the state-owned CITIC Securities Co. of China. Citigroup in November raised capital from the Abu Dhabi Investment Authority. In December, Morgan Stanley would tap the Chinese sovereign wealth fund, and Merrill Lynch a Singapore government investment company. These and other foreign government investments in U.S. financial firms drew scrutiny from Congress. Lawmakers should have been pleased that capital had arrived to strengthen the wobbly American financial system. Instead, they worried about foreign influence on U.S. institutions. Yet for the most part these investments were passive and left control of business decisions to the existing shareholders and management.

Despite the occasional pieces of good news, including a strong jobs report for October, the economic outlook deteriorated in the weeks following the October 30–31 FOMC meeting. Funding pressures rose sharply midmonth and the stock market slid about 8 percent in the three weeks following the meeting. More important, the Main Street economy was increasingly feeling the effects of the financial disruptions. Home construction continued its steep descent as mortgage credit tightened, foreclosures spread, and house prices fell. Household spending weakened in the face of falling income and confidence, as well as high oil prices. The reasonably good pace of economic growth that we had seen for most of the year was clearly not going to continue.

By mid-November, markets began to assume that the FOMC would soon cut interest rates again. But a press interview by Bill Poole, the president of the St. Louis Fed, and a speech by Board member Randy Kroszner, both voting members of the Committee, caused them to reassess, at least temporarily. Poole, who had joined the majority in voting for rate cuts in September and October, told Dow Jones Newswires on November 15 that he saw the economic risks as roughly balanced between higher inflation and weaker

growth (as the Committee’s October 31 statement had suggested), and that it would take new information to change his mind. Randy, in a speech the next day in New York, agreed.

It seemed to me that Bill had intended to send the signal he sent, while Randy’s message was probably inadvertent. Randy had followed a long-standing practice of FOMC members who want to avoid sending market signals by paraphrasing the October 31 statement, the most recent Committee pronouncement on the outlook for the economy and monetary policy. But financial and economic conditions were changing rapidly, and it now seemed likely that the FOMC had not yet done enough to offset the housing decline and the credit crunch. Moreover, Randy, unlike Bill, was seen as a centrist rather than as a committed hawk or dove. Fed watchers read his remarks as offering more information about the views of the FOMC as a whole.

I had consciously taken a democratic approach in leading the FOMC. I wanted people to understand that a wide range of views and perspectives were being taken into account as we made important policy choices. I saw the public airing of differences among FOMC participants as generally helpful, despite complaints that free speech sometimes created cacophony. But I also knew that a decisive and clear message would be needed at times. With uncertainty about the economic outlook and our strategy for monetary policy high, this was one of those times. I was in Cape Town, South Africa, the weekend of November 16–18, attending a meeting of the Group of 20 (G-20), a forum for the central bank governors and finance ministers of nineteen countries and the European Union. On Monday, the nineteenth, at 2:43 a.m. Washington time, the BlackBerrys of the directors of the Board’s three economic divisions buzzed with an incoming email from me: “I think it would be good to give the market more guidance about our thinking leading up to the Dec FOMC.” My plan was to use a speech scheduled for November 29 in Charlotte. Don Kohn had a scheduled speech in New York the day before and could reinforce the message.

Our guidance was this: Financial stresses had materially weakened the outlook for the economy and we were prepared to respond. Don answered Fed critics who saw our interest rate cuts as rescuing the Wall Street firms and big banks from their poor judgment. “We should not hold the economy hostage to teach a small segment of the population a lesson,” he said. In my remarks, I acknowledged that the economic outlook had been “importantly affected over the past month by renewed turbulence in financial markets” and that we would “take full account” of both incoming economic data and ongoing financial developments.

Markets received our message loud and clear, with the Dow surging more than 400 points from the day before Don spoke to the day after I spoke. We looked at the stock market not because we wanted to move it by a particular amount, but because its reaction was a good measure of whether or not our policy message had been understood.

The clarity of our message collided, however, with the opaque economic outlook. Markets scaled back rate-cut hopes generated by Don’s and my speeches after the release of a relatively positive

employment report on December 7, the Friday before the meeting. Employers had added 94,000 jobs in November and the unemployment rate was steady at 4.7 percent. Whatever the ill effects of financial turmoil, it was still not fully evident in the job market, whose health had a much more direct effect on most Americans than volatility on Wall Street.

Notwithstanding the seemingly benign jobs situation, the Board’s economists told the FOMC at the December 11 meeting that they had marked down their growth forecast for 2008 to a sluggish 1.3 percent. And Dave Stockton acknowledged that even this gloomier forecast could prove too optimistic because it showed the economy avoiding a recession. He joked that he was trying not to take personally a recent HR office decision to increase the frequency of staff drug tests: “I can assure you . . . we came up with this projection unimpaired and on nothing stronger than many late nights of diet Pepsi and vending-machine Twinkies.” Whether or not the staff was operating under the influence, it turned out to be the wrong call. A year later, with the substantial benefit of hindsight, the National Bureau of Economic Research would declare that what we now call the Great Recession had begun in December 2007.

Given what we knew, we moved cautiously. The FOMC voted 9–1 in December to cut the target for the federal funds rate by only a quarter point, to 4-1/4 percent. We deleted the balanced risks language from our statement, which had created the impression that we were done with rate cutting, but we avoided any new language that might seem to promise additional cuts. This time the dissenter was a dove—Eric Rosengren. He had argued for a half-point cut, along with Board member Rick Mishkin. Rick also had been inclined to dissent, but, at my request, he did not. I thought that a strong vote for the Committee’s action would avoid sending mixed messages to fragile markets. However, with my support, Rick would soon speak publicly about the dangers posed to the economy by continued financial stress.

I had been torn about the rate decision. In the end I asked the Committee to approve a quarter-point reduction because I was concerned that a half point would be viewed as a lurch and a signal of greater worry about the economy. “I am quite conflicted about it, and I think there is a good chance that we may have to move further at subsequent meetings,” I said.

On a second front, we dusted off and implemented the plans we had shelved in September to auction discount window credit to banks and for central bank swap lines. In the process, we created the first of many crisis-related acronyms—TAF, for Term Auction Facility (the word “term” referring to the fact that loans would be for terms longer than overnight). We started relatively small, by central banking standards. We planned two $20 billion auctions of discount window loans of approximately one-month maturities. We said we’d conduct two more auctions, of unspecified size, in January—and then see if we wanted to continue. To relieve pressure in dollar funding markets in Europe, we established temporary currency swap lines, for six months, with draws limited to $20 billion by the European Central Bank and $4 billion by the Swiss National Bank.

With both the TAF and the currency swaps in place, we were entering what Don Kohn, an avid sailor, called uncharted waters. We were acutely aware of the risks of failure. TAF auctions were, by design,

intended to overcome the stigma of borrowing from the Fed. But what if stigma, which had kept banks away from the discount window, attached to the auctions, too? We also recognized that providing short-term loans to banks, while reducing funding pressures, would not erase subprime mortgage losses. (We hoped, though, that by reducing the need for stressed institutions to sell their assets, we might slow the price declines in mortgage-backed and other securities.) Similarly, we worried that our first tentative step on the swap lines might not be big enough to significantly reduce the strains in Europe. “This may not work. I don’t want to oversell it,” I told the FOMC. “If we do it, we are just going to have to give it a try and see what happens.”

WE THOUGHT THAT our actions at the December 11 meeting would be roughly in sync with investor expectations. The market reaction quickly told us otherwise; by the end of the day the Dow Jones industrial average had fallen 294 points. Apparently, some in the markets had hoped for a larger rate cut, and many expected a stronger hint in our statement that more rate cuts were in train. “There is a growing sense the Fed doesn’t get it,” said David Greenlaw, an economist at Morgan Stanley, which had already begun forecasting a recession.

Much of the negative reaction resulted from a communications misstep. After the FOMC meeting, we didn’t immediately announce our new currency swap lines or the creation of the TAF, even though reporters had been speculating since early December about the possibility of some action aimed at money market functioning. Inferring that no announcement meant no new actions, market participants grew even more concerned that the Fed wasn’t being proactive enough.

We had agreed to delay announcing the new programs until the following morning because we wanted to coordinate with six other central banks that would be issuing statements. The ECB and the Swiss National Bank, our partners in the swap lines, were planning to announce they would provide banks in their jurisdictions with dollar funding, while the Bank of England and the Bank of Canada would announce new steps to provide liquidity in their own currencies. The central banks of Sweden and Japan took no action but planned to express their support. I thought coordinating our statements would provide greater clarity to markets and potentially boost global confidence.

The logistical decision had a subtext, however. ECB president Jean-Claude Trichet wanted the TAF and swaps announcements out at the same time to foster the impression that the swap lines were part of a solution to a U.S. problem, rather than an instance of the Fed helping out Europe. His goal was to avoid highlighting the dollar-funding difficulties faced by European banks. A career French civil servant, educated in elite schools and a former governor of the French central bank, Trichet was gentlemanly, diplomatic, and always attentive to public messaging. Beneath his sometimes grandfatherly demeanor, however, he also had considerable skills as a political infighter and was an excellent judge of market psychology.

I had some sympathy for Jean-Claude’s concerns. The subprime mortgage securities at the heart of the

financial crisis had originated in the United States. But, in truth, the turmoil in dollar funding markets was his problem, too. As it turned out, not only did the $24 billion initially distributed through the swaps go to Europe, all but about $3 billion of the $40 billion distributed in the first two TAF auctions went to European and other foreign institutions operating in the United States, with German banks leading the way. Foreign bank branches in the United States aren’t eligible for U.S. deposit insurance and thus couldn’t rely—as did U.S. banks—on a stable funding base of deposits. By law, however, our discount window is open to all banks operating in the United States. That makes sense because U.S. businesses and households rely on loans from both foreign and domestic banks. A liquidity crunch at the U.S. operations of a foreign bank would hurt their U.S. customers.

SHORTLY AFTER THE December FOMC meeting, I began brainstorming with Don Kohn, Tim Geithner, Kevin Warsh, and Michelle Smith about how we could avoid seesawing market expectations in the run-up to meetings. At one point we discussed whether I should hold regular news conferences. News conferences are routine in Washington—and routine for many other central banks. But they would be a big step for the Fed. Paul Volcker had called one, on October 6, 1979, a Saturday, to announce his anti-inflation campaign. But that was considered extraordinary.

I already was painfully aware that the Fed chairman’s remarks can easily be misunderstood or overinterpreted. And I knew that if we began holding regular news conferences, there would be no going back. Nevertheless, I was eager to explore the idea. Don suggested a slow start, with twice-a-year news conferences in April and October that would complement my monetary policy testimonies in February and July. I also raised the heretical idea, at least for the Fed, of doing on-the-record newspaper interviews every other month. I knew that the ECB president granted regular media interviews, rotating by country around the currency zone. Caution prevailed that weekend. We agreed on nothing more than that Don, Tim, and I should continue to try to shape markets’ policy expectations through more strategic timing of our speeches.

THE WEEK AFTER the FOMC meeting, we turned our attention to a promise I had made early in my tenure as chairman—strengthening regulations protecting mortgage borrowers. Though most mortgages were made by institutions supervised by other federal agencies or the states, the Fed’s rules applied to all lenders.

With a few exceptions, the Fed had resisted spelling out the acts and practices it deemed “unfair and deceptive” under HOEPA, the Home Ownership and Equity Protection Act, preferring a “case-by-case” approach. Many at the Fed had believed that blanket prohibitions of certain practices could have unintended consequences, inadvertently making legitimate loans illegal or at least difficult to obtain.

By late 2007, however, it was clear that some practices had to be banned, unintended consequences or not. On December 18, the Board proposed a rule prohibiting lenders from making loans without considering borrowers’ ability to repay and requiring lenders to verify borrowers’ incomes and assets.

These bits of common sense had been discarded in the frenzy of the housing boom, and in a system in which loan originators could effectively pass any problems on to the unwitting purchasers of mortgage-backed securities. We also proposed limits on penalties imposed on borrowers who prepaid their mortgages.

The rule-writing process, with its rounds of public comment, could be maddeningly slow. We had launched our effort to rewrite our HOEPA rules with hearings conducted by Randy Kroszner over the summer of 2006. We would not propose new rules until December 2007, however, and final rules were not adopted until July 2008. The final rules in turn would not be fully implemented by the industry and the supervisors until October 2009. By that point, of course, subprime lending had already virtually ended.

The Board meeting to propose the new HOEPA rules also represented a modest step forward in openness. For the first time, television cameras recorded the entire meeting. Before then, public Board meetings had essentially been print media–only affairs, with broadcasters permitted to film, without sound, for only the first few minutes.

ANNA AND I spent the holidays in Washington, taking time off when we could. On the Friday before Christmas, we lunched with the security agents who protected us, an annual tradition. With twenty-four-hour-a-day security, we spent a great deal of time with Bob Agnew, his deputy, Ed Macomber, and the other agents, and we considered them friends. Anna would often surprise me with facts that she had learned about agents’ families or their backgrounds that they would never share with me. From the time that I cut my thumb in the kitchen to the time I was accosted by a self-described independent journalist wielding a video camera at an awards dinner of the United States–Mexico Chamber of Commerce in May 2011, the team was always there to help. In April 2008, six hundred demonstrators from National People’s Action, a network of grassroots organizations advocating racial and economic justice, arrived in a caravan of buses and protested in front of our home. The agent on duty, Charles Briscoe, stood alone, blocking our front door. After twenty minutes or so he persuaded the protesters to leave. The police were never called.

From various holiday destinations (Tim and his family were in Bali, Don was visiting family in Seattle), the crisis management team kept in touch through conference calls and by email. On the afternoon of December 31, I poured out my worry and frustration to Don and Tim in a long email. “I have become increasingly concerned that our policy rate is too high . . . with very little insurance for what are, to my mind, some large and growing downside risks,” I wrote. Market players had been criticizing us for “being too indecisive and too slow to respond to the gathering storm.” Politicians, I predicted, would soon join them. “Part of this game is confidence, and looking clueless and uncertain doesn’t help.”

I had found it difficult to choose, at the December meeting, between a quarter-point and a half-point rate cut. Now I knew we needed to do more. A December 28 report had shown an unexpectedly sharp 9 percent drop in sales of new houses in November, to a twelve-year low. The housing collapse and credit

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