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Greenspan himself was clearly aware of potential financial risks. At the January 2004 meeting he worried openly about low interest rates on bonds issued by companies with weak credit, a signal that investors might be underestimating risks. “We are vulnerable at this stage to fairly dramatic changes in psychology,” he said. “We are seeing it in the asset-price structure. The structure is not yet at a point where ‘bubble’ is the appropriate word to describe it, but asset pricing is getting to be very aggressive.”

For my part, I argued for more systematic monitoring of threats to the financial system. At the March 2004 meeting, I said we ought to follow the lead of the Bank of England and other major central banks by publishing a quarterly or semiannual “financial stability report.” Such a report would warn investors about possible dangers and pressure us, and other regulators, to take action as needed. I acknowledged we might be tempted to paint a benign picture to avoid stirring public concern. But, I said, “financial conditions do change, and it’s our collective responsibility both to monitor those changes and to

communicate truthfully to the public what we see.”

As house prices continued to increase, the FOMC paid more attention. The FOMC heard a special staff presentation on the topic at its June 2005 meeting. I did not attend, having left the Fed by that time for a job in the White House, but I doubt that I would have been more foresighted than those who were there. Today the transcript of that meeting makes for painful reading. The staff presentation was set up as a debate. Staff economists on the pro side argued for the existence of a national housing bubble. They pointed out that house prices had risen far more quickly than rents. If you think of a house as an investment, in addition to being a place to live, then rents and house prices should rise at a similar pace. Housing was like a company whose earnings were flat but whose stock price kept rising—the hallmark of a bubble.

Taking the con side of the debate, other staff members downplayed the possibility of a bubble—or suggested that, if a bubble existed, the economic risks it posed were manageable. Rising house prices were justified, they said, by growing consumer income and confidence, relatively low mortgage rates, and local zoning restrictions that increased the value of housing in desirable locations. To the extent that any mispricing existed, historical experience suggested that it would correct slowly, perhaps through an extended period of stagnant prices. And, the staff economists argued, if housing prices did fall, interest rate cuts by the Fed could cushion the blow to the broader economy.

Most policymakers at the meeting, like most staff economists, downplayed the risks. Sue Bies again took a relatively more pessimistic view, worrying about poor lending practices such as increased reliance on adjustable-rate mortgages with low initial “teaser” rates, and “interest-only” mortgages in which borrowers did not pay down their loan principal. These practices could lead to losses at banks and other lenders, she said. But she did not see the threats to housing or banking as extraordinarily large.

Shortly before the special FOMC discussion, Greenspan had started to speak publicly about “froth”— a collection of small, local bubbles—in the housing market. The mantra of real estate agents—“location, location, location”—seemed to apply. It was easy to conceive of a housing bubble in one metro area, or even across several regions of the country. It was more difficult to imagine a nationwide boom and bust in house prices because local conditions varied. (Rating agencies assumed that combining mortgages from different parts of the country in securitized credit products would protect investors—a critical mistake.) Ultimately, the size of the housing boom and bust did vary considerably by region and by city, with the “sand states” (like Florida, Nevada, and Arizona) having much larger bubbles than, say, midwestern states. But the magnitude and geographical extent of the boom were large enough that the effects of the bust were felt nationally.

Greenspan’s froth comments were among several veiled warnings in 2005 of imbalances in both financial and housing markets. In his February Humphrey-Hawkins testimony to Congress, he said, “history cautions that people experiencing long periods of relative stability are prone to excess.” In August of the same year, at Jackson Hole, he suggested people could be paying too much for stocks,

bonds, and houses, which meant they weren’t taking adequate account of the riskiness of those assets. “History has not dealt kindly with the aftermath of protracted periods of low risk premiums,” he said. A month later, he warned that exotic forms of adjustable-rate mortgages to subprime borrowers could, in the event of what he called “widespread cooling in house prices,” expose both borrowers and lenders to significant losses. Markets, which had briefly quaked in 1996 when Greenspan mused publicly about “irrational exuberance,” shrugged off these valedictory year ruminations. House prices rose 15 percent in 2005, on top of a 16 percent increase in 2004. Meanwhile the stock and bond markets ended 2005 about where they had begun.

CLEARLY, MANY OF US at the Fed, including me, underestimated the extent of the housing bubble and the risks it posed. That raises at least two important questions. First, what can be done to avoid a similar problem in the future? Improved monitoring of the financial system and stronger financial regulation are certainly part of the answer. A second question is even more difficult: Suppose we had done a better job of identifying the housing bubble in, say, 2003 or 2004? What, if anything, should we have done? In particular, should we have leaned against the housing boom with higher interest rates? I had argued in my first speech as a Fed governor that, in most circumstances, monetary policy is not the right tool for tackling asset bubbles. That still seems right to me.

The jobless recovery and the risk of deflation that followed the 2001 recession were real and serious problems. Greenspan believed, and I agreed, that the first priorities for monetary policy should be to help the job market and to avoid slipping further toward deflation. An example of what can go wrong when a central bank focuses too much on asset prices occurred some years later. Swedish central bankers raised interest rates in 2010 and 2011 in response to concerns about rising mortgage debt and house prices, even though inflation was forecast to remain below their target and unemployment was high. As a result, the Swedish economy fell into deflation, forcing the central bank to cut rates from 2 percent to zero over the next three years—an embarrassing reversal.†

Some have argued—most prominently, Stanford economist John Taylor—that I’ve depicted the choice between achieving the Fed’s inflation and employment goals, on the one hand, and letting the air out of the housing bubble, on the other, too starkly. Taylor argues that somewhat higher interest rates during the early 2000s could have cooled the bubble while still keeping inflation on track and bringing unemployment down. He has contended that the Fed could have avoided the worst of the housing bubble by setting monetary policy in accordance with a simple rule that he developed.

Could monetary policy during the early 2000s have been easy enough to achieve our employment and inflation goals while simultaneously tight enough to significantly moderate the housing boom? It seems highly implausible. Modestly higher interest rates, as implied by Taylor’s rule, would have slowed the recovery while likely having only small effects on house prices. Research at the Fed in 2010 showed that following Taylor’s rule over 2003–2005 would have raised the initial monthly payment of a typical

borrower with an adjustable-rate mortgage by about $75. According to surveys conducted at the time, many people were expecting double-digit gains in house prices. An extra $75 doesn’t seem like enough to have significantly affected those buyers’ behavior. In any case, the Fed did begin tightening steadily in June 2004, but house prices continued to rise sharply for several more years.

Many who argue that interest rates should have been raised earlier to control house prices implicitly assume that monetary policy that was too loose caused the housing boom in the first place. But it’s easy to identify factors other than monetary policy that contributed to the boom. Robert Shiller, who correctly predicted both the dot-com stock bubble and the housing bubble, attributed the housing bubble largely to psychological factors rather than low interest rates. He noted in 2007 that house prices began to accelerate rapidly in the United States around 1998, well before the Fed’s 2001 rate cuts. Sharp increases in house prices occurred at about the same time in other countries, including in countries (like the United Kingdom) that ran more restrictive monetary policies than the United States.

Additionally, the remarkable economic stability of the latter part of the 1980s and the 1990s—a period that economists have dubbed “the Great Moderation”—likely bred complacency. The generally successful monetary policies of those decades probably contributed to the Great Moderation and thus may have contributed to the bubble psychology indirectly. But monetary policy cannot intentionally foster economic instability to guard against future complacency.

Yet another factor driving house prices was a tidal wave of foreign money that poured into the United States. These inflows—largely unrelated to our monetary policy—held down longer-term rates, including mortgage rates, while increasing the demand for mortgage-backed securities. Other countries with large inflows of foreign capital, like Spain, also experienced housing booms. When longer-term interest rates failed to rise after the Fed tightened monetary policy in 2004–2005, Greenspan called it a “conundrum.” In speeches, I tied the conundrum to what I called the “global savings glut”—more savings were available globally than there were good investments for those savings, and much of the excess foreign savings were flowing to the United States. Additional capital inflows resulted from efforts by (mostly) emerging-market countries like China to promote exports and reduce imports by keeping their currencies undervalued. To keep the value of its currency artificially low relative to the dollar, a country must stand ready to buy dollar-denominated assets, and China had purchased hundreds of billions of dollars’ worth of U.S. debt, including mortgage-backed securities.

IF MONETARY POLICY was not the right tool for addressing a possible house-price bubble, then what was? In my 2002 speech, I had said that financial regulation and supervision should be the first line of defense against asset-price bubbles and other risks to financial stability. If those more focused tools are used effectively, then monetary policy can be left free to pursue low inflation and unemployment. Unfortunately, in this instance, regulatory and supervisory tools were not used effectively, either by the Fed or by other financial regulators. Without doubt, that contributed importantly to the severity of the

crisis.

Banking regulation and supervision, broadly speaking, have two purposes: first, to ensure that banks are financially sound and, second, to protect consumers. At the Board, the Division of Banking Supervision and Regulation managed safety-and-soundness regulation and supervision. The Division of Consumer and Community Affairs focused, among other duties, on writing rules to protect consumers and examining banks for compliance with those rules. Either or both of these sets of powers could have helped address the buildup of risks in housing and mortgage markets. They did not. The question is why.

Booming house prices in the early 2000s seemed to go hand in hand with risky mortgage lending, including subprime lending, but also lending involving bad underwriting practices (no verification of borrower income, for example) or with special features (like interest-only payments) that were risky for weaker borrowers. Risky mortgage lending increased the demand for housing, pushing prices higher. At the same time, the more house prices rose, the less careful lenders became. By far the worst loans were made in 2005, as house prices were nearing their peak, and in 2006, just as prices began to reverse. Indeed, by 2006 and 2007, some borrowers were defaulting on loans after making only a few, or even no, payments.

Subprime lending was not new in the early 2000s, but its share of total mortgage lending was rising steadily. In 1994, fewer than 5 percent of new mortgages were subprime, but by 2005 subprime’s share of originations had risen to about 20 percent. Moreover, a substantial portion of subprime loans originated in the early 2000s were adjustable-rate mortgages. The interest rate on these loans initially was set low, typically for two or three years. After that, it adjusted to move in line with market rates. These teaser rates, together with very low down payments in many instances, made it possible for borrowers with poor credit to buy homes that, under ordinary circumstances, they could not afford. Both borrowers and lenders counted on borrowers being able to refinance before the interest rate on their mortgage reset higher. But refinancing was only an option so long as house prices (and thus homeowners’ equity) kept rising.

Regulators, including the Fed, were aware of these trends, but, in retrospect, we responded too slowly and cautiously. I don’t think the slow response can be attributed to ill-prepared examiners, the foot soldiers who interacted most closely with the banks. Like any large organization, the Fed had stronger and weaker employees, but the general quality of the supervisory staff was high. I also don’t think that key Fed staff were captured by the firms they regulated, in the sense that they perceived it to be in their own career or financial interest to go easy. They were, however, open to arguments that regulatory burden should not be excessive and that competitive market forces would to some extent deter poor lending practices. Maintaining the appropriate balance between bank safety, on the one hand, and the availability of credit, on the other, is never easy, and the Fed and other regulators probably tipped too far in the direction of credit availability. Stationing on-site teams of examiners at the same large banks for protracted periods could have made them too willing to accept the prevailing assumptions and biases at the institutions they supervised.

A perennial problem at the Fed was the difficulty of maintaining consistent, tough supervisory practices across the twelve Federal Reserve districts. Ultimately, the Board is responsible for bank supervision, but the Reserve Banks housed the examiners who oversaw banks day in, day out. Reserve Banks often chafed at directions from Washington, arguing that they were better informed than the Board staff about conditions in their districts. Indeed, the Reserve Bank presidents succeeded in resisting a 2005 attempt by Sue Bies to make supervision more centralized.

Although regulatory philosophy and management issues at the Fed played a role, some of the greatest barriers to effective supervision lay outside the Fed, in the broader structure of financial regulation. The U.S. financial regulatory system before the crisis was highly fragmented and full of gaps. Important parts of the financial system were inadequately overseen (if overseen at all) and, critically, no agency had responsibility for the system as a whole. The reasons for this fragmentation were both historical and political. Historically, regulatory agencies were created ad hoc in response to crises and other events— the Office of the Comptroller of the Currency during the Civil War, the Federal Reserve after the Panic of 1907, and the Federal Deposit Insurance Corporation and Securities and Exchange Commission (SEC) during the Depression. Politically, conflicts between competing power centers within government (congressional committees with overlapping jurisdictions, state versus federal regulators) and special interests, such as the banking and housing lobbies, have routinely blocked attempts to rationalize and improve the existing system.

The result was a muddle. For example, regulation of financial markets (such as the stock market and futures markets) is split between the SEC and the Commodity Futures Trading Commission, an agency created by Congress in 1974. The regulation of banks is dictated by the charter under which each bank operates. While banks chartered at the federal level, so-called national banks, are regulated by the OCC, banks chartered by state authorities are overseen by state regulators. State-chartered banks that choose to be members of the Federal Reserve System (called state member banks) are also supervised by the Federal Reserve, with the FDIC examining other state-chartered banks. And the Fed oversees bank holding companies—companies that own banks and possibly other types of financial firms—independent of whether the owned banks are state-chartered or nationally chartered. Before the crisis, still another agency, the Office of Thrift Supervision (OTS), regulated savings institutions and the companies that owned savings associations. And the National Credit Union Association oversees credit unions.

Institutions were able to change regulators by changing their charters, which created an incentive for regulators to be less strict so as not to lose their regulatory “clients”—and the exam fees they paid. For example, in March 2007, the subprime lender Countrywide Financial, by switching the charter of the depository institution it owned, replaced the Fed as its principal supervisor with the OTS, after the OTS promised to be “less antagonistic.” The OCC at times actively sought to induce banks to switch to a national bank charter. Both the OCC and the OTS benefited the institutions they regulated by asserting that the institutions were exempt from most state and local laws and regulations.

This fragmentation of financial regulation often limited the ability of federal regulators to monitor system-wide developments. For example, in 2005, only about 20 percent of all subprime mortgages were made by banks and savings institutions under federal supervision. Another 30 percent of subprime loans were made by nonbank subsidiaries of federally regulated institutions. The remaining 50 percent of loans were originated by independent mortgage companies chartered and supervised only by the states. A few states—Massachusetts and North Carolina are often cited—did a good job in overseeing nonbank mortgage lending. Lacking resources and political support, most did not.

Even the regulatory oversight of mortgage securitization was split among agencies. The Office of Federal Housing Enterprise Oversight (OFHEO) regulated the government-sponsored companies that securitized mortgages (Fannie Mae and Freddie Mac), while the SEC oversaw the Wall Street investment banking firms that also created various securities backed by mortgages (known as private-label securitization). Like the Indian folktale of the blind men and the elephant, each regulator was aware of only part of the problem, and some parts were not examined at all.

It didn’t help that many financial institutions, in their rush to embrace profitable new products and markets, did a poor job of measuring and managing the risks they were taking on. A spate of mergers among financial institutions, each with its own information system, exacerbated the difficulty. Large banks, it turned out, were exposed to the risk of mortgage defaults not only through the mortgages on their balance sheets but through many other channels, including through securitized assets they held or guaranteed. The systems that firms used to measure their exposures could not keep up with the rapid changes in the holdings of various subsidiaries, the many channels of risk exposure, or the extent to which the risks interacted.

The Fed and other regulators pushed banks to improve their systems for assessing and measuring their risks. And Sue Bies, at industry forums, regularly promoted the virtues of comprehensively assessing risks for the firm as a whole, rather than looking at risks only for each separate part of the business. But, in truth, in the years just before the crisis, neither banks nor their regulators adequately understood the full extent of banks’ exposures to dicey mortgages and other risky credit. The experience of the Great Moderation had led both banks and regulators to underestimate the probability of a large economic or financial shock.

Meanwhile, constrained by bureaucratic, legal, and political barriers, regulatory agencies struggled to keep up with fast-moving changes in financial products and practices. The federal bank regulators (the Fed, the OCC, the FDIC, and the OTS) often responded to new issues by issuing official “guidance” to banks. Guidance has less legal force than regulations, but it still carries considerable weight with bank examiners. In the years before the crisis, regulators issued guidance on subprime lending (1999 and 2001), low-down-payment real estate lending (1999), real-estate appraisal practices (2003 and 2005), predatory (abusive) lending (2004 and 2005), and lending against home equity (2005). The federal agencies also proposed in 2005, and finalized in 2006, guidance on the “nontraditional” features (like the

option to skip payments) that had become prevalent in subprime mortgages. Yet most of the guidance and rules weren’t tough enough or timely enough.

Bureaucratic inertia, as well as legal and political impediments, slowed the issuance of guidance. When the regulatory agencies issued guidance jointly, the usual case, they had to reach agreement first within their own ranks and then across agencies. Promulgating rules, and sometimes also guidance, required an elaborate legal process that included periods for affected parties to comment and the agencies to respond. Whenever rules or guidance threatened the interests of favored groups, political pressure followed. In the summer of 2005, for example, regulatory agencies became concerned that some banks, especially smaller banks, were making and holding too many commercial real estate loans—which financed the construction of office buildings, shopping malls, apartment complexes, and housing developments. The agencies proposed guidance pushing banks to limit their risks in this area. Though an improvement over existing practices, the draft guidance wasn’t particularly strict. Janet Yellen, then president of the San Francisco Fed, whose examiners were trying to rein in commercial real estate lending in red-hot markets in the West, later derided the final version. “You could take it out and rip it up and throw it in the garbage can. It wasn’t of any use to us,” she said in 2010.

Even so, the proposed guidance drew fierce resistance from community bankers, who relied heavily on profits from commercial real estate lending. Community banks, though a small part of the banking system, have disproportionate political clout. Thousands of letters of protest poured in, and a House Financial Services subcommittee held a hearing. The regulators pushed back against the lobbyists and politicians but spent months assuring critics (and themselves) that the guidance could achieve its objectives without overly crimping smaller banks. All of the back-and-forth meant the agencies did not issue the final guidance until the end of 2006, at least a year and a half after the problem had been identified.

WHILE IT WAS trying to protect banks from themselves, the Fed also was attempting to protect consumers from banks. Sue Bies’s counterpart for consumer protection was Ned Gramlich. Ned had chaired the Board committee that oversaw the Division of Consumer and Community Affairs for four years when I arrived in 2002, and he would hold that position until he left the Board in 2005. I was a member from shortly after I arrived until the spring of 2005, with Sue Bies serving for much of that time as the third member. Humane and thoughtful, Ned felt strongly about consumer protection and was skeptical of simplistic free-market dogma. Nevertheless, despite his presence, here too regulation and supervision fell short.

Congress had tasked the Fed with writing regulations implementing many of the most important laws designed to protect financial services consumers, such as the Truth in Lending Act, which governs disclosures to borrowers. However, the responsibility for enforcing the Fed’s rules was dispersed among many federal and state agencies, overseeing various types of institutions. The Fed directly enforced its

own rules only in the state-chartered banks that had joined the Fed System (about 900 out of 7,500 commercial banks in total at the end of 2005) and at about 5,000 bank holding companies (many of which were shell companies created only to serve as an umbrella over a group of subsidiary companies).

Unfortunately, the consumer division had a relatively low status within the Board and lacked the resources of the supervisors focused on safety and soundness. Chairman Greenspan did not put a high priority on consumer protection. He distrusted what he saw as heavy-handed interventions in the financial services marketplace, although he readily supported improvements in consumer disclosures and in financial education, which he thought helped markets operate more efficiently.

My assignment to the consumer committee reflected my lack of seniority, but I didn’t object. Although I had little experience with regulation, I thought the work would be interesting and saw it as a way to help average Americans. I joined my colleagues in regular meetings with the Board’s advisory council on consumer issues and with other outside groups, and I tried to educate myself about the complex rules overseen by the Board.

Philosophically, I did not view myself as either strongly pro- or anti-regulation. As an economist, I instinctively trusted markets. Like Greenspan, in most cases I supported clear disclosures about financial products and financial education for consumers rather than banning practices outright. On the other hand, as adherents of the relatively new field of behavioral economics emphasized, I knew that psychological as well as economic factors motivate human behavior. Realistically, behavioral economists would say, people don’t have the time or energy to puzzle out all the contractual details of their mortgages. Consequently, sometimes it may be better simply to ban practices that are not in consumers’ interest. The government doesn’t allow sales of flammable children’s pajamas, for example, no matter how clear the warning label. Over time I would become more sympathetic to the behavioral view. Later, during my chairmanship, the Fed would begin routinely testing the understandability of proposed disclosures (for credit card terms, for example) with actual consumers—an obvious step but an innovation for regulators. We found it was almost impossible to write sufficiently clear disclosures for some financial products. Like flammable pajamas, some products should just be kept out of the marketplace.

DURING MY FIRST two years as chairman, in 2006 and 2007, I would hear repeatedly at congressional hearings that the Fed had been “asleep at the switch” in protecting consumers earlier in the decade. The critics often focused on our failure to use our authority, under the Home Ownership and Equity Protection Act (HOEPA), to outlaw abusive mortgage lending practices. The story of the Fed and HOEPA isn’t uplifting, but there’s more to it than has been portrayed.

HOEPA, passed by the Congress with Federal Reserve support in 1994, targeted so-called predatory lending practices used by unscrupulous companies to cheat borrowers, particularly elderly, minority, and low-income borrowers. Examples of predatory practices include bait-and-switch (borrowers receive a different type of loan than they were told to expect); equity stripping (lending to borrowers without

enough income to repay, with the intent of ultimately seizing their homes); loan flipping (racking up loans and fees by encouraging repeated refinances); and packing (charging borrowers at mortgage origination for unnecessary services).

HOEPA was based on the premise that mortgage loans with very high interest rates were more likely to be predatory. The law required additional disclosures from lenders making high-cost loans and gave the borrowers additional protections not afforded to others. For example, it limited the use of pre-payment penalties that trapped borrowers in high-cost loans by making it costly for them to refinance. It also specified that investors who purchased high-cost loans could be liable for violations, which discouraged securitization. Importantly, the law applied to mortgages made by any originator— independent mortgage companies, for example—not only those regulated by the Fed or other federal agencies.

Date: 2016-04-22; view: 772