Federal Reserve documents 8 page

In December 2001, the year before I joined the Board, the Fed expanded the definition of a high-cost loan by the maximum extent permitted by law, thereby extending HOEPA protections to more loans. This change, prompted by a series of hearings held by the Fed on predatory lending, increased the share of subprime first mortgages covered by HOEPA from about 12 percent to about 26 percent.

Before the crisis, a controversy sprang up over a provision in HOEPA that authorized the Fed to prohibit practices it found to be “unfair or deceptive.” Crucially, this provision applied to all mortgages, not just high-cost loans. In essence, this part of HOEPA gave the Fed a blank check to ban any mortgage practice it thought unfair—although, again, not the authority to enforce the ban, which fell to the federal or state supervisor of each lender. In 2001, in addition to extending high-cost protections to more loans, the Fed had banned three specific practices it deemed unfair or deceptive, the most important being loan flipping. It did not, however, ban other dubious practices, such as making loans without adequately verifying the borrower’s income or ability to repay.

In part, the Fed’s reluctance to impose blanket prohibitions grew out of the strong distinction that bank regulators, consumer advocates, and politicians made between subprime lending and predatory lending. In contrast to predatory lending, which was universally condemned, with good reason, the increase in lending to borrowers with blemished credit histories was widely extolled. Ned Gramlich, in praising the Fed’s expansion of HOEPA protections in 2001, said: “We tried to make our amendments narrow and selective so as not to impede the general growth of the legitimate subprime mortgage market.”

Why the support for subprime lending? Historically, lenders had often denied low-income and minority borrowers access to credit. Some lenders redlined whole neighborhoods, automatically turning down mortgage applications from anyone who lived in them. To fight redlining, Congress in 1977 passed the Community Reinvestment Act, which requires bank regulators to encourage banks and savings and loans to serve the entire community where they do business. The law provided some impetus to lend in lower-income or minority neighborhoods, but for various reasons subprime lending ultimately became economically attractive even to lenders, such as independent mortgage companies, not subject to the law.

For example, the elimination of usury laws allowed lenders to charge risky borrowers higher interest rates. And, improvements in information technology, combined with the development of standardized credit scores (which summarized complicated credit histories into a single number), facilitated cheap automated lending decisions.

Subprime lending was widely seen as the antidote to redlining—and thus a key part of the democratization of credit. It helped push the U.S. homeownership rate to a record 69 percent by 2005, up from 64 percent a decade earlier. Many of the new homeowners were African Americans and Hispanics, and people with low incomes. As suggested by Ned Gramlich in 2001, federal bank supervisors, including the Fed, tried to avoid interfering with the “legitimate” subprime market—even after the shoddy practices employed in much subprime lending became evident.

Beyond the concerns about inhibiting subprime lending, as distinguished from predatory lending, Greenspan and senior Fed attorneys were reluctant as a matter of principle to aggressively use the HOEPA “unfair or deceptive” authority in a broad-brush way. In public remarks and letters to Congress before and immediately after I joined the Board, Greenspan worried that banning certain categories of practices, which by definition did not take into account the particular circumstances of each mortgage transaction, could have unintended consequences. Instead, the Fed would make case-by-case determinations of whether practices were “unfair or deceptive” as examiners looked at each bank. It could also be claimed, with some justification, that the HOEPA authority did not extend to poor underwriting practices (such as the failure to document income), which were undesirable but not necessarily predatory in intent.

I don’t recall that the issue of how to use the unfair-or-deceptive authority was ever formally discussed during my time as a governor, but I was aware of the “case-by-case” approach and did not object. It seemed logical to me that categorical bans could have unintended results. For example, if we had used our unfair-and-deceptive authority to impose strict requirements for documenting borrowers’ capacity to repay, then community bankers’ ability to make “character loans” based on their personal knowledge of borrowers might be eliminated. That could squeeze out potentially creditworthy borrowers and further erode the competitiveness of community banks. The Fed also took the position that the case-by-case approach would in time provide the information necessary to decide whether categorical bans of certain unfair practices were warranted.

Whatever the validity of these arguments in the abstract, in practice we used our unfair-or-deceptive authority infrequently, and we failed to stop some questionable practices. The hole in our logic was that, as lending standards deteriorated, the exception became the rule. To preserve the ability of bankers to make character loans, for example, the Fed did not ban low-documentation loans. But then, many lenders failed to get adequate documentation even for borrowers they did not know. Similarly, we didn’t categorically ban certain types of exotic mortgages, such as those requiring payment of interest only, because they were appropriate for some borrowers. But some lenders offered those types of mortgages to

people without the financial wherewithal or sophistication to handle them. Given the bureaucratic barriers to the rapid development of effective interagency guidance, the Fed’s unfair-or-deceptive authority, although far from the ideal tool, was probably the best method then available to address unsafe mortgage lending. Early in my term as chairman, the Fed would make extensive use of the authority. Of course, by that time much of the damage had been done.

Although the HOEPA controversy turned on the Fed’s ability to write rules about mortgage lending practices, rules aren’t useful unless they are enforced. Enforcement engaged Ned Gramlich early on. He observed frequently that, because of the fragmentation of the regulatory system, the enforcement of consumer protection laws was highly uneven. Banks and savings institutions with insured deposits were regularly examined by federal regulators, including the Fed. However, many bank holding companies owned subsidiaries that were not banks or savings institutions funded by deposits—companies that made personal loans to consumers, or mortgage companies financed through Wall Street, for example. These subsidiaries were mostly overseen by state regulators, who generally had few resources, or by the Federal Trade Commission (FTC). The FTC, too, had few resources; moreover, its responsibilities extended far beyond financial matters and included enforcement of antitrust laws and investigations of scams emanating from all manner of businesses. It operated by responding to complaints and did not conduct regular examinations. Finally, lenders that were neither banks nor owned by a bank holding company were beyond the reach of federal banking regulators and were overseen, if at all, only by state regulators and the FTC.

Ned recognized that, barring congressional action, not much could be done at the federal level about independent mortgage companies and other firms not affiliated with banks or bank holding companies. His focus instead was on nonbank lenders owned by bank holding companies. In principle, the Fed, as the overseer of the umbrella bank holding company, had the right to enforce its rules on their subsidiaries, even if those subsidiaries were not banks. And indeed, in one egregious case, the Fed had intervened. In 2004, the Fed hit CitiFinancial, a subsidiary of Citigroup that offered unsecured personal and home equity loans, with a $70 million penalty and a remediation order for a range of violations.

CitiFinancial was an exception, though. The overhaul of financial regulation by Congress, which resulted in the Gramm-Leach-Bliley Act of 1999, presumed that the Fed should defer to the primary regulator of a holding company subsidiary (say, a state regulator in the case of a nonbank mortgage company) and send examiners into the subsidiary only if evidence suggested that the primary supervisor was overlooking significant problems. The purpose of this approach, dubbed “Fed lite,” was to avoid double oversight by the Fed of firms that had another regulator.

Ned believed that the Fed should routinely examine nonbank subsidiaries of holding companies for consumer protection violations, not just when obvious problems with state regulation surfaced. Three months before he died, in 2007, Ned told the Wall Street Journal that he proposed the idea privately to Chairman Greenspan around 2000. Ned said that Greenspan opposed it, “so I didn’t really pursue it.”

Green-span told the newspaper he didn’t remember the conversation with Ned but acknowledged his opposition to the idea. He said he was worried about the cost of examining large numbers of small institutions, the risk of undermining legitimate subprime lending, and the possibility that borrowers might get a false sense of security from lenders that advertised themselves as Fed-inspected.

I would hear Ned mention the enforcement issue on subsequent occasions, but to my knowledge he didn’t press it very hard, even internally. I think he, too, had mixed feelings about the rise of subprime lending. As Ned’s Subprime Mortgages: America’s Latest Boom and Bust (2007) suggests, although he saw the risks earlier than many others, he continued to see positive aspects of subprime lending as well, including the opportunity for increased homeownership. But, while not foreseeing all that would occur, Ned unquestionably did see more, and do more, than the rest of us on the Board.

Would routine exams of holding company subsidiaries by the Fed, as Ned had proposed, have made a difference? Probably yes, although the difference might not have been large, because of the Fed’s sensitivity to the distinction between predatory lending and subprime lending. The Fed, in any case, could not examine the freestanding mortgage companies. In 2007, after I became chairman, the Fed, in coordination with state and federal regulators, would examine nonbank subsidiaries of bank holding companies for compliance with consumer protection laws.

By then, as with many of the steps we and other regulators took in 2006 and after, it was too late. With inadequate oversight, greedy and unethical lenders had made hundreds of thousands of bad mortgage loans. Those loans would ultimately expose the vulnerabilities of a fragile financial system. U.S. house prices would plunge more than 30 percent from the spring of 2006 to the spring of 2009 and would not begin a sustained recovery until early 2012. The percentage of subprime mortgages seriously delinquent or in foreclosure would soar from just under 6 percent in the fall of 2005 to more than 30 percent at the end of 2009. Those mortgages had been bundled and sliced and diced into complex instruments and distributed around the world. No one really knew where the losses would surface.

* Typically, subprime borrowers had FICO (Fair Isaac and Company) scores of 620 or less, which made them ineligible for regular (prime) mortgages, unless they made significant down payments.

† In February 2015 the Swedish central bank was forced to go even further to fight deflation, by beginning purchases of government bonds and setting a negative interest rate on bank reserves.

CHAPTER 6

Rookie Season

Early in 2005 Greg Mankiw announced he was leaving his post as chairman of President Bush’s Council of Economic Advisers (CEA) to return to teaching at Harvard. Greg—whom I had known since graduate school—called and asked if I had any interest in succeeding him.

For an economist with a policy bent, being a member, let alone chairman, of the CEA is one of the most interesting jobs in Washington. Created in 1946, the council functions as the White House’s internal economic consulting firm. It consists of a chairman and two members. About two dozen additional economists, most on temporary leave from a university or from the Fed or other government agencies, make up the staff. A few recent college graduates or graduate students serve as research assistants.

The council is not usually thought of as overtly political—it exists to provide the administration with objective economic advice—but it was certainly more political than the rigorously nonpartisan Fed. It would be easy for a CEA chairman with a political tin ear to get into trouble. Mankiw himself had ignited a short-lived media controversy by speaking favorably about outsourcing jobs to other countries—“a new way of doing international trade,” he called it. I had to think about whether I would be comfortable in the job. Thus far in my short Washington career, no one at the White House seemed interested in applying any litmus tests when considering me. The screening of my political views had consisted of White House staff asking whether I was registered as a Republican voter and my exchange with Bush about the school board.

I thought of myself as a moderate Republican—liberal on social issues, more conservative on fiscal and defense, with the standard economist’s preference for relying on market forces where possible. I had read Ayn Rand, Greenspan’s guru, as a teenager, but I had never gone overboard on libertarianism. I

believed (and still do) that respect for the rights of individuals must be balanced with support for families, communities, and other institutions that promote the values of society and provide for the common good. I thought that I would fit in reasonably well with the “compassionate conservatism” but pro-market agenda of President Bush. I knew that, as in any administration, I would have to hew to White House talking points, even when I did not fully agree with them. But at the CEA I would also see firsthand the sausage-making of economic policy, as idealized economic analyses met the rough-and-tumble of Washington politics. And, with the president having just been reelected, I could expect to be involved in new policy initiatives.

With both kids now away at college (Alyssa was attending St. John’s College in Annapolis), Anna was ready for a change of scene. We had bought a town house a dozen blocks east of the Capitol. Anna had received an offer to teach Spanish at the National Cathedral School, a private girls’ school in northwest Washington. Taking the new position in the third and final year of my leave from Princeton also meant that I would have to resign my tenured professorship. In terms of job security, I was moving in exactly the wrong direction: from a job with lifetime tenure, to a job as Federal Reserve governor that carried a fourteen-year term, to the Council of Economic Advisers, where I served at the pleasure of the president. But I was eager to work in the White House.

Once nominated, I stopped attending FOMC meetings to avoid any appearance of administration influence on monetary policy decisions. The March 2005 meeting, at which we raised the federal funds rate target to 2-3/4 percent, was my last as a governor. I appeared before the Senate Banking Committee on May 25 and was confirmed by the full Senate on June 21. Between Mankiw’s departure and my confirmation, Harvey Rosen—a friend and Princeton colleague who had been a member of the council under Mankiw—served as chairman. Harvey, a quiet academic, seemed well liked in the White House. I took this as a good omen. Harvey introduced his wife and two adult children at his going-away party. “Pollsters say that only one out of four Jews vote Republican,” he said. “My family is a perfect microcosm of that finding.” Deputy Chief of Staff Karl Rove cracked up.

Both member positions on the council needed to be filled. Working with CEA’s chief of staff, Gary Blank, I found two strong candidates: Katherine Baicker, a Harvard-trained rising star in health economics; and Matt Slaughter of Dartmouth College, a versatile economist who specialized in trade and globalization. We also recruited economists from academia and government to serve as visiting staff. Fortunately, permanent staff members provided continuity. This included Steve Braun, a former Fed staffer who single-handedly produced the council’s macroeconomic forecasts.

For years the council had been housed at the Eisenhower Executive Office Building next to the White House. A grand nineteenth-century building in the French Empire style, it had once housed the State, War, and Navy departments. My high-ceilinged office directly overlooked the entrance to the West Wing.

Unfortunately, extensive renovations to the building had forced most of my staff to relocate to a prosaic office building a block away. I wanted to be close to the West Wing and also in close touch with my staff,

so I found myself frequently walking between the White House complex and our temporary headquarters. The council is a remarkably flat organization, with everyone working collaboratively regardless of

title or seniority. I sometimes coauthored policy memos with research assistants fresh out of college. The pace was much faster than at the Fed. Despite our limited resources we covered a wide range of issues, including topics that were only partly economic, like immigration or climate change. We prided ourselves on writing thoughtful and well-referenced memos in a few hours. We also monitored economic data and news and provided daily updates to the White House. I reviewed everything that we sent to the West Wing. I knew economic jargon would be ignored, so we worked hard to be clear. As chairman, I represented the Council at the daily 7:30 a.m. White House staff meetings, led by Chief of Staff Andy Card and Karl Rove in the Roosevelt Room. (Rove took to calling me “Doctor Data” at the meetings, but it didn’t really catch on.) Rove usually called on me to summarize economic developments, so I arrived in my office by 7:00 a.m. to review the overnight news. My staff and I frequently worked late into the evening, dining on take-out meals from a nearby Subway.

White House economic policy discussions were organized by Al Hubbard, director of the National Economic Council (NEC). The NEC was created during the Clinton administration to play a role analogous to those of the National Security Council (which handles foreign policy and military issues for the White House) and the Domestic Policy Council (which covers noneconomic domestic issues, like education). The NEC was charged with collecting economic policy views from throughout the executive branch, resolving differences, and making recommendations to the president. A gangly, energetic man with a distinctive resonant laugh, Hubbard (no relation to Glenn Hubbard) was a great policy traffic cop. A businessman rather than an economist, he was always willing to acknowledge when he didn’t know something and usually deferred to me on technical economic matters. He also made sure that the CEA had a chance to comment whenever economic issues were discussed.

I had a friendly, though not particularly close, relationship with President Bush. (I was invited once, but only once, to the Bush ranch in Crawford, Texas, where I declined an invitation to go running in hundred-degree heat.) I regularly briefed the president and vice president in the Oval Office (usually weekly), with eight or ten other senior staff in attendance. President Bush was a quick study and asked good questions, but he would not hide his impatience if the presentation was too basic or otherwise uninteresting. Sometimes he or the vice president would relay follow-up questions via Hubbard or Hubbard’s deputy, Keith Hennessey.

Morale at the White House was good. Bush was loyal to his staff, including an inner circle that went back to his days as governor of Texas, but he was also supportive to others, like me, with less history with the Bush team. He told us frequently it was a privilege to be working in the White House and we should think about that every day. He paid several surprise visits to the CEA’s offices to shake hands and talk to staff members.

Famously, Bush liked to tease. Once, when I was making a presentation in the Oval Office, the

president walked over to me and lifted my pants leg. With a professor’s finely honed sartorial sense, I was wearing tan socks with a dark suit. “You know,” he said sternly, “this is the White House, we have standards.” I replied that I had bought the socks at the Gap, four pairs for ten dollars, and wasn’t he trying to promote conservative spending habits in the administration? He nodded, deadpan, and I went on with the presentation. The next day, I attended another Oval Office meeting. When the president entered, every member of the economic team in the room—plus Vice President Cheney—was wearing tan socks. The president tried to pretend that he didn’t notice, but before long he burst out laughing. Keith Hennessey masterminded the prank.

Good morale or no, the period was difficult. Some of the president’s initiatives advanced, including several trade deals, and he negotiated a major highway spending bill with Congress. Important groundwork was laid for the eventual reform of Fannie Mae and Freddie Mac. But Bush’s proposal to add private accounts to Social Security went nowhere, as did his comprehensive immigration plans.

AFTER HURRICANE KATRINA ravaged New Orleans and the Gulf Coast in August 2005, killing more than 1,800 people, CEA economists put in long hours. Richard Newell, an energy economist now at Duke, provided us with a continuous stream of information on the conditions of refineries and pipelines and on gasoline shipments and shortages. The CEA also wrestled with the problem of developing economically sensible reconstruction plans for the city. On a C-SPAN call-in show about the administration’s plans for rebuilding New Orleans, I got carried away discussing the economic costs of the hurricane and various strategies for rescuing the local economy. The first caller commented: “You know, I think you’re so involved in all the numbers that you’ve forgotten the human beings involved.” It was a good lesson: Never forget the people behind the numbers.

As CEA chair, I also occasionally testified before congressional committees, delivered speeches on economic policy issues, and met with print reporters. However, the White House asked me only infrequently to appear on TV and never involved me in a political event. I’m not sure whether that was because I was an inadequate spokesperson (as the C-SPAN experience suggested) or because they knew I might be considered to succeed Greenspan and didn’t want me to appear too political.

When I did speak in public, the rapid increases in house prices proved one of the thorniest issues. I didn’t know how house prices would actually evolve so I avoided making public forecasts. I noted that at least some of the house price appreciation was the result of fundamental factors such as growing incomes and low mortgage rates. I was certainly aware, and occasionally pointed out in both internal and external discussions, that housing, like any asset, could not produce unusually high returns indefinitely. But I thought a slowdown or modest reversal of house price appreciation was more likely than a sharp decline. Nevertheless, with Steve Braun’s help, I analyzed the possible economic consequences of a substantial drop in house prices and a resulting decline in homeowners’ equity. In an Oval Office presentation, Steve and I concluded that the effects on household spending would produce a moderate recession, similar to or

perhaps somewhat deeper than the eight-month-long 2001 recession. We failed to take sufficient account of the effects of falling house prices (and the resulting mortgage delinquencies) on the stability of the financial system.

MY NOMINATION TO the CEA fueled speculation about whether I would be considered for the Fed chairmanship when Greenspan’s term ended in January 2006. The CEA had been a stepping-stone to the Fed chairmanship for Greenspan, who had served President Ford, and Arthur Burns, who had served President Eisenhower. When I was eventually named Fed chairman, Princeton economist and New York Times columnist Paul Krugman called my time at the CEA “the longest job interview in history.” But Ididn’t take the possibility seriously when I was considering the CEA job. When my Princeton colleague Alan Blinder asked about my prospects of becoming Fed chairman, I downplayed the idea, saying the probability of that happening was “maybe 5 percent.” I never politicked for the job and never discussed it with President Bush.

In his last years in office, Greenspan was considered so indispensable that during a Republican presidential primary debate in 1999 John McCain said that if the chairman died, he would prop him up in a chair, put some dark glasses on him, and keep him in office. I suspect President Bush would have reappointed Greenspan—almost eighty years old but still sharp and active—if he could have. But the law says a Federal Reserve Board member can serve no more than one complete fourteen-year term. Greenspan had originally been appointed to a partial term on the Board, then was reappointed to a full term in 1992. That meant that he would be ineligible to serve on the Board after January 2006 and thus disqualified from continuing as chairman. Alan had served more than eighteen years, four months short of breaking the record established by William McChesney Martin, who served as chair through most of the 1950s and 1960s.

The president created a committee headed by Vice President Cheney to recommend a successor to Greenspan. It included Al Hubbard, Andy Card, and White House personnel director Liza Wright. I know little about the committee’s deliberations. Journalists (and online betting sites) speculated that Marty Feldstein, Glenn Hubbard, and I were the leading contenders. Feldstein, the instructor of my introductory economics class at Harvard, had a distinguished academic career and had served as CEA chair under President Reagan. At that time he had clashed with Treasury secretary Don Regan and others in the administration when he voiced concern about the budget deficits generated by Reagan’s tax cuts. Rumor had it that the controversy, though more than twenty years in the past, would hurt Feldstein’s chances. I thought Glenn Hubbard, who after serving as CEA chairman had gone on to serve as the dean of Columbia University’s Graduate School of Business, was the favorite. He had a close relationship with the president and had helped devise Bush’s signature tax cuts. Glenn had also been active in Republican politics. My own case seemed to rest primarily on my relatively brief Fed experience and my writing and speeches on monetary and financial issues. Both Feldstein and Hubbard were known primarily for work

on fiscal policy rather than monetary policy.

In September 2005, the search committee invited me to an interview in the vice president’s office. Pretending to read the Wall Street Journal, I sat impatiently in the waiting room in the West Lobby of the White House. As visitors passed through, I remember thinking that this probably wasn’t the best way to keep the interview under the radar. I was called in about twenty minutes past the appointed time. The meeting itself took maybe a half hour. Mostly we talked about my prior experience and my qualifications. I said that if I were not chosen to be Fed chairman I would be happy to stay at the CEA as long as the president wanted me there.

Weeks passed with no word, and I became convinced that I would be staying at the CEA. When Andy Card asked me to see him for five minutes before the morning staff meeting, I figured that my hunch would be confirmed. Instead, Card asked me whether I would like to serve as chairman of the Fed. I asked for a few hours to think about it but I think it was clear to both of us that I planned to accept.

I called Anna as soon as I left Card’s office. “Oh no,” she said, in tears. “I was afraid this would happen.” Anna had a better idea than I did of the mental, emotional, and physical demands the job would make on both of us. But she would stand by me, for which I will always be grateful. Over the next eight years, a frequent conversation in our house would consist of Anna criticizing a journalist or politician who had gotten it all wrong, with me in the incongruous position of explaining why the person in question might not have been entirely wrong.

Date: 2016-04-22; view: 725