Federal Reserve documents 10 page

Hank worked briefly in the White House during the Nixon administration but had spent almost all his career at the investment bank Goldman Sachs, the final years as CEO. One of Hank’s strengths as CEO was his interest in and knowledge of China, the world’s most important emerging market. As Treasury secretary, he would set up a semiannual Strategic Economic Dialogue with Chinese officials, which I regularly attended. Although Hank earned hundreds of millions of dollars at Goldman, I admired that he and his wife, Wendy, lived modestly, spending much of their free time bird-watching and pursuing conservationist activities. A Christian Scientist, Hank doesn’t smoke or drink.

President Bush had chosen captains of industry as his first two Treasury secretaries, but—political considerations aside—having someone with financial services experience made more sense. The work of the Treasury is overwhelmingly on financial and fiscal policy, neither of which a nonfinancial CEO would be expected to know well.

Hank and I continued the weekly Fed-Treasury breakfasts, sharing among other things an affinity for oatmeal. We hit it off well, notwithstanding the sharp differences in our backgrounds and personalities. It was academic rigor meeting street smarts, which Hank possessed in abundance.

PART II

THE CRISIS

CHAPTER 7

First Tremors, First Response

On August 15, 2007, I took a few minutes between conference calls and market updates to email my brother, Seth. Anna and I would have to cancel our planned vacation with him and other family members the following week in Myrtle Beach, South Carolina.

“You can probably guess why,” I wrote.

The beach trip was a family tradition. I hated to give it up. My parents, like many owners of small businesses, took almost no time off. Yet nearly every summer they found a free week to take me, Seth, and my sister, Sharon, to Myrtle Beach. As adults, my siblings and I had continued the practice with our parents and our own children. I had my planned beach reading picked out: The New Bill James Historical Baseball Abstract. But it wasn’t to be this year.

“Sorry to hear that. Good luck with all that’s going on,” Seth replied.

“All that’s going on” was something of an understatement. After months of uncertainty, the troubles in housing and subprime mortgage lending were now deepening into a much more serious financial threat— something with the potential to derail, or worse, what Fortune magazine had declared only a month earlier to be “the greatest economic boom ever.” The previous week, on August 9, BNP Paribas, France’s largest bank, had barred investors from withdrawing money from three of its investment funds that held securities backed by U.S. subprime mortgages. BNP Paribas said that it could not determine the value of its funds because of the “complete evaporation of liquidity” in the markets for those securities. In other words, investor distrust of subprime-backed securities was so great that potential buyers had withdrawn from the market entirely.

A wave of panicky selling in markets around the world followed. Investors were realizing that they

did not know exactly who held subprime-related securities, had little reliable information about the loans that backed those securities, and could not anticipate which financial entity might be next to deny them access to their money. Since the French bank’s announcement in Paris, key parts of the global credit markets looked as though they might seize up, with potentially grave economic consequences. A further blow occurred on August 15, the day of my email to Seth, when an analyst suggested that the largest mortgage lender in the United States, Countrywide Financial, might be facing bankruptcy. The Dow Jones industrial average fell steeply to a four-month low.

AT THAT POINT, the Fed had been working for some time to assess the causes and consequences of the subprime mortgage bust—and, more broadly, the housing slowdown. Our housing experts circulated frequent updates on the mortgage market and on home sales, prices, and construction. We viewed some cooling in what had been an overheated sector as inevitable and even desirable. But in the early months of 2007, my second year as chairman, the cooldown was beginning to appear much less benign.

Housing, as I told the Joint Economic Committee in March 2007, had entered a “substantial correction.” Mortgage delinquencies were on the rise, particularly for subprime loans with adjustable rates. And, particularly worrying, early defaults (defaults that occur shortly after a loan is made) had soared. As investors soured on mortgages, potential homeowners, especially those with weaker credit records, were finding loans increasingly difficult to get. Yet the economy as a whole continued to expand and create new jobs. Indeed, economic growth would exceed our expectations in the second and third quarters of 2007, with output expanding at close to a 4 percent rate, according to contemporaneous reports, while unemployment remained low. What was the bottom line? I offered committee members my tentative conclusion: “At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

By the time I emailed Seth in mid-August, I knew I had been quite wrong, of course. The phrase “likely to be contained” would dog me. But at the time my conclusion was widely shared within the Fed, as well as by most market participants and media commentators. We believed the housing slowdown and subprime mortgage problems would affect the economy primarily through two channels: first, by reducing jobs in construction and in industries related to housing, like home furnishings, and, second, by damping consumer spending. (Falling prices make homeowners feel less wealthy and reduce their ability to tap the equity in their homes—either by “cash-out” refinancing or through home equity loans.) The basic logic was the same as Steve Braun and I had applied in 2005 at the Council of Economic Advisers, when we estimated the effects of a housing price bust in our presentation to President Bush.

Steve’s and my presentation proved wrong because we did not take into account the possibility that losses on subprime mortgages could ultimately destabilize both the U.S. and global financial systems. Even by early 2007, that outcome seemed remote. Only about 13 percent of outstanding mortgages were subprime. And fixed-rate subprime mortgages were performing reasonably well, as were prime loans and

so-called Alt-A mortgages (mortgages with credit quality somewhere between subprime and prime). Adjustable-rate subprime mortgages, where delinquencies were climbing as introductory teaser interest rates expired, constituted only about 8 percent of all outstanding mortgages. Even if subprime mortgages defaulted at extraordinarily high rates, we calculated, the resulting financial losses would be smaller than those from a single bad day in global stock markets.

Moreover, the nation’s banks seemed ready to withstand any spillover from housing. The Federal Deposit Insurance Corporation had reported in late 2006 that continued strength in most parts of the economy was offsetting the effect on banks of the “pronounced weakness” in housing. “FDIC-insured institutions continue to ride a string of six consecutive years of record earnings,” the agency reported. “Bank capital levels remain at historic highs, while loan performance has slipped only slightly from record levels. Only one FDIC-insured financial institution has failed over the past two and a half years.” Bank stocks were also performing well, a sign of investor confidence in the industry.

The FDIC’s observation that bank capital levels remained historically high was comforting. Capital— which represents the stake of a bank’s owners, or shareholders—acts as a buffer against losses. Imagine a hypothetical bank that made $100 in mortgage loans, with $90 of the funds lent coming from deposits. The remaining $10 of needed funding was raised from the bank’s shareholders—that is, the bank’s capital. If the bank lost $5 on the mortgages, its shareholders would be hurting—their $10 stake would now be worth only $5—but the bank would still be solvent, able to pay back its depositors if they withdrew their money. If instead the bank had funded its lending with less capital, say $5, and $95 in deposits, then a loss of $5 or more on the bank’s mortgage lending would wipe out the shareholders and put the bank out of business. Ample capital accordingly implies that the banking system can withstand significant losses and continue to extend credit to households and businesses.

Seen from the vantage point of early 2007, the economy’s good performance, combined with the relatively small size of the subprime mortgage market and what appeared to be a healthy banking system, led me and others at the Fed to conclude that subprime problems—though certainly a major concern for affected communities and the housing sector generally—were unlikely to cause major economic damage. But we failed to anticipate that problems in the subprime mortgage market could trigger an old-fashioned financial panic, albeit in a new, unfamiliar guise.

THE RECURRING FINANCIAL panics in the nineteenth and early twentieth centuries often began with bank runs triggered by events that, considered alone, didn’t appear serious enough to cause a systemic crisis. The Panic of 1907, for instance, had modest origins. A group of speculators suffered a big loss after they tried, unsuccessfully, to corner the stock of the United Copper Company. The speculators were known to have close connections to New York City banks and trust companies (banklike financial institutions). Depositors had no idea whether their particular institution had financed the speculators, and in an era before federal deposit insurance, naturally they lined up to withdraw their cash. The runs spread, sparking

a nationwide financial panic that contributed to a serious recession. The ultimate economic costs of the panic far outweighed the magnitude of the trigger—a failed scheme by a handful of speculators.

Today, depositors almost never line up at tellers’ windows to take out their cash. Since 1934, the federal government has protected bank depositors against losses, up to a limit, even if their bank fails. But that didn’t mean that runs were history. As we were learning in August 2007, they now occurred in different forms.

Over the past few decades, a network of diverse nonbank financial firms and markets, dubbed the shadow banking system by economist Paul McCulley, had developed alongside the formal banking system. The shadow banking system included nonbank lenders like mortgage companies and consumer finance companies, as well as companies operating in securities markets, such as investment banks. These firms relied on short-term funding other than government-insured deposits. Commercial banks, too, increasingly supplemented their insured deposits with uninsured funding, including short-term lending between banks in the so-called interbank market.

This short-term, uninsured financing—typically provided by institutional investors, like money market funds or pension funds—is called wholesale funding, to distinguish it from the bank deposits of individuals, known as retail funding. But, like retail funding in the days before deposit insurance, wholesale funding is potentially subject to runs. Many of the complex securities that proved troublesome during the crisis were financed, directly or indirectly, by wholesale funding, mostly in the form of commercial paper or repurchase agreements.

Commercial paper—short-term debt with a typical maturity of thirty days or less—has been used by both financial and nonfinancial companies since at least the mid-1800s. Traditionally, commercial paper has been unsecured—repayment is based only on the promise of the borrower and not on collateral. Thus, only well-established, creditworthy companies could issue it. However, the years before the crisis saw a rapid expansion in the use of a new form of commercial paper—so-called asset-backed commercial paper (ABCP).

ABCP was issued by a type of shadow bank known as a conduit, also called a special-purpose vehicle. A conduit is a legal entity set up (usually by a bank or other financial institution) to hold mortgages, credit card debt, auto loans, and many other forms of credit, as well as more complex securities that combined different types of loans (so-called structured credit products). ABCP was asset-backed in the sense that, if necessary, the conduit could presumably sell off its loans and securities to repay the ABCP it had issued.

A repurchase agreement—a repo, for short—is technically a sale and repurchase of a security, but it functions as a collateralized loan, usually with short maturity, often only overnight. A firm that wants to borrow cash in the repo market offers Treasury securities, mortgage-backed securities, corporate bonds, or other financial assets as collateral. When the repo agreement comes due, the borrower (a Wall Street investment bank, say, or a hedge fund) can renew, or “roll over,” the loan with the same lender (a money

market fund, for example) or another one. If for some reason the borrower can’t pay back the loan on time, the lender is free to sell the securities.

Even though wholesale funding is not government-insured, most market participants and regulators saw it as relatively impervious to runs. Repos were considered particularly safe, because, even if the borrowing firm went bankrupt, the collateral protected the lender. But when subprime mortgages began to go bad, wholesale funding providers were forced to consider anew the riskiness of the borrowing firms and the complex and opaquely structured securities that they sometimes offered as collateral.

Many lenders had been relying on credit ratings to evaluate collateral. The ratings were issued by private firms—the best known were Standard & Poor’s (S&P), Moody’s, and Fitch—that were paid by the securities issuers. When losses started surfacing in even highly rated mortgage-related securities, lenders understandably lost faith in the ratings. Unable to evaluate the risks of complex securities on their own, they pulled back from lending against any type of security that included even a small amount of subprime or other risky mortgages. They behaved like grocery shoppers who, after hearing reports of mad cow disease, decide to avoid all beef even though only a minute fraction of cattle are affected.

When retail depositors run, they simply withdraw their money. Runs by wholesale funding providers are more complicated because, as an alternative to withdrawing their money completely, they can ask for greater protections or more favorable terms. As a first step many commercial paper lenders, for example, shortened the term for which they would lend, to as little as overnight. Repo lenders had the option of asking for more collateral per dollar lent or refusing to lend against riskier or more complex securities. As in a traditional run, however, the outcome was that shadow banking entities (including conduits) found it increasingly difficult to obtain funding. As a result, they came under growing pressure to shrink, for example, by selling assets or refusing to extend new credit.

Just as the bank runs of the Panic of 1907 amplified losses suffered by a handful of stock speculators into a national credit crisis and recession, the panic in the short-term funding markets that began in August 2007 would ultimately transform a “correction” in the subprime mortgage market into a much greater crisis in the global financial system and global economy.

ALTHOUGH THE EARTHQUAKE struck in August in the form of BNP Paribas’ announcement that it had suspended withdrawals from its subprime mortgage funds, we had felt the first significant tremors of the coming crisis in June. Two mortgage-heavy hedge funds run by Bear Stearns—the fifth-largest Wall Street investment bank—began to suffer large losses. In response, the Bear funds’ repo lenders demanded more collateral or simply refused to lend. On June 7, Bear froze redemptions by investors in the funds. Bear had no legal obligation to bail out its funds, which were in separately incorporated entities—“off-balance-sheet” vehicles. But the company was concerned about maintaining good relationships with the lenders to the funds, many of them other investment banks. So, it propped up one of the funds with a $1.6 billion loan. On July 31, both funds declared bankruptcy, and Bear lost most of what it had lent. In

addition, Bank of America had, for a fee, guaranteed some of the assets in the Bear funds. It ended up losing more than $4 billion. The travails of Bear’s hedge funds made short-term lenders wary of funding any mortgage-related investment, particularly the complex and difficult-to-evaluate structured credit products that mixed various types of mortgages and often other forms of credit.

In late July, subprime woes surfaced overseas. Rhineland, an off-balance-sheet vehicle funded by ABCP, had been created in 2002 by the German bank IKB, a midsized business lender. Rhineland’s managers had made heavy bets on U.S. mortgages, including subprime mortgages, as well as on complex securities partially backed by mortgages. Concerned about those bets, lenders refused to renew Rhineland’s commercial paper. IKB guaranteed a substantial part of Rhineland’s funding, and, as outside funders withdrew, IKB in effect became the unwilling owner of Rhineland and its bad assets, which in turn brought IKB to the brink of failure. Ultimately, with the prodding of German regulators, the German banking group that controlled IKB bailed out the bank. But the Rhineland debacle made lenders more concerned about other conduits funded by ABCP. ABCP funding would soon begin to shrink rapidly, from about $1.2 trillion at the end of July 2007 to about $800 billion by the end of the year. When conduits lost funding, their sponsors had two options (other than allowing the conduit to go bankrupt). The sponsors could sell off some of the conduits’ assets or they could themselves fund the conduits, which both exposed the sponsors to losses and increased their own funding needs.

Over the summer, we tracked the increasing strains in short-term funding markets. We were hampered because we had no authority to obtain confidential data from investment banks (like Bear Stearns), which were regulated by the Securities and Exchange Commission, or over foreign banks not operating in the United States (like IKB), or over hedge funds, which were largely unregulated. We worried that a retreat by wholesale funding providers would force more firms and investment vehicles to sell mortgage assets in “fire sales,” pushing down prices and spreading the problem to other firms holding similar assets. Unfortunately, we could see little more to do at the time other than monitor market developments. Perhaps the stresses in funding markets would recede. Perhaps they wouldn’t.

We discussed the market turbulence at the FOMC meeting on August 7. The day before, American Home Mortgage Investment Corporation, the nation’s tenth-largest mortgage lender, had been brought down by its losses on some of the more exotic forms of adjustable-rate mortgages, in which it specialized. We also noted that markets had shifted slightly toward the view that the FOMC eventually would cut interest rates to offset the risks that recent financial turmoil posed to the economy.

But, at that point, the broader economy didn’t seem to need help from lower interest rates. Job growth had been relatively steady, if unspectacular, and unemployment remained very low, at 4.4 percent. Moreover, oil prices, which had risen to a record $78 a barrel at the end of July, had pushed overall inflation to an uncomfortably high level of 5.2 percent at an annual rate over the April–June period. Even the doves on the Committee had to worry at least a bit that stimulating faster growth with rate cuts could generate higher inflation. Some FOMC members, I knew, continued to believe we had made a mistake a

year earlier when, at my urging, we had halted a two-year series of inflation-damping interest rate increases.

We voted unanimously to hold the federal funds rate target at the past year’s level of 5-1/4 percent, but our postmeeting statement reflected our competing worries. We acknowledged that recent market volatility had increased the risks to economic growth. But we repeated that inflation remained our “predominant” policy concern. The sharpest debate at the meeting turned on the seemingly narrow point of whether or not to keep the word “predominant” in the statement. Several around the boardroom table— including New York Fed president Tim Geithner and San Francisco Fed president Janet Yellen—argued for deleting the word, a step that would have caused markets to increase the odds of an interest rate cut later in the year. Most of the remaining members feared that removing “predominant” would signal insufficient concern about inflation. Some worried about appearing to overreact to what so far had been relatively modest market turmoil. I believed that the majority of the FOMC members still were more concerned about inflation than risks to economic growth, and so I supported retaining “predominant” as better reflecting the sense of the Committee. The reality that small changes in the phrasing of the FOMC’s statement could have important effects on policy expectations sometimes led us to spend what seemed like an inordinate amount of time on the choice of a single word.

ON THURSDAY, AUGUST 9, the sun had been up for nearly two hours and the temperature was already in the mid-80s when I stepped outside my home shortly after 7:00 a.m. I climbed into the rear of a chauffeured black SUV for the fifteen-minute ride to the office. Hank Paulson and I were scheduled to share breakfast in my private dining room.

The BNP Paribas announcement had come earlier that morning. Almost as worrisome as the suspension of withdrawals from its subprime funds was the bank’s judgment that the troubled assets in its funds could not be fairly valued. A Catch-22 was developing: Investors were unwilling to buy securities they knew little about. But without market trading, there was no means to determine what the securities were worth. I received sketchy information and an early indication of market conditions from staff emails as I prepared to meet Paulson. It was already late in the trading day in Europe, where markets had reacted very badly to the BNP Paribas announcement, with interest rates on short-term bank borrowings spiking and stock prices falling. American markets, for the most part, were not yet open, but the available information implied that we were in for a bad day.

The European Central Bank had already taken steps to try to counter the tumult. Ironically, the problems with U.S. subprime mortgages were being felt more strongly in Europe than in the United States, although we knew the market distress could easily cross the Atlantic. Markets had ultimately absorbed the July announcement of IKB’s subprime woes. But, unlike the regional IKB, BNP Paribas was a global player. If it was infected by the subprime virus, who else was? And how fairly valued were other types of asset-backed securities? Securitization was supposed to disperse risk by packaging thousands of loans

into securities, which could then be further sliced into segments and sold around the world. Increasingly, however, it was instead seen as an agent of global contagion.

As distrust grew, banks hoarded cash and lent to each other only reluctantly, causing the federal funds rate, the rate at which banks lend to each other overnight, to rise above the 5-1/4 percent target the FOMC had affirmed two days earlier. Increased demand for dollars from foreign banks added to the stress. At breakfast, Hank and I discussed developments in Europe and agreed to keep in close touch. That morning, I emailed Brian Madigan, who had succeeded Vince Reinhart as head of the Board’s Division of Monetary Affairs, to instruct the New York Fed to buy large quantities of Treasury securities on the open market. The cash that the sellers of the securities received from us would end up in banks, meeting the banks’ increased demand for cash. If banks had less need to borrow, the federal funds rate should move back to target and the pressures in short-term funding markets should ease. If all went well, we could withdraw the cash from the system in a day or two.

Walter Bagehot’s lender-of-last-resort concept argues that central banks should stand ready during a panic to lend as needed, which in turn should help stabilize financial institutions and markets. Later that morning, consistent with Bagehot’s advice and my instructions to Brian, the New York Fed injected $24 billion in cash into the financial system. Conditions in the European financial system—closer to the BNP Paribas spark—were even worse, and the ECB had injected even more cash, 95 billion euros ($130 billion). For both central banks, the goal was to ensure that financial and nonfinancial firms would have adequate access to short-term funding. Over the next week, the central banks of Canada, Japan, Australia, Norway, and Switzerland would conduct similar operations.

We issued a statement the next morning, Friday, August 10, on the heels of an emergency conference call of the FOMC. It had been the Committee’s first unscheduled call during my chairmanship and the first since the start of the war in Iraq four years earlier. The Board convened at 8:45 a.m. in the Special Library, a dark, musty room with floor-to-ceiling book-lined shelves. We sat at a table that had served the first Federal Reserve Board in 1914. Metal nameplates showing the places of the original members were still screwed into its sides. The Reserve Bank presidents joined the meeting by video. A large screen displayed the presidents in a configuration that reminded me of the old TV game show Hollywood Squares.

The bureaucratic tone of our August 10 statement belied its potential power. “The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets,” we said. “As always, the discount window is available as a source of funding.” The discount window (once literally a teller window manned by a lending officer, but no more) is the facility through which the Fed provides overnight loans to deposit-taking institutions, including commercial banks and savings and loans. The interest rate charged is called the discount rate. After issuing the statement, we added $38 billion more to the financial system through securities purchases. Again, reflecting greater stress in European markets, the ECB did more, injecting 61 billion euros ($84 billion).

Similar statements from the Fed had helped calm markets after the stock market crash in 1987 and again after the 9/11 attacks in 2001. This time the problems ran deeper and the statement did not have its hoped-for effect. Investors remained reluctant to provide short-term credit and shifted their money into safer and more liquid assets, like short-term Treasury securities. Commercial paper issuance (especially of asset-backed commercial paper) had fallen sharply and maturities had shortened dramatically, often to only a day or two, as lenders aimed to tie up their money for the shortest time possible. Ominously, the problems with subprime mortgages were prompting the reevaluation of other types of credit as well. Wholesale funders were becoming more wary of medium-quality Alt-A mortgages, second mortgages (used by some homeowners to cash out the equity in their homes), and some commercial real estate mortgages. If funding conditions continued to tighten, firms and investment vehicles that held these securities might be forced to dump them on the market for whatever they could get. Fire sales would drive the prices of these assets down further and make financing even more difficult to obtain, both for the selling firms and for firms holding similar assets.

BY THE TIME I emailed Seth to cancel our vacation it was clear that the Fed needed to do more—but what? In response to current events, people often reach for historical analogies, and this occasion was no exception. The trick is to choose the right analogy. In August 2007, the analogies that came to mind—both inside and outside the Fed—were October 1987, when the Dow Jones industrial average had plummeted nearly 23 percent in a single day, and August 1998, when the Dow had fallen 11.5 percent over three days after Russia defaulted on its foreign debts. With help from the Fed, markets had rebounded each time with little evident damage to the economy. Not everyone viewed these interventions as successful, though. In fact, some viewed the Fed’s actions in the fall of 1998—three quarter-point reductions in the federal funds rate—as an overreaction that helped fuel the growing dot-com bubble. Others derided what they perceived to be a tendency of the Fed to respond too strongly to price declines in stocks and other financial assets, which they dubbed the “Greenspan put.” (A put is an options contract that protects the buyer against loss if the price of a stock or other security declines.)

Date: 2016-04-22; view: 640