Federal Reserve documents 11 page

Newspaper opinion columns in August 2007 were rife with speculation that Helicopter Ben would provide a similar put soon. In arguing against Fed intervention, many commentators asserted that investors had grown complacent and needed to be taught a lesson. The cure to the current mess, this line of thinking went, was a repricing of risk, meaning a painful reduction in asset prices—from stocks to bonds to mortgage-linked securities. “Credit panics are never pretty, but their virtue is that they restore some fear and humility to the marketplace,” the Wall Street Journal had editorialized, in arguing for no rate cut at the August 7 FOMC meeting.

Of course, investors were desperate to escape the “fear and humility” that the Journal editorial writers wanted to inflict on them. Perhaps the most colorful plea for looser monetary policy had been a screaming on-air rant by CNBC TV personality Jim Cramer on August 6. Michelle emailed me about the

video. “I should warn you—he’s not at all respectful of you,” she wrote. I suspected that was an understatement. I never watched it. When the criticism devolves into name-calling or screaming, I pass.

Though I ignored Cramer, I was hearing from others whose views demanded greater attention. “Conditions in the mortgage market are the worst I’ve ever seen and are deteriorating day by day,” former Board member Lyle Gramley wrote in an email forwarded by Don Kohn. “I am not one to cry wolf,” Gramley added. After leaving the Board in 1985, Gramley had worked for more than a decade for the Mortgage Bankers Association of America and had served on Countrywide’s board. He spoke with expertise, but perhaps also from a perspective influenced by his post-Fed positions.

It’s a truism that market people “talk their book”—that is, argue for policies that benefit their own investments or interests. That’s a fact of life that I always tried to keep in mind when hearing outside views. But I could not easily dismiss the concerns of Gramley and many other contacts with similar messages. I knew that financial disruptions—if allowed to snowball—could choke off credit to households and businesses and in worst-case scenarios send the economy into a tailspin. At the same time, I was mindful of the dangers of moral hazard—the risk that rescuing investors and financial institutions from the consequences of their bad decisions could encourage more bad decisions in the future.* I wanted to avoid the perception of a “Bernanke put” if at all possible.

We needed the right tool—a tool that would break the run mentality, calm market fears, and allow financial assets, from stocks to subprime mortgages, to reprice to their fundamental values without markets freezing or prices overshooting on the way down. We were close to settling on a plan that at first we had rejected, namely, making changes to our discount window policies to encourage banks and savings institutions to borrow from us.

Banks had largely ignored the come-and-get-it hint in our August 10 statement. As an alternative, the FOMC could have cut the federal funds rate, but that would have had broad economic effects, including possibly fueling inflation. Lending through the discount window was a more precise tool focused on the specific issue we faced: the growing scarcity of short-term funding. However, we faced two problems.

The first was the stigma associated with borrowing from the Fed. As Bagehot advised, we routinely charged a “penalty” rate on our discount window loans. At the time, that interest rate, the discount rate, was 6-1/4 percent—one percentage point above our target for the federal funds rate, the interest rate that a bank would pay another to borrow overnight. Under normal conditions, the penalty rate encourages banks to look first to private markets for funding, rather than relying on the Fed. But a side effect of this arrangement was that banks feared they would look weak if it became known that they had borrowed from the Fed—and that would make it even harder for them to attract private funding. Why would a strong bank pay the penalty rate if it didn’t have to? We kept the identity of discount window borrowers strictly confidential, but banks worried that money market participants—by observing their behavior, or perhaps through careful analysis of the Fed’s balance sheet figures—could guess when a bank had come to the window. Nearly all discount window loans were, and are, to sound institutions with good collateral.

Since its founding a century ago, the Fed has never lost a penny on a discount window loan. Nevertheless, the perceived stigma of borrowing from the discount window was and remains a formidable barrier to its effectiveness. If banks won’t borrow because they fear that doing so might send a bad signal about their financial health, then having a lender of last resort does little good.

The second problem, in addition to stigma, was that the financial system had outgrown the discount window. The Federal Reserve Act stipulates that, under normal circumstances, only depository institutions—banks and savings institutions—are eligible to borrow from the Fed. But in recent decades, the shadow banking system, with its reliance on wholesale funding rather than insured deposits, had come to play an increasingly prominent role in credit markets. Our discount window could not directly help nonbanks that had lost their funding, limiting our ability to stop panics.

So, even though we had been thinking about ways to encourage greater use of the discount window, we feared they wouldn’t work. It could be like throwing a party that nobody attended. If we took highly visible steps to bring banks to the window, and they had no effect, it could shake confidence in the Fed’s ability to fashion an effective response to the crisis and thus fuel the panic.

However, by August 16, financial conditions had deteriorated to the point where we were ready to be more aggressive. Tim Geithner, Don Kohn, and I conferred that morning with our central bank counterparts in Europe, Canada, and Japan. I scheduled another emergency conference call of the FOMC at six o’clock that evening. To try to overcome stigma, we decided we would make discount window loans more attractive by halving the interest rate penalty. Banks would be able to borrow at a half percentage point, rather than a full point, above the FOMC’s target for the federal funds rate. We’d also try to persuade some leading banks to borrow at the window, thereby suggesting that borrowing did not equal weakness. To encourage credit to flow at terms longer than overnight, we would offer loans through the discount window for up to thirty days and indicate that we’d be liberal about renewing the loans as needed. And a new FOMC statement acknowledging increased risks to economic growth and saying we were “prepared to act as needed” would signal our willingness to push down interest rates more generally if necessary to prevent the financial upset from spilling over into the economy.

We considered cutting the discount rate more than a half percentage point, a step advocated by Rick Mishkin, but we were balancing two competing concerns. If we didn’t cut the discount rate enough, banks, worried about stigma, wouldn’t borrow. But, if we cut it too much, smaller banks—who can’t borrow overnight funds in the open market as cheaply as larger banks—might overwhelm the Reserve Banks with requests for relatively small loans, which we were not prepared to handle administratively. We might have to turn away would-be borrowers.

We announced the discount rate cut and issued the FOMC’s new statement at 8:15 a.m. on Friday, August 17. Short-term funding markets, unfortunately, showed little immediate reaction, but the stock market soared reflexively. Futures on the S&P 500 index jumped 3.6 percent within 46 seconds of the announcement. “The market thinks Bernanke is a rock star!” Bob Pisani of CNBC declared (prematurely,

to say the least).

My FOMC colleagues and I worked the phones and shared our intelligence by email. As predicted, bankers remained nervous about the potential stigma of borrowing from the Fed. Boston Fed president Eric Rosengren reported that Ron Logue, chief executive of State Street, was reluctant to borrow. State Street was the largest bank in the district, so if the Boston Fed reported a large surge in discount window borrowing, speculation would naturally fall on Logue’s institution. He asked Rosengren if the weekly district-by-district reporting of loan totals could be eliminated. But changing our accounting procedures without warning, even if legally feasible, would hardly have inspired confidence. A Texas banker advised Dallas Fed president Richard Fisher that if the Fed could persuade some “big boys” to use the discount window, “it could be a life-changing event in removing the stigma.”

At 10:00 a.m., Tim and Don hosted a conference call with the Clearing House Association, an organization of the nation’s major commercial and investment banks, and told them that we would consider borrowing at the discount window “a sign of strength.” That evening, Tim relayed word from his on-site supervisors at Citibank that its managers had authorized the bank to borrow from the window. On Wednesday, August 22, Citi announced it was borrowing $500 million for thirty days; JPMorgan Chase, Bank of America, and Charlotte, North Carolina–based Wachovia also announced that they had each borrowed $500 million. Our weekly report the next day showed discount window borrowing of $2.3 billion on August 22, up from $264 million a week earlier.

The Fed’s Board also sent letters to Citigroup, JPMorgan, and Bank of America granting temporary exemptions from Section 23A of the Federal Reserve Act, which normally prevented them from funneling discount window credit to nonbank components of their companies, such as subsidiaries engaged in consumer finance or securities trading. Our goal was to increase the supply of short-term funding to the shadow banking system. Because transactions between a bank and its holding company could put the bank’s insured deposits at risk, the FDIC needed to sign off. I reached out to FDIC chairman Sheila Bair.

Sheila, a Kansas Republican and protйgй of former senator Bob Dole, had been appointed to the FDIC by President Bush in June 2006. She had been teaching at the University of Massachusetts–Amherst, but she had government experience as well, including at the Treasury Department. A prairie populist, she inherently distrusted the big Wall Street banks and the government agencies charged with overseeing them —most especially the Fed and Treasury. She could be turf-conscious and hard to work with, but I also couldn’t help but grudgingly admire her energy, her political acumen in pursuing her goals, and her skill in playing to the press. And I appreciated the crucial role her agency played in the regulatory system. When circumstances required cooperation among the Fed, Treasury, and FDIC, it often fell to me to make the call to her, as it did this time. I didn’t want an unintentional slight on my part to impede good policies.

Sheila responded to our request for 23A exemptions by the end of the day that we announced the rate cut. I emailed, thanking her for the prompt response. “Amazing what a little credit crisis can do to motivate,” she replied.

Unfortunately, our initial success in ramping up our discount window lending did not persist. The four big banks that trumpeted a collective $2 billion in borrowing from the Fed also—with stigma doubtless in mind—made very clear in their announcements that they didn’t need the money. Five weeks later, discount window borrowing had fallen back to $207 million, a little less than it had been before we eased the terms of borrowing.

AS WE WERE working our way toward cutting the discount rate, the problems of Countrywide, the source of nearly one in five mortgages made in the United States, had remained on the front burner. Examiners from three agencies—the Federal Reserve, the FDIC, and the Office of Thrift Supervision—had been trying to determine whether the lender, with its large subprime portfolio, could remain afloat.

On August 16, nervous depositors queued at a branch of its savings and loan near its Calabasas, California, corporate headquarters. Many left reassured after they were told the deposits were FDIC-insured. But Countrywide faced a bigger threat: The company’s commercial paper and repo lenders had refused to renew their loans on August 2. Raising funds by selling some of its assets would not solve its problems. The value of the suspect mortgages it held had fallen sharply—if buyers could be found at all. To avoid bankruptcy, Countrywide drew $11.5 billion from previously established emergency lines of credit with major banks—every penny that was available to it.

On August 10, I had asked Brian Madigan and Roger Cole, director of our Division of Banking Supervision and Regulation, to evaluate whether Countrywide was systemically important. In other words, would the firm’s failure endanger the entire financial system? “What would its failure do to major banks or investment banks? To the mortgage market?” I had asked.

It was the first time that I had to pose such questions about a large financial institution. I emailed Madigan and Cole less than an hour after receiving an oddly upbeat note from OTS director John Reich. Reich, a former community banker as well as a former longtime aide to Senator Connie Mack of Florida, was an ardent advocate of deregulation. In 2003, then vice chairman of the FDIC, Reich had posed proudly at a press event, holding garden shears in front of a stack of paper wrapped in red tape— representing the regulations he was charged with enforcing.

Just before leaving his office for a planned two-week vacation, Reich sought to reassure me, Fed Board member Randy Kroszner, Sheila Bair, and a fourth bank regulator—John Dugan, director of the Office of the Comptroller of the Currency—that rumors of Countrywide’s imminent bankruptcy were untrue. He acknowledged that the lender faced a liquidity challenge, but, putting a positive spin on the many recent failures of mortgage lenders, he wrote, “the longer-term looks positive, as their competition has greatly decreased.”

Reich would soon back a request from Angelo Mozilo, Countrywide’s white-haired, unnaturally tanned CEO. Mozilo wanted an exemption from the Section 23A rules that prevented Countrywide’s holding company from tapping the discount window through a savings institution it owned. Sheila and the

FDIC were justifiably skeptical, as was Janet Yellen at the Federal Reserve Bank of San Francisco, in whose district Countrywide’s headquarters were located. Lending indirectly to Countrywide would be risky. It might well already be insolvent and unable to pay us back. The day after the discount rate cut, Don Kohn relayed word that Janet was recommending a swift rejection of Mozilo’s request for a 23A exemption. She believed, Don said, that Mozilo “is in denial about the prospects for his company and it needs to be sold.”

Countrywide found its reprieve in the form of a confidence-boosting $2 billion equity investment from Bank of America on August 22—not quite the sale that Janet thought was needed, but the first step toward an eventual acquisition by Bank of America. Countrywide formally withdrew its request for a 23A exemption on Thursday August 30 as I was flying to Jackson Hole, Wyoming, to speak at the Kansas City Fed’s annual economic symposium. The theme of the conference, chosen long before, was “Housing, Housing Finance, and Monetary Policy.”

I HADN’T SPOKEN publicly about the economy since delivering the Board’s twice-a-year monetary policy report to the House and Senate in back-to-back hearings in July. With credit-market problems beginning to slow the economy, market participants would be looking for any sign that we were planning to broadly reduce short-term interest rates. We were definitely moving in that direction. Indeed, two days prior to my departure for Jackson Hole, I had been debating with Don and Tim whether to cut rates without waiting for the next scheduled FOMC meeting on September 18. Markets weren’t expecting an intermeeting move, though, and we were concerned that a surprise cut might lead traders to believe we were even more worried than they had thought.

“Going sooner risks, ‘What do they know that we don’t,’” Don wrote in an email to Tim and me. He recommended waiting until the FOMC meeting, but then cutting the federal funds rate by a half a percent, double the generally expected decrease.

In the cloistered world of central banking, the Kansas City Fed’s two-day symposium at Jackson Lake Lodge was a major international event. For the past twenty-five years, just before Labor Day, top policymakers and staff from the Fed, international central bankers, well-known academic and private-sector economists, and leading U.S. economic journalists had been attending. The participants—about 110 in all—spent mornings debating monetary policy and the state of the global economy under elk-antler chandeliers. Evenings were given over to banquet dinners and entertainment. Afternoons were for enjoying the spectacular surroundings. From the rear of the lodge lay the glorious sight of the snow-capped Grand Tetons. On clear days, Jackson Lake’s icy waters were visible. Every year, Don led a strenuous hike into the mountains that became known as the Kohn Death March. The less fit, or less ambitious, could fly-fish, take a boat ride on the lake, or simply sit on the veranda observing, through binoculars, moose and elk grazing on the highland meadows that stretched toward the mountains.

As a professor at Princeton, I had been pleased to occasionally receive one of the coveted invitations

to Jackson Hole, but as chairman I was already looking at the meeting as something of a chore. I was always happy to talk economics, but it’s difficult to have useful, free-flowing discussions in the glare of intense media coverage. I was acutely aware that any slip would be echoed and amplified, so I limited my participation to delivering my prepared remarks.

The turbulent markets of August 2007 made those risks even greater. Michelle Smith, after conferring with me, Don, and Tim, took the unusual step of emailing the Reserve Bank presidents asking them to refrain from media interviews. Also unusually, most complied. Randy Kroszner flew to Jackson Hole early to avoid having all of the Board members in the air and out of reach on the day before the conference. And we dispatched a team of computer specialists who would wire a conference room at the lodge to permit us to review market conditions as needed.

I arrived at the lodge late Thursday afternoon and, after a market-review meeting, headed to a dinner that always precedes the business sessions of Friday and Saturday. It was a somber event. Our friend and colleague Ned Gramlich was gravely ill with leukemia. He had been scheduled to address the symposium but his illness had prevented him from making the trip. Anna and I had only recently seen Ned and his wife, Ruth, at a brunch hosted by Lyle Gramley and his wife, Marlys. Ned knew then that he didn’t have much time left, but he was upbeat and happy to spend time with friends. In my welcoming remarks at the conference dinner I noted that we would miss not only Ned’s insights but also his warmth and generosity of spirit. At the luncheon on Saturday, David Wilcox, the Board’s deputy research director and a close friend of Ned’s, would read Ned’s prepared speech. The topic was the boom and bust in subprime lending.

In my own speech the next morning, August 31, I had to walk a fine line. I wanted to put a rate cut squarely on the table. But I had to avoid damaging the comity of the FOMC by explicitly signaling a rate cut before members could debate and vote on it.

I described the toll that the housing downturn and associated financial stress had taken on the economy and reminded my listeners—pointedly, I thought—that “well-functioning financial markets are essential for a prosperous economy.” To douse the idea that the FOMC might act solely to bail out Wall Street, I said, “It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions.” But, I promised, the Federal Reserve “will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.” I was addressing multiple audiences simultaneously—trying to convince critics that we were motivated by a desire to help Main Street Americans while hoping to persuade investors not to overreact by retreating from all forms of private credit.

Market reaction was positive but subdued. Many traders apparently had hoped for an explicit signal that rate cuts were imminent. Dow Jones columnist Laurence Norman summed it up: “Like a hungry Oliver Twist accepting his gruel at the poor house . . . markets . . . made it clear they wanted more.”

So it was that, even before the last of the attendees departed, Don and Tim and I were thinking about

how to persuade our colleagues to do more to protect American jobs and livelihoods from turmoil on Wall Street. We wanted them to support a broad-based cut in short-term interest rates at the next FOMC meeting and, if necessary, to consider unorthodox measures. Tim and I left the conference early. Don stayed to hear the Saturday morning speakers. In an email, he recapped a particularly gloomy presentation by Martin Feldstein. Don, far from an optimist himself, thought that Feldstein’s outlook was too dark. But, he confessed, “I wasn’t that disturbed. . . . I saw it as a useful softening up of FOMC members.”

Back in Washington we were ramping up what I was calling “blue-sky thinking.” By focusing on discount window lending rather than on standard monetary policy as our response to the crisis, we had already departed somewhat from convention. But I was determined to go further if necessary. We could not let the fear of appearing unorthodox prevent us from attacking the problem with any tool available. That Sunday, in an email to Don, Tim, and Board member Kevin Warsh, I laid out the case for doing more and summarized ideas that had been percolating among policymakers and staff.

One intriguing proposal was to establish a currency swap line with the European Central Bank— effectively, a facility through which the Federal Reserve would provide dollars to the ECB, with the repayment collateralized by euros. Its purpose would be to help insulate U.S. markets from financial turbulence in Europe. Though the ECB was providing euros to the continent’s money markets, much financial activity in Europe is transacted in dollars. Establishing a currency swap line with the ECB (or another foreign central bank) would provide it with dollars that it could subsequently lend to the commercial banks in its jurisdiction, reducing the scramble by foreign banks for dollar funding that had been disrupting U.S. markets. A swap line with a foreign central bank wouldn’t be politically popular, but it could prove essential to protecting our own economy. Don initially had been skeptical, saying he needed to see a better case for why the ECB couldn’t use its own dollar reserves for its lending. But Tim had been more open, arguing that establishing swap lines with the ECB and two or three other major central banks could reduce the need for foreign banks operating in the United States to borrow dollars directly from the Fed. Instead, they could borrow from their home-country central banks, which would be responsible for managing the loans and would be on the hook for any losses.

I also discussed a staff proposal to set up two facilities to auction Federal Reserve loans—one for depository institutions and the other for nondepositories, such as the Wall Street investment banks. It seemed possible that setting the interest rate on loans through an auction in which potential borrowers bid for funds, rather than fixing a rate as we currently did with the discount rate, might reduce the stigma of borrowing from the Fed. Borrowers could claim that they were paying a market rate, not a penalty rate. And, because it takes time to conduct an auction and determine the winning bids, borrowers would receive their funds with a delay, making clear that they were not desperate for cash.

Last on the blue-sky list was forcing banks to disclose more information about their condition and, importantly, about affiliated off-balance-sheet vehicles that had become linchpins of shadow banking. What they disclosed might be scary, but at least participants in the money markets could again

realistically assess lending risks, and extend or not extend credit on that basis, instead of pulling back from all counterparties out of fear.

One of these items in particular—letting nondepository institutions like investment banks participate in auctions of Federal Reserve loans—would require a leap over a particularly high psychological hurdle. We would have to invoke the little-known Section 13(3) of the Federal Reserve Act, which authorized the Reserve Banks to lend to virtually any creditworthy person or entity. We hadn’t used the authority since the Great Depression. I knew it was a hard sell, but I wanted the idea to remain under consideration.

“Staff arguments do not persuade me to drop this option from the playbook altogether,” I wrote in the email to Don, Tim, and Kevin after Jackson Hole. Broadening Federal Reserve lending beyond depository institutions could be necessary in a financial system that had become less bank-centric. “But I agree that it should be filed under the ‘Hail Mary’ section,” I wrote.

* The idea of moral hazard came from writings about insurance, where it referred to the tendency of people whose property is insured to make

less effort to avoid loss or accident.

CHAPTER 8

One Step Forward

The turbulence that buffeted financial markets in August appeared to have eased just a bit when the Federal Open Market Committee met on September 18, 2007. The stock market had more than regained the ground it lost in August, and funding and credit markets were a little calmer.

Still, the situation was far from normal. Issuance of asset-backed commercial paper had declined further and interest rates on it had moved higher. In the repo market, lenders were demanding more collateral for their loans, even when the collateral was of relatively high quality. And banks remained skittish. The premium they charged each other to borrow for longer than overnight remained elevated, and they were growing reluctant to lend, even to household and corporate borrowers with sterling credit histories. Meanwhile, the economic news was downbeat, with the Labor Department having reported a loss of 4,000 jobs in August, the first monthly drop since 2003.

THE WEEK BEFORE the FOMC meeting, Anna and I had attended a small memorial gathering for Ned Gramlich at the Gramlichs’ elegant apartment overlooking Rock Creek Park and downtown Washington. Ruth was gracious despite her grief. Ned had died on September 5, just days after his prepared remarks were read at Jackson Hole. Later in the month, in accordance with Ned’s wishes, I would speak at his memorial service. As it ended, a New Orleans jazz band marched into the church, playing a raucous version of “When the Saints Go Marching In.”

By the morning of the FOMC meeting, Washington’s oppressive summer heat had eased. The weather was pleasant as my SUV turned into the Board garage. From there I rode a wood-paneled elevator to the second-floor Board members’ offices.

I had been working to line up support on the FOMC for more action to cushion the economy from the effects of credit market turbulence. As it turned out, the hawks and doves flocked together this time— more or less. After the meeting we announced that the Committee had voted unanimously to cut the target for the federal funds rate by a half-percentage point, to 4-3/4 percent. It was the first cut in four years. Market expectations had been for only a quarter-point cut, so the announcement caused stocks to jump and bond yields to fall.

Some of the hawks—Jeffrey Lacker of the Federal Reserve Bank of Richmond and Richard Fisher of Dallas—had argued for a smaller rate reduction, but the rotation of votes among the Reserve Bank presidents left both of them without a vote in 2007. The often hawkish Thomas Hoenig of Kansas City and Bill Poole of St. Louis were voters that year, but neither dissented. They said they hoped that taking more action sooner would forestall the need for, and expectation of, greater interest rate reductions later. The hawks were at least slightly reassured by a modest recent improvement in inflation data, as well as by the staff’s forecast of sub-2 percent inflation in both 2008 and 2009.

Date: 2016-04-22; view: 729