Federal Reserve documents 14 page

problems could feed on each other and fuel a more general downturn. I told Don and Tim that house price decreases were “starting to sink in” with consumers, and surveys showed that consumer confidence had declined to levels seen in previous recessions. I proposed a special videoconference meeting of the FOMC. If the economic data remained soft, particularly the employment data, we should cut rates twice in January—by a quarter point at the videoconference and another quarter point at the meeting scheduled for January 29–30. Tim and Don, in separate replies, cautioned once again against a rate move between regularly scheduled FOMC meetings, an action that would usually be taken in response to an emergency. Tim wrote that it was difficult to judge whether a surprise rate cut earlier in the month would reassure or roil markets. “They want agility and force, but they also want predictability and steadiness,” he said.

We continued our long-distance debate into New Year’s Day. I pointed out that, at the late January meeting, the FOMC vote would rotate to two hawkish Reserve Bank presidents—Richard Fisher of Dallas and Charles Plosser of Philadelphia. We’d have a better chance of minimizing dissenting votes against a half-percentage point reduction in January—or even a three-quarters percentage point cut, if necessary—by acting in two steps. Don agreed that I had made a convincing case for at least scheduling an early January conference call, but he was keeping an open mind about whether we needed to act at it. “I’d be more comfortable if there was a demonstrable loss of [market] confidence,” he wrote.

When the FOMC videoconference began at 5:00 p.m. on January 9, I had decided not to ask for an intermeeting rate cut. I thought we could get about the same effect, with less damage to the FOMC’s deliberative process, if I used the call to build a consensus for a large rate cut at the next scheduled meeting. I could then send a strong signal in my speech the next day. I told the Committee that it looked like we were headed into a recession. I noted that the staff had again cut its economic growth forecast for 2008, to a scant 1 percent, and that the unemployment rate had risen from 4.4 percent in March to 5 percent in December. The economy had never been able to crawl along at a 1 percent growth rate without lapsing into recession, and unemployment had never increased by that much without presaging a much greater rise. “The concern I have is not just a slowdown but the possibility it might become a much nastier episode,” I said.

Don and Tim, I knew, would have supported an intermeeting move, as would doves such as Janet Yellen and Eric Rosengren. But other FOMC members, such as Jeff Lacker of Richmond, did not want to appear to be responding to a single economic report. The Labor Department had reported on January 4 that employers had added a disappointingly low 18,000 jobs in December. The afternoon of the employment report, amid press stories that the Bush administration was considering a fiscal stimulus package, I had attended a meeting at the White House with President Bush, Hank Paulson, and other top economic officials. On our FOMC conference call, senior Board staff and even some Committee members, including Gary Stern of the Minneapolis Fed, worried about the “optics” for central bank independence if a Fed rate cut followed less than a week after the well-publicized White House meeting.

The videoconference ended at about 7:00 p.m. and I turned to finalizing the luncheon speech I would

deliver the next day. That evening and the next morning, I conferred with Don, Tim, Kevin, and senior staff. We sweated every word. Should I say that additional rate cuts “may be necessary” or “may well be necessary”? Should I say that we stood ready to take “substantive additional action” to support growth or “meaningful additional action”? The absurdity of our discussion did not escape us, but we had learned through bitter experience that a single word often mattered. Our goal was to send the markets as clear and strong a signal as possible, while still allowing us enough wiggle room to change course if necessary.

The day of the speech, I visited the Board’s barber shop for a haircut and beard trim from Lenny Gilleo (the “Hairman of the Board,” according to his business cards). Lenny leased a small shop in the basement of the Martin Building and had been cutting what was left of my hair since I had joined the Board in 2002. He had trimmed the hair of Alan Greenspan, Paul Volcker, and Arthur Burns before me and dispensed wisdom on politics, monetary policy, and baseball. A sign on his wall read: “My money supply depends on your growth rate.”

Back in my office, I opted to use the language options we judged to be a shade stronger—“may well be necessary” and “substantive additional action.” The message was received. The speech, at the Mayflower Hotel (scene of my ignominious National Spelling Bee performance in 1965), solidified Wall Street analysts’ expectations for a half-point interest rate cut at the end of the month, instead of a quarter point.

Stocks rallied, supported not only by my speech but also by reports that Bank of America would take over the troubled mortgage lender Countrywide. Optimists saw the $4 billion takeover as a sign of a possible bottom in the subprime crisis and good news for Bank of America, which was acquiring Countrywide’s sprawling mortgage origination and servicing business at what was considered a cheap price. Pessimists wondered if Bank of America, the nation’s largest bank as measured by deposits, wasn’t buying a parcel of ticking time bombs in the form of future losses.

AS WE AT THE FED came to grips with the need to counter the cumulating economic weakness with more aggressive monetary policy, the administration was contemplating fiscal remedies. Since November, Hank Paulson and I had been discussing whether some form of fiscal stimulus—such as a temporary cut in Social Security and Medicare payroll taxes—might boost the economy. I told Hank a broad-based tax cut could prove particularly helpful at this point, with homeowners struggling to meet monthly mortgage payments. I also pushed the idea of using federal loan guarantees or other incentives to induce state and local governments to speed up job-creating infrastructure projects. Word came back, though, that the Council of Economic Advisers thought the infrastructure idea impractical. The objection, essentially, was that there were not enough “shovel-ready” projects that could be undertaken in a short time.

As politically independent central bankers, we had to walk a fine line. We believed that the country was best served if we made monetary policy free of political interference, so long as we were accountable for reaching the goals Congress set for us. And we couldn’t expect elected leaders to honor

the long tradition of Fed autonomy if we tried to exert influence on fiscal matters not within our purview. At the same time, we had a lot of expertise at the Fed. I thought we should be willing to offer advice, at least in private, if it would be helpful and we could avoid becoming embroiled in a partisan fight. In that spirit, just as I had met with Paulson and President Bush on January 4, I met privately on January 14 with the top Democrat in the House, Speaker Nancy Pelosi, who on January 8 had called for stimulus legislation. Shortly afterward, a Bloomberg News story appeared reporting that I supported fiscal stimulus. It was attributed to an anonymous Democratic aide. I did think that some kind of stimulus plan would be a good idea, as I would testify to the House Budget Committee on January 17, but with caveats that the anonymous aide apparently had omitted. The leak annoyed but didn’t surprise me; I had learned that’s how Washington works.

Board staff at first advised me to avoid taking any kind of position on fiscal stimulus. Then, after I resisted their advice, they asked me to consider advocating that any stimulus be conditioned on an objective trigger, such as the size of job losses. They were still predicting an economic slowdown in 2008, rather than an outright recession, and they weren’t convinced fiscal stimulus was justified. “A positive word from you would give this locomotive a big shove out of the station,” warned David Wilcox, who had served at Treasury during the Clinton administration and had sharper political instincts than most Fed career economists. In this case, though, I wasn’t so sure. I doubted that my words would have the weight of Greenspan’s, and in any case it seemed to me that Congress is ruled first and foremost by interests and ideology, not by the advice of experts or supposed experts, including the chairman of the Fed.

In the end, I testified that “fiscal action could be helpful in principle” if it could be implemented quickly, focused on affecting the economy over the short term, and be explicitly temporary to avoid increasing the long-term deficit. I expressed no preference for whether the stimulus should take the form of tax cuts, spending increases, or both. I—a Republican appointee, albeit at a nonpartisan institution— was delivering the same message that Larry Summers, a former Treasury secretary under President Clinton, had delivered more concisely the day before to the Joint Economic Committee. “A stimulus program,” he said, “should be timely, targeted, and temporary.” On January 18, the day after my testimony, the president proposed a $150 billion stimulus package, consisting mostly of temporary tax cuts for individuals, families, and businesses.

AS I PREPARED for the budget testimony, I was regretting my decision of a week earlier to refrain from insisting on an intermeeting rate cut. The drumbeat of bad financial news continued: more big write-downs at Merrill Lynch and Citigroup, deepening troubles at the monoline insurers, and repeated sharp drops in stock prices. The wider economy looked shakier, too: Retail sales had declined in December. On January 15, the day of the retail sales release, I emailed Don and Tim: “If I could pull the trigger [on a rate cut] myself, I would do it this week.” They talked me off the ledge that morning. I would wait until

the scheduled meeting, but I soon began lining up support for a very large rate cut—at least three-quarters of a percentage point. The following week, an unanticipated event—in the form of what Don had earlier called “a demonstrable loss of confidence”—would give us a reason to act.

The Board was closed on Monday, January 21, for Martin Luther King Jr. Day. I was in the office that morning. Like my father, I grew distracted and unhappy when I could not usefully occupy my time. This character trait (“flaw” is probably a better word) had caused some tension with Anna early in our marriage. But we had struck a deal: I would work in the morning on weekends and holidays and in the afternoon and evening devote my full attention to family and recreation. On this particular holiday, I would not return home until long after dark.

On arrival I checked the Bloomberg screen in my office and saw that a wave of selling, originating in the Far East, was sweeping across European stock markets. Futures markets were predicting a steep 3.5 percent drop when U.S. stock markets reopened the next day. I called Tim Geithner. He was already checking in with his market contacts. Kevin Warsh emailed: “Should we do a markets call?” I agreed that we should. I called Don. He was on the road but thought he could make an 11:00 a.m. call. I emailed dial-in numbers to Don, Tim, Kevin, Michelle Smith, Bill Dudley (the markets chief in New York), and Brian Madigan. Brian headed to the office. (I don’t know when Brian slept. I can’t remember ever sending him an email, day or night, without getting a response in ten minutes.)

We decided to convene the full FOMC by videoconference that afternoon and propose an immediate rate cut of three-quarters of a percentage point, with a statement suggesting more to come at the end of the month. I sat down at my computer terminal, banged out the first draft of the statement, and circulated it for comment. Brian then set about arranging the videoconference, including trying to track down the two Board members and eleven Reserve Bank presidents not on the morning call. By 3:15 p.m., everyone had been reached except Rick Mishkin. Charles Plosser of the Philadelphia Fed was traveling in Florida but could participate using a secure line at the Jacksonville branch of the Atlanta Fed. Gary Stern of the Minneapolis Fed would participate from Chicago. We set the conference time at 6:00 p.m. The staff reached Rick shortly before 4:00 p.m. He was on the top of a mountain, cross-country skiing at Lake Tahoe, and wouldn’t be able to get to a secure phone line in time.

The videoconference began with a report on markets from Bill Dudley. Bill, affable and with a quick laugh, had a PhD in economics from Berkeley. He had been the chief economist for Goldman Sachs for ten years before Geithner hired him to succeed Dino Kos as head of the Open Market Trading Desk at the New York Fed. He understood macroeconomics and monetary policy, but he also knew how Wall Street worked.

U.S. stock values had declined nearly 10 percent during the first three weeks of the new year, Bill said, and futures prices suggested stocks could open an additional 5 percent lower on Tuesday. We didn’t know what was driving the latest selling wave. Bill mentioned the Merrill Lynch and Citigroup write-downs of the previous week and the possible spillover of the monoline insurers’ troubles into the

municipal bond market. His European contacts were citing the growing odds of a U.S. recession and its likely effect on their economies.

I told the Committee our job wasn’t to protect stock investors. But, I said, the sharp stock declines “reflect a growing belief that the United States is in for a deep and protracted recession.” That belief was creating a worrisome dynamic: Investors were withdrawing from risk and lenders were withdrawing from lending. A large and immediate cut in our target for the federal funds rates might help arrest the dynamic.

“We are facing, potentially, a broad crisis,” I said. “We can no longer temporize. We have to address this crisis. We have to try to get it under control. If we can’t do that, then we are just going to lose control of the whole situation.”

Bill Poole objected: “Whenever we act between meetings, we set a precedent.” Markets would anticipate a Fed rate cut whenever stocks declined significantly. Tom Hoenig, the other hawk with a vote, was torn. He understood the need to break markets’ bad psychology and to get ahead of the deteriorating economy but continued to worry about inflation. Don, Tim, Eric Rosengren, Kevin Warsh, Randy Kroszner, and Charlie Evans of Chicago supported my proposal. Don, the conciliator, said, “We could look panicky. . . . But I think the greater risk would be in not acting.”

The Committee voted 8–1 to cut the federal funds rate to 3-1/2 percent (from 4-1/4 percent) and issue a statement promising to “act in a timely manner as needed.” Poole dissented; Hoenig didn’t. It was the FOMC’s biggest rate cut since 1982 and its first move between meetings since September 11, 2001. We announced our decision before markets opened on Tuesday. The Dow Jones nevertheless plunged 464 points. But then it rebounded, closing down 128 points, or 1 percent.

Some of the commentary on our action focused on a perceived shift in my leadership style. Depending on the perspective of the commentator, the surprise rate cut was either evidence of a new decisiveness or a vacillation in the face of pressure from the markets. I believed I hadn’t changed—circumstances had. In earlier months, I had emphasized the importance of considering all points of view and developing consensus. But, in a crisis, collaboration must give way to stronger direction. I was determined to offer that direction as needed.

On January 24, news emerged that cast doubt on our decision. Sociйtй Gйnйrale (SocGen), France’s second-largest bank, announced that unauthorized futures trading by a single employee, later identified as Jйrфme Kerviel, had caused a $7.2 billion pre-tax loss. The bank had uncovered the loss after questioning Kerviel on January 19 but kept mum in public to give itself time to unwind its trading positions. Now it looked as if at least part of the Martin Luther King Jr. Day sell-off in Europe might have resulted from a one-off event. We had no idea the rogue-trading bombshell was coming. In fact, on a conference call the morning of January 19 Paris time, senior SocGen managers in Paris and New York had told New York Fed supervisors that the bank would report positive earnings for the fourth quarter, even after taking write-downs on its subprime mortgage exposure.

Some commentators said we had been stampeded into unnecessary action, but I had become convinced even before the market turbulence that we needed to get ahead of the curve with larger rate cuts. Some of the criticism took a personal turn. I had been in office only two years and still had two years left in my term, yet journalists began to speculate on whether I would be reappointed by a new president (who wouldn’t take office for another year). The New York Times asked Senator John McCain of Arizona, a presidential hopeful and fellow Republican, how I was doing. “It’s not clear yet,’’ he replied. Meanwhile, Reuters suggested that if a Democrat won the White House, he or she would choose my replacement from among Janet Yellen, Larry Summers, and my former Princeton colleague Alan Blinder.

Reuters quoted House Financial Services Committee chairman Barney Frank as saying a Democratic president “might find someone who’s more in tune with Democratic views.” Upon seeing the quote, Barney directed a senior aide to call the Board’s general counsel, Scott Alvarez, to say he had not meant to indicate dissatisfaction or call for my replacement. He had thought he was stating the obvious—that a new president would have the option to appoint a new Fed chairman when my term expired. If it had been anyone but Barney, I might have doubted the explanation. Barney has a sharp tongue, but he is direct and honest. When he means to criticize you, he leaves no doubt. The next day he issued a six-paragraph clarification. He said he was embarrassed by his “rookie mistake.” His prompt apology was an extraordinary and rare act in Washington. I admired him for it.

In the week leading up to the January 29–30 FOMC meeting, I laid the groundwork for another interest rate cut. Staff economists continued to call for slow growth rather than an outright recession, even nudging up their growth forecast slightly. But the risks to growth seemed significant to me, and we cut our target for the federal funds rate another half-percentage point, to 3 percent. We also tweaked the language of our statement. While it still leaned toward additional rate cuts in the future, it also acknowledged the sharpness of the recent cuts and the possibility that those cuts might be sufficient for the time being.

The vote was 9–1. Richard Fisher told us he had prayed over his decision but couldn’t join the majority. He was worried about inflation, which had ticked up in the second half of 2007, even when volatile food and energy costs were excluded. And he didn’t want to react to financial turmoil. “When the market is in the depressive phase of . . . a bipolar disorder, crafting policy to satisfy it is like feeding Jabba the Hutt—doing so is fruitless, if not dangerous, because it will simply insist upon more,” he said.

Within the majority, views differed over whether we had cut our federal funds rate target enough. Most believed it probably would provide sufficient support if the economy followed staff projections and skirted a recession. But Rick Mishkin scoffed at the glimmers of optimism around the table. “It reminds me a little of one of my favorite scenes in a movie, which is Monty Python’s Life with [sic] Brian,” he said. “I remember the scene with them there all on the cross, and they start singing, ‘Look on the Bright Side of Life.’”

Rick’s instincts proved correct. But at the time we were balancing competing concerns. We were

worried about inflation. We knew it was difficult to assess the effect of financial turbulence on the broader economy. And we didn’t want to overreact to financial stress and thereby exacerbate moral hazard in markets. Still, over the six months from August 2007 to January 2008, we had slashed our target interest rate to 3 percent from 5-1/4 percent, an earlier and more rapid response than any other major central bank. We also established innovative lending programs to ease pressures in funding markets. At the end of January 2008 it seemed that our response might now be correctly calibrated. We couldn’t be sure, but we hoped we might just have reached the beginning of the end of the crisis. As it turned out, we were only at the end of the beginning.

CHAPTER 10

Bear Stearns: Before Asia Opens

The Senate Banking Committee had moved its hearing from the usual room to a more spacious venue, Room G50, on the ground floor of the Dirksen Senate Office Building. Once an auditorium, G50 was packed nonetheless that morning, April 3, 2008. Bright television lights shone on the green felt of the witness table. I sat behind it with Chris Cox, chairman of the Securities and Exchange Commission; Treasury undersecretary Bob Steel (subbing for Hank Paulson, who was on a trip to China); and Tim Geithner. The senators looked down from a raised platform. On the floor between the witness table and the dais, a dozen or more photographers jostled for better shots.

I waited, my hands folded atop my prepared statement—a glass of ice water to my left, a gooseneck microphone and a timer to my right, a small sign with my name in front of me. I reminded myself to remain calm and deliberate. In the hubbub, committee chairman Chris Dodd, whose shock of thick silver hair gave him the look of a senator straight out of central casting, banged his gavel for order. Ten minutes after the scheduled 10:00 a.m. start time, the room quieted and the hearing began.

“We are not in our traditional hearing room, and the size of the crowd in the room is evidence of the reason why,” Dodd began.

The senators and audience were there to hear our firsthand account of the Federal Reserve’s decision in mid-March—during what Dodd called “this momentous four-day period”—to lend $30 billion in taxpayer funds to prevent the failure of the eighty-five-year-old Bear Stearns Companies, the nation’s fifth-largest Wall Street investment bank. Additionally, to stem the panic that gripped financial markets, we had opened our lending, normally reserved for commercial banks and savings institutions, to Bear Stearns’s Wall Street competitors. In both actions, we had declared the existence of “unusual and exigent

circumstances.”

Dodd continued, evidently savoring the drama. “There can be no doubt that these actions taken in order to calm financial markets that appeared to be teetering on the brink of panic have set off a firestorm of debate.” I was glad he seemed to be assuming our good intentions. Then he asked, “Was this a justified rescue to prevent a systemic collapse of financial markets or a $30 billion taxpayer bailout, as some have called it, for a Wall Street firm while people on Main Street struggle to pay their mortgages?”

Dodd’s question hung in the air as the members of the committee made their opening statements. Richard Shelby of Alabama, the senior Republican, focused on legal issues. How is it, he asked, that the Federal Reserve had “unilateral regulatory authority” to extend the government’s safety net to previously unprotected investment banks? “The committee here today,” he intoned in his soft drawl, “needs to address whether the Fed or any set of policymakers should have such broad emergency authority going forward.”

When all the members had spoken, Dodd addressed me, attempting to lighten the mood: “Chairman Bernanke, you have spent quite a bit of time in Congress these last few days. I suggested in private before the hearing that we might find an office up here for the chairman, he has been here so often over the last number of days.”

I thanked him, and I began to explain what had happened leading up to and during the weekend of March 15–16.

Only six weeks before that crucial weekend, after an unprecedented, rapid series of interest rate cuts and some creative use of our lending authority, we had been feeling a bit better about the prospects for the economy and financial system. Our rate cuts in January seemed well justified, given the subsequent report that the United States had unexpectedly lost 17,000 jobs that month. Fiscal help was on the way as well. The president signed a bipartisan tax cut on February 13, in time for the coming tax-filing season. Between April and July, individuals would receive tax rebates of up to $300 and families with children, up to $1,200.

The day after the president had signed the tax cut, I tried to strike a balance in Senate testimony. I predicted “a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt.” But I cautioned that “downside risks remain” and promised that the Fed would “act in a timely manner as needed to support growth.” Alan Greenspan generated financial wire headlines the same day when he told a Houston conference that the economy was “clearly on the edge” of a recession.

I wasn’t willing to use the r-word in public at that point, even though the risk of a downturn was clearly significant. I didn’t have the freedom of expression that Alan enjoyed as a private citizen again. John Maynard Keynes had observed that emotions often drive economic decisions—“animal spirits,” he called them. I wanted to paint a realistic picture, but, with Keynes’s insight in mind and with consumer sentiment approaching a sixteen-year low, I did not want to add unnecessarily to the prevailing gloom by

talking down the economy.

Animal spirits, sentiment, psychology, whatever you want to call it, was central to the economic and financial story in February and March. Consumer sentiment was in decline, and financial market sentiment was plummeting. Nervous buyers and lenders were shunning more and more classes of securities, including securities with no relation to subprime mortgages, such as municipal bonds, securities backed by student loans, and low-rated bonds used to fund corporate buyouts. This lack of discernment meant one thing: A panic was building. And the economy and credit markets were increasingly mired in their own destructive feedback loop—bad economic news fueled financial turmoil, and the turmoil in turn disrupted the flow of credit that powered economic activity.

The troubles of the monoline insurers deepened. One of the most prominent, Ambac Financial Group, had lost its AAA credit rating on January 18. Prodded by New York State insurance regulators, eight big banks and Wall Street firms were negotiating a rescue. Another monoline insurer, FGIC, was downgraded on January 30, and a third, MBIA Inc., looked like it might be next. Our ad hoc crisis management team— Don Kohn, Tim Geithner, Kevin Warsh, and I, along with general counsel Scott Alvarez, monetary adviser Brian Madigan, and other staff—was following the situation closely.

The monolines’ guarantees of subprime securities were behind their ratings downgrades. Because the monolines also insured municipal bonds, however, investors grew wary of those bonds as well. We brainstormed about ways to help the muni market, which was largely an innocent bystander of the ongoing financial mayhem. We had authority to purchase some types of shorter-term municipal bonds (six months or less in maturity) in the New York Fed’s market transactions, but any substantial lending to states or cities would require us to use our 13(3) authority. After a meeting with other regulators and Treasury officials, Don summarized the cautious consensus against bailing out the muni market: “Monitoring and helping affected parties get together is the federal government’s proper role—they don’t require any explicit support or bailout.” Kevin seconded him: “I think we want to avoid suggesting any sort of intervention.”

Financial turmoil had spread to another obscure, but significant, credit market—the market for so-called auction-rate securities, many of which the monolines also insured. Introduced in the mid-1980s, auction-rate securities were long-term bonds that, for the buyer, functioned like safe, easy-to-sell short-term securities. They were issued mostly by state and local governments, student-loan authorities, and nonprofit organizations such as hospitals. Buyers included corporations, retirement funds, and wealthy individuals. Issuers got to borrow long-term but pay a (generally lower) short-term interest rate; investors received a rate slightly higher than those paid on other low-risk short-term, but simpler, securities. The rates on the securities were not fixed but were reset in regular auctions, held every one to seven weeks. Investors could sell their securities at one of these auctions and take the cash. New investors could buy in. If an auction failed for a lack of new buyers, the issuer had to pay a penalty rate to investors stuck with the unwanted securities.

Date: 2016-04-22; view: 680