Federal Reserve documents 17 page

But how strong were the companies, really? The GSEs’ vaunted underwriting standards, it would turn out, did not ensure that the companies would acquire only high-quality mortgages. Fannie and Freddie

were not allowed to buy subprime and other exotic mortgages directly from originators. However, anxious about the competition posed by private-label MBS, and eager for the high returns that lower-quality mortgages seemed to promise, they bought and held private-label MBS that included subprime and other lower-quality mortgages. By some estimates, the GSEs had bought about one-third of the $1.6 trillion in lower-quality, private-label mortgage-backed securities issued from 2004 through 2006. The CEOs of both companies strongly supported this strategy and remained resolute even as losses in lower-quality mortgages began to mount.

As house prices continued to decline, delinquencies and defaults increased to levels not seen since the Depression, and not only among subprime borrowers. In early June, our economists told me that they expected 2.2 million homes to enter foreclosure in 2008, up from 1.5 million in 2007. Mortgage delinquencies were a double whammy for Fannie and Freddie: They lost money both on the mortgages they held on their balance sheet as well as on the mortgages held by others that the companies had guaranteed.

With their profits turning to losses, Fannie and Freddie slashed the dividends they paid to their shareholders, and their stock prices plummeted. Stock investors had never expected to be protected by the government’s implicit guarantee, and they were not. The implicit guarantee did keep most investors from abandoning the companies’ MBS and debt, but even there confidence was waning, notably overseas. Foreign central banks and sovereign wealth funds (such as those that invest the earnings of oil-producing countries) had loaded up on Fannie and Freddie MBS because they were considered close substitutes for U.S. government debt and were highly liquid—easily bought and sold. In 2008, China alone held more than $700 billion in GSE mortgage-backed securities, slightly more than it held in long-term U.S. Treasuries.

As doubts grew about the GSEs, both Hank Paulson and I received calls from central bank governors, sovereign wealth fund managers, and government officials in East Asia and the Middle East. Were the companies safe? Would the U.S. government stand behind them? Several of my callers had not realized that the government did not already guarantee the GSEs. News coverage had alerted them to the risk. I was as reassuring as I could be, but I was not in a position to offer guarantees, implicit or otherwise.

With so much risk still in the system, Hank and I were eager to focus Congress on the gaps in financial regulation. On July 10, Paulson and I testified before Barney Frank’s House Financial Services Committee about the need for comprehensive reforms. Highlighting the problems inherent in piecemeal supervision of the financial sector, Paulson suggested that Congress make the Fed responsible for the overall stability of the financial system, an important feature of regulatory reforms the Treasury had proposed in March. The proposal seemed to meet with a generally favorable response. (Barney said that the Fed was not ideal for the role but that it was the best alternative. He cited as his authority the comedian Henny Youngman: “How’s your wife?” Youngman was asked, to which he replied, “Compared to what?”) Both Hank and I called for a more orderly system that could wind down large financial firms

on the verge of failure. Barney hoped legislation could be completed early in 2009, but that did not seem realistic to me.

Events moved much more quickly than the congressional debate. On the Monday before the testimony, Fannie’s and Freddie’s stock prices had dropped sharply when an industry analyst speculated that, as the result of an accounting change, the companies might have to raise tens of billions in new capital. Few doubted that lax accounting rules and regulatory standards had allowed the companies to hold very little capital relative to the potential losses on the mortgages they held or guaranteed.

Meanwhile, the FDIC seized IndyMac at the end of the week. The failure would cost the FDIC about $13 billion. In its wake, OTS Director John Reich and Senator Chuck Schumer of New York engaged in mutual finger-pointing. The run had begun in earnest after June 26, when Schumer said in a letter to Reich and the FDIC that IndyMac posed “significant risks to both taxpayers and borrowers.” Reich issued a press release complaining that Schumer’s letter had provoked the run. Schumer responded that the run was caused by regulators’ failure to prevent IndyMac’s “poor and loose lending practices.” Both had valid points. IndyMac was in deep trouble and would have certainly failed in any case. But in a financial crisis, the words of government officials carry extraordinary weight.

Fannie and Freddie would need shoring up, and soon, although—as IndyMac’s collapse had illustrated—Treasury and the Fed had to be cautious not to acknowledge that fact in so many words. The implicit guarantee notwithstanding, investors were wary of new debt issued by the GSEs, and rumors were spreading among market participants that the Fed would soon open its discount window to them. I certainly did not want to do that. How ironic would it be for the Fed to help rescue the GSEs after all the years spent criticizing them? Moreover, I saw the GSEs as the responsibility of Congress and the administration. After Reuters reported a rumor July 11 that I had spoken to Dick Syron about opening the discount window to the GSEs, I emailed the Reserve Bank presidents. “There was absolutely no truth to the rumor,” I wrote. “I wanted to be clear on this point.” My plan instead was for our examiners to independently evaluate the GSEs’ condition. Whatever course we chose would need to be based on the best possible information.

The Fed and the Office of the Comptroller of the Currency had struck an agreement with OFHEO, the GSE regulator, to “deepen our mutual understanding” of the risks the GSEs were facing. In other words, bank regulators would look closely at the GSEs’ books. Don Kohn hoped the effort could be kept quiet, to avoid stirring market fears. With that objective in mind, the Fed and OCC examiners reviewed the GSEs’ data at OFHEO’s offices rather than going physically into the companies.

My resolve against backstopping Fannie and Freddie didn’t last long. On the day of IndyMac’s failure, the GSEs’ stock prices, especially Fannie’s, fell sharply despite supportive words from President Bush and Secretary Paulson. They had lost close to half their value in a single week. Meanwhile, scenes of depositors lining up to withdraw their money from IndyMac played over and over on cable television, and oil prices hit a record $145 per barrel. In the midst of all this bad news, Paulson called to tell me that

he had obtained the president’s permission to ask Congress for help with Fannie and Freddie.

Hank kept us up to date on his progress with Congress and on his conversations with management at Fannie and Freddie. With mortgage losses rising and investor confidence in the GSEs dropping, he saw no alternative to asking Congress to authorize whatever financial support might be necessary to stabilize the companies. He was worried, however, that the very act of proposing the legislation, by revealing the government’s deep concerns, could set off a run on the companies. He asked me whether the Fed would provide a temporary credit line to Fannie and Freddie until legislation was in place.

I agreed, with reluctance. To lend to Fannie and Freddie, which were not banks and thus not eligible to borrow at our regular discount window, we’d invoke yet another rarely used lending authority, this one under section 13(13) of the Federal Reserve Act. Our authority under section 13(13) was more limited than the 13(3) authority we had used to rescue Bear Stearns. Under 13(13), our loans must be collateralized by Treasury securities or securities guaranteed by an “agency” such as Fannie and Freddie. But both authorities could be used only in unusual and exigent circumstances—13(3) by law and 13(13) by Board regulation. Hank emphasized that our credit line would be temporary and precautionary. And, as was the case with all Fed loans, any extension of credit would be fully secured by collateral. I consulted with Board members, who all agreed that maintaining the stability of Fannie and Freddie was paramount. The Board met on Sunday, July 13, and invoked 13(13), giving the New York Fed the go-ahead to lend to Fannie and Freddie if necessary. We acted, we said in a press release, “to help ensure the ability of Fannie Mae and Freddie Mac to promote the availability of home mortgage credit during a period of stress in financial markets.”

Hank made his pitch to the Senate Banking Committee on July 15. SEC chairman Chris Cox and I sat at his side. Paulson asked Congress for “unspecified”—meaning unlimited—authority for the administration to purchase the GSEs’ securities and stock. Hank explained that unlimited authority would so reassure markets that he might be able to avoid using it. “If you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out,” he said. Sometimes market fears can be self-fulfilling, and a strong demonstration can avoid the worst outcomes. I was reminded of the military doctrine of “overwhelming force” as the way to prompt quick surrender and minimize casualties.

A bipartisan measure to backstop the GSEs passed the House on July 23 and the Senate on July 26, and President Bush signed it into law on July 30. The legislation also included reform measures that GSE critics had long advocated—stronger capital requirements and a new, more powerful regulator, the Federal Housing Finance Agency (FHFA, or “fuff-a,” in Beltwayese) to replace OFHEO. If it had been five years earlier, GSE critics would have celebrated the reforms as real progress. But in the summer of 2008, given the condition of Fannie and Freddie and of financial markets, the reforms would prove largely irrelevant. All that mattered was the backstop.

THE NEXT FOMC MEETING, on August 5, 2008, would be Rick Mishkin’s last. It would also be the first for Board member Betsy Duke, who had been nominated by President Bush in May 2007, along with Larry Klane of Capital One Financial Corp. I was sorry to see Rick return to Columbia University. He had been an early and ardent supporter of strong measures to counter financial turbulence. To keep the mood light at his going-away luncheon, all I had to do was read from Rick’s previous remarks to the FOMC. For example, he had once described his ambivalence about a close FOMC vote: “As you know, sitting on a fence and having a fence right in that anatomically uncomfortable position is not a good place to be.”

Betsy had spent most of her career in community banking in Virginia (although, after a series of acquisitions, she found herself working for Wachovia). She was a welcome addition to the Board— friendly and good-hearted, but blunt when she needed to be. I often relied on her terrific good sense. She also brought a practical banker’s perspective, a valuable complement to the economists on the Board and the FOMC. I swore her in just before the meeting began. She had waited fifteen months for Senate confirmation, while Larry Klane’s nomination was blocked by Democrats after community activists complained of his employer’s subprime lending practices. Klane had called me several times to express his deep frustration and disappointment.

Randy Kroszner’s Board term had expired at the end of January and Democrats refused to confirm him to a new term. With Betsy’s nomination the exception, the Senate seemed to be creating a regrettable convention, that no one could be confirmed to the Fed’s Board in the last year to eighteen months of the president’s term. (In 1999, ahead of the 2000 presidential election, one of Chris Dodd’s Republican predecessors as Senate Banking Committee chairman, Phil Gramm, had blocked President Clinton’s nomination of Roger Ferguson to a second Board term. After the election, President Bush renominated him.) I was grateful that Randy agreed to continue serving until a replacement was sworn in. But it was unfortunate that, largely for political reasons, two Board seats remained unfilled, leaving us shorthanded during a difficult period.

At the FOMC meeting, Bill Dudley focused his briefing on Fannie and Freddie. The bill signed into law the week before had helped avert a meltdown in the markets for GSE-guaranteed mortgage-backed securities as well as the debt the GSEs issued to finance their portfolios. But, for the housing market, the measure was at best a palliative. Even though the new law allowed the GSEs to support the mortgage markets by increasing their MBS portfolios, they were shrinking their holdings to reduce risk. And, despite the “bazooka” written into the legislation, foreign investors had also retreated from buying GSE securities. The reduced demand for MBS helped push mortgage rates higher. Notwithstanding our sharp cuts to the federal funds rate, thirty-year fixed-rate mortgages hovered around 6-1/2 percent, up from 5-1/2 percent at the start of the year.

I had asked Bill to discuss the state of the Federal Reserve’s balance sheet in his briefing. We were facing what might prove to be a critical question: Could we continue our emergency lending to financial institutions and markets, while at the same time setting short-term interest rates at levels that kept a lid on

inflation? Two key elements of our policy framework—lending to ease financial conditions, and setting short-term interest rates—could come into conflict.

When the Fed makes a loan, taking securities or bank loans as collateral, the recipient of the loan deposits the funds in a commercial bank. The bank in turn adds the funds to its reserve account at the Fed. When banks hold substantial reserves, they have little need to borrow from other banks, and so the interest rate that banks charge each other for short-term loans—the federal funds rate—tends to fall.

But the FOMC targets that same short-term interest rate when making monetary policy. Without offsetting action, our emergency lending—by increasing the reserves that banks held at the Fed—would tend to push down the federal funds rate and other short-term interest rates. Since April, we had set our target for the federal funds rate at 2 percent—the right level, we thought, to balance our goals of supporting employment and keeping inflation under control. We needed to continue our emergency lending and at the same time prevent the federal funds rate from falling below 2 percent.

Thus far, we had successfully resolved the potential inconsistency by selling a dollar’s worth of Treasury securities from our portfolio for each dollar of our emergency lending. The sales of Treasuries drained reserves from the banking system, offsetting the increase in reserves created by our lending. This procedure, known as sterilization, allowed us to make loans as needed while keeping short-term interest rates where we wanted them.

But this solution would not work indefinitely. We had already sold many of our Treasury securities. If our lending continued to expand—and the potential appetite for our loans at times seemed infinite—we could run out of Treasuries to sell, making sterilization infeasible. At that point, the funds injected by any additional loans would increase the level of bank reserves, and we could lose control of interest rates. This concern was very much on our minds, and it provided additional ammunition to FOMC participants who were uncomfortable with our growing array of lending programs.*

David Wilcox followed Dudley’s briefing. Wilcox told the FOMC that the Bush administration’s temporary tax cuts had helped the economy grow at a moderate clip earlier in the year, but that weak job data and renewed financial turmoil led the staff to expect growth in the second half of 2008 of a half percent or less. In a particularly worrisome development, our quarterly survey of bank loan officers had revealed that banks were tightening the terms of their loans, especially loans to households, very sharply. The staff maintained its view, first laid out in April, that the economy was either in or would soon enter recession.

At the same time, we could not completely dismiss inflation concerns. Oil prices had fallen to $120 per barrel from their record high of $145 in July. However, staff economists still saw inflation running at an uncomfortable 3-1/2 percent in the second half of the year. Even excluding volatile food and energy prices, the staff expected inflation to pick up to around 2-1/2 percent, more than most FOMC members thought was acceptable. Like all central bankers, we were always alert to the possibility that households and firms might lose confidence in our commitment to price stability. Indeed, responding to perceived

inflation risks, the European Central Bank had just a month earlier raised interest rates despite slowing economic growth and continuing financial pressures. Still, I sided with the members concerned about the debilitating effects of financial stress on economic growth and employment. We agreed to keep our target interest rate unchanged and wait for more information. Only Dallas Fed president Richard Fisher, who wanted to raise the federal funds rate immediately, voted no.

It was a good result, but the 10–1 vote understated rising hawkishness on the Committee. I vented in an email the next day to Don Kohn: “I find myself conciliating holders of the unreasonable opinion that we should be tightening even as the economy and financial system are in a precarious position and inflation/commodity pressures appear to be easing.” The subject line of the email had been “WWGD?”— meaning “What Would Greenspan Do?” Don, who had been Greenspan’s closest adviser before becoming a Board member, reassured me that my management of the FOMC was going about as well as could be expected, given the circumstances. “It’s not clear that the squeaky wheels represent the majority on the Committee,” he wrote. And he reminded me that things hadn’t always gone smoothly for Greenspan. After a honeymoon period of three meetings without dissent in 1987, the Maestro had faced dissents in nineteen of his next twenty-one meetings.

To someone accustomed to watching a legislative body, or the Supreme Court, where close votes are hardly unusual, my concern about having a few dissents on the Committee—which at full strength has twelve voting members—might seem strange. But FOMC tradition called for consensus decision making, and in that context a “no” vote represents a strong statement of disagreement. Most central banks strive to present a united front, although there are exceptions—like the Bank of England, where the governor (the equivalent of the Fed chairman) is sometimes outvoted. Part of a central bank’s ability to influence financial conditions—and by extension the economy—depends on whether markets believe it will follow a consistent policy path. Too many dissents, I worried, could undermine our credibility.

AUGUST IS USUALLY slow in Washington, with Congress in recess and many federal workers on vacation. Like the previous August, however, August 2008 was hectic at the Fed. I did not even bother to plan a vacation, although I did try to take in the occasional Nationals game. Baseball would remain one of my few respites—at least for a handful of hours at a time—as the financial crisis intensified. I had been a Nats fan since the team had arrived in Washington in 2005. Unfortunately, there was no turning off my BlackBerry, and I was often forced to look for a quiet corner of the stadium to take a call. One Sunday afternoon, I found refuge in the stadium’s first-aid area; two nurses watched me curiously as I spoke in low tones.

On August 6, Kevin Warsh reported on a breakfast meeting with Fannie CEO Daniel Mudd. Third-quarter results would be “miserable”—with losses triple what the market expected. Mudd was concerned the company might not have enough capital, a change from his earlier, more confident tone. I heard from our supervisors that Freddie, too, would be announcing significant losses, although Dick Syron continued

to insist that the company would raise $5.5 billion of capital. (It never did, although Fannie did follow through on a promise to raise $7.4 billion.) On August 11, Hank and Treasury staff members came to the Eccles Building for a meeting about the GSEs, with Bill Dudley and others from the New York Fed joining by phone. Despite the July reforms, the GSEs’ capital was not going to cover the likely losses.

The July legislation had included a provision that the Fed consult with FHFA, the new GSE regulator, about Fannie’s and Freddie’s financial condition. On August 14, Don, Kevin, and I, along with several of our supervisors, met with FHFA director Jim Lockhart and his staff to discuss how we could build on the informal arrangements set up earlier in the summer. I liked Lockhart, a numbers guy who had previously served as the chief operating officer for the Social Security Administration, and who had consistently pointed out that Fannie and Freddie were undercapitalized. But he was clearly torn between his concerns about the GSEs and the normal inclination of an agency head to protect his staff’s prerogatives. As a general matter, I tried to be sensitive to other agencies’ turf concerns, on the grounds that doing so was more likely to foster cooperation and good policy in the end. But the situation at the GSEs was getting more dire by the day. “The GSEs have been running with such low capital levels and dysfunctional and confused internal dynamics for so long that I have felt that they could blow up at any time,” Kevin Warsh wrote in an email.

The GSEs’ troubles were further undermining fragile financial markets and quashing any hope of a recovery in housing. Without invoking any extraordinary authorities, we had the power to purchase MBS guaranteed by the GSEs, and I asked Bill Dudley whether we should start doing that as a way to help housing. Dudley was initially skeptical. It might be technically difficult to efficiently buy and manage the GSE securities, and (as he had explained at the FOMC meeting) we had limited room on our balance sheet to buy more securities while still maintaining control of monetary policy. He agreed, though, to look into the idea.

INDYMAC AND FANNIE and Freddie weren’t the only big financial institutions on our radar that summer. We were also watching Washington Mutual, WaMu for short, a mortgage lender based in Seattle. The OTS was WaMu’s lead regulator. The FDIC, as deposit insurer, also monitored it, as did the San Francisco Fed, in case it asked for a discount window loan.

WaMu was founded in 1889 with the goal of helping the city recover from the great Seattle Fire, which had destroyed its entire business district. Over the next century, WaMu survived numerous traumas, including the bank runs of the Great Depression, only to flirt with failure during the savings and loan crisis of the 1980s. The lesson the company took from the 1980s was that long-term viability required growth and diversification, which it achieved largely by purchasing other companies. Nobody bought into that philosophy more than WaMu CEO Kerry Killinger, a former stock analyst. Distinguished by dyed sandy-brown hair that he arranged in a careful comb-over, Killinger, nicknamed “the Energizer Banker,” took over in 1990 at the age of forty. Through a remarkable series of acquisitions, he set out to make

WaMu the nation’s number-one home lender, eventually making it the country’s second-largest mortgage lender, behind Countrywide. I had encountered Killinger at meetings of the Federal Advisory Council, a group (including one banker from each Federal Reserve district) created by the Federal Reserve Act to advise the Board. Even in these staid meetings, Killinger’s energy and strong opinions came through.

Expansion, if it is too rapid, can also be dangerous. As early as 2004, the OTS expressed concern about whether WaMu was doing enough to integrate its many acquisitions. Worse, as part of its growth strategy WaMu plunged into subprime lending; in time, it began to suffer significant losses. In March 2008 our supervisors reported that WaMu was calling an emergency board meeting to consider possible responses, including the sale of the company. Its board had hired Lehman Brothers to help identify potential acquirers.

By the summer of 2008, it seemed questionable whether the company would survive. Nonetheless, the OTS believed that its problems, though serious, were manageable. The more conservative FDIC—always sensitive to any risk to the deposit insurance fund—wanted to intervene. Our people sided with the FDIC. I worried that the OTS was focused too much on preserving a regulatory client and not enough on the broader risks to the system. I had been glad to hear from John Reich on August 2 that Killinger was being replaced. It sounded like the OTS was taking the matter seriously after all.

Don Kohn watched WaMu and reported regularly. Tension between the OTS (under Reich) and the FDIC (under Sheila Bair) continued. Bair wanted WaMu to look actively for potential acquirers—ideally more than one or two. This would ensure that the company could sell itself for a reasonable price and thereby avoid an FDIC payout. Sheila informed OTS that she was going to approach Wells Fargo and JPMorgan, to gauge their interest—just in case. But, as Don reported, OTS officials “went ballistic” and accused the Fed and the FDIC of “being fronts for JPM.” Sheila backed off—for the moment.

IN THE SECOND HALF of August, the Jackson Hole conference loomed. My speech this year would be especially closely watched, and I badgered the staff and various Board members to read draft after draft. I wanted it to provide a road map for monetary policy while at the same time acknowledging the especially high level of uncertainty.

On Thursday, August 21, the select group of conference participants converged on Jackson Lodge. The sight of the snow-capped Grand Teton range was awe-inspiring, as always. Also unchanged from previous years: media trucks with their satellite dishes pointing skyward, tents set up on the lodge terrace for interviews, and TV reporters standing in front of the mountains as they spoke to the cameras.

Fed technicians had again set up an information center in a meeting room. Warsh, Geithner, Kohn, and I frequently left the formal proceedings to discuss the latest market data and developments regarding Fannie and Freddie. We tried to remain inconspicuous by leaving the conference at different times. I also found time to meet with foreign central bankers to update them and hear their views and concerns.

The news on the GSEs was not good. The Fed and OCC supervisors agreed that a realistic assessment

of the two companies would leave them insolvent. A team from the investment bank Morgan Stanley was reviewing the GSEs’ books for Treasury and was coming to a similar conclusion. If intervention became necessary, the most likely alternatives seemed to be receivership (bankruptcy) or conservatorship, an alternative to bankruptcy in which the companies would continue to operate under the direction of their regulator.

On Friday morning, I began my speech by observing that continued financial stress, a weakening economy, and a jump in inflation had created “one of the most challenging economic and policy environments in memory.” I tried to set market expectations for steady monetary policy: We would keep policy easy to support the economy, but we would also do what was necessary to ensure price stability. I also explained why we had intervened with Bear Stearns and laid out an approach to avert future crises. As before, I argued that financial regulation should take a more system-wide approach, to detect risks and vulnerabilities that might be missed by the current, fragmented regulatory oversight.

After my remarks, the rest of the conference focused on the causes and effects of the financial crisis. Gary Gorton of Yale University argued that we were seeing a financial panic similar in structure to, though differing in many details from, the panics of the nineteenth and early twentieth centuries. I agreed. Indeed, we saw our responses to the panic as fulfilling the classic central banking role of lender of last resort. Other speakers and conference participants took a less generous view. Our Bear Stearns intervention came in for a good bit of criticism. A few participants argued that letting a big financial firm fail would be good for the financial system. Willem Buiter of the London School of Economics unrelentingly attacked both our monetary policy and our lending programs. Too-easy monetary policy would lead to serious inflation, he said. In an email to Michelle Smith and Dave Skidmore I half-jokingly suggested that I ought to make a public bet with Buiter on the inflation rate over the next year. They quickly quashed that idea. (But I would have won the bet if it had been made.) There was certainly no consensus at the meeting about the economy or about our response thus far, and little appreciation of what lay ahead.

Date: 2016-04-22; view: 891