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Days Before 2007 Crisis, Fed Officials Doubted Need to Act Days Before Housing Bust, Fed Doubted Need to Act
(about 9 hours later)
WASHINGTON — Federal Reserve officials in August 2007 remained skeptical that housing foreclosures could cause a financial crisis, just days before the Fed was jolted into action, according to transcripts that the central bank published Friday. WASHINGTON — When Federal Reserve policy makers convened in August 2007, one of the nation’s largest subprime mortgage lenders had just filed for bankruptcy, and another was struggling to find the money it needed to survive.
Worries about the health of financial markets dominated a meeting of the Fed’s policy-making committee on Aug. 7, but officials decided there was not yet sufficient evidence that the problems were affecting the growth of the broader economy. Officials decided not to cut interest rates. The Fed did not even mention housing in a statement announcing its decision. The economy was growing, and a transcript of the meeting that the Fed published on Friday shows officials were deeply skeptical that problems rooted in housing foreclosures could cause a broader crisis.
Just three days later, the Fed’s chairman, Ben S. Bernanke, convened an early-morning conference call to inform them that the central bank had been forced to start pumping money into a financial system that was suddenly seizing up. More than five years later, the system remains heavily dependent on those pumps. “My own bet is the financial market upset is not going to change fundamentally what’s going on in the real economy,” William Poole, president of the Federal Reserve Bank of St. Louis, told his colleagues at the meeting.
“The market is not operating in a normal way,” Mr. Bernanke said on that August call, in a moment of historic understatement. “It’s a question of market functioning, not a question of bailing anybody out. That’s really where we are right now.” That was on a Tuesday. By Thursday, the European Central Bank was offering emergency loans to continental banks, the Fed was following suit, and an alarmed Mr. Poole had persuaded the board of the St. Louis Fed to support a reduction in the interest rate on such loans. The somnolent Fed was lurching into action.
The actual conversations from the Fed’s meetings are released once a year after a five-year delay. With a wealth of detail beyond the terse statements and formal minutes issued in the hours and weeks after the meetings, the transcripts provide fresh insights into the debates, actions and judgment of policy makers. “The market is not operating in a normal way,” the Fed chairman, Ben S. Bernanke, told colleagues on a hastily convened conference call the next morning. Mr. Bernanke, a former college professor and a student of financial crises, was typically understated as he explained that the Fed was pumping money into the financial system because private investors were fleeing. “It’s a question of market functioning, not a question of bailing anybody out,” he said. “That’s really where we are right now.”
August 2007 was the month that the Fed began its long transformation from somnolence to activism. Mr. Bernanke and his colleagues would continue to wrestle with misgivings about the extent of the Fed’s powers, and about the limits of appropriate action. At times they would hesitate or move slowly. At times they even would reverse course, most importantly in standing by as Lehman Brothers collapsed the following year. But it is now widely accepted that their efforts helped to arrest the economic chaos unleashed by the financial crisis. More than five years later, the Fed continues to prop up the financial system, and the transcripts of the 2007 meetings, released after a standard five-year delay, provide fresh insight into the decisions made at the outset of its great intervention.
Some of what followed might have been predicted by close readers of Mr. Bernanke’s work as an academic. He had long argued that the big lesson of the Great Depression was that a central bank should never allow its financial system to run short of money. Even more than its efforts to reduce borrowing costs, the Fed’s policy over the coming years would be defined by its determination to provide the funding private investors were withholding. They show that Mr. Bernanke and his colleagues continued to wrestle with misgivings about the need for action, because at the time there was little evidence of a broader economic downturn. Several officials worried that the economy would instead overheat, causing inflation to rise. By December, as the Fed began to act with consistent force, the economy was already in recession.
But in the face of an unprecedented crisis, Mr. Bernanke also would set aside his own work. He had long argued that the Fed should strive to respond to economic circumstances as transparently and predictably as possible, a break from the intuitive and unpredictable style of his predecessor, Alan Greenspan. Officials lacked clear information, relying on anecdotes like a reported conversation with a Wal-Mart executive who said Mexican immigrants were sending less money home. They were also limited by economic models that could not simulate the problems that seemed to be unfolding.
By the end of 2007, even as the available economic data remained fairly strong, Mr. Bernanke and his colleagues instead concluded that they could see the future, that they did not like what they saw, and that it was time to act. “This may be a situation in which you will have to resolve your ambivalence quickly,” Timothy F. Geithner, then president of the Federal Reserve Bank of New York, warned in September. “You may not be able to resolve it.”
“Intuition suggests that stronger action by the central bank may be warranted to prevent particularly costly outcomes,” Mr. Bernanke said in an October 2007 speech that marked the beginning of his public embrace of the need for pre-emptive action. They questioned, too, the Fed’s ability to stimulate the economy, an issue that is still at the center of the debate about its policies.
The Fed’s most dramatic steps did not begin until December 2007, when it created the Term Auction Facility, the first in a series of new programs intended to pump money into the financial system, and arranged to pump dollars into the European financial system in partnership with the European Central Bank. “There’s no guarantee whatsoever that this thing will do what we’re trying to do,” Donald Kohn, then the Fed’s vice chairman, said at a meeting later in August. As the Fed debated a strategy to encourage bank lending, he said, “I just think it’s worth giving it a try under the circumstances.”
And by January 2008, the Fed’s response to the crisis was in full swing. But eventually, Mr. Bernanke and his colleagues concluded that they could see the future, that they did not like what they saw and that it was time to act.
The Fed began 2007 still deeply immersed in complacent disregard for problems in the housing market. Fed officials knew that people were losing their homes. They knew that subprime lenders were blinking out of business with every passing week. But they did not understand the implications for the broader economy. “At the time of our last meeting, I held out hope that the financial turmoil would gradually ebb and the economy might escape without serious damage,” Janet L. Yellen, then president of the Federal Reserve Bank of San Francisco, said in December. “Subsequent developments have severely shaken that belief. The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real.”
“The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,” Mr. Bernanke said in Congressional testimony in March. The Fed’s eventual response, which it expanded significantly in 2008 and 2009, is now widely credited with preventing an even more catastrophic financial crisis and a deeper recession. It is not clear that quicker or stronger action in the fall of 2007 would have made a big difference. Critics focus instead on the Fed’s earlier failure to keep banks healthy and to prevent abusive mortgage lending, and on its later role in allowing the collapse of the investment bank Lehman Brothers.
The mortgage industry was imploding by the time the Fed’s policy-making committee met on Aug. 7. American Home Mortgage, a leading subprime lender, had filed for bankruptcy the previous day. One week earlier, the investment bank Bear Stearns had liquidated a pair of mortgage-focused hedge funds. But officials did not cut interest rates. The economy, they said, “seems likely to continue to expand.” The statement did not even mention the housing market. “The outcome would have been different only if the Fed and others had reacted back in 2004, 2005, 2006” to curtail subprime mortgage lending, Mr. Poole, now a senior fellow at the libertarian Cato Institute, said on Friday in an interview on CNBC.
The transcripts show that many Fed officials at the August meeting remained deeply skeptical about the likely economic impact of those problems. The transcripts show that the Fed entered 2007 still deeply complacent about the housing market. Officials knew that people were losing their homes. They knew that subprime lenders were blinking out of business with each passing week. But they did not understand the implications for the rest of the nation.
“My own bet is the financial market upset is not going to change fundamentally what’s going on in the real economy,” William Poole, president of the Federal Reserve Bank of St. Louis, told the committee on Aug. 7. “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,” Mr. Bernanke said in March.
That was a Tuesday. The image of calm would last exactly two more days. By Thursday morning, the European Central Bank was offering emergency loans to Continental banks and the Fed was following suit. And Mr. Poole and his board voted that day to ask for the Fed to reduce the interest rate on such loans, becoming the first official arm of the central bank to push for stronger action. Officials said at the time that they took particular comfort in the health of the largest banks. Even as the housing market deteriorated, the Fed approved acquisitions by some of the banks with the largest exposure to subprime mortgages, like Citigroup, Bank of America and the Cleveland-based National City.
Two weeks later, at 6 p.m. on a Thursday, Fed officials dialed in to an emergency conference call where they agreed to adopt the St. Louis Fed’s proposal. By the early August meeting, Fed officials had moved from denial to puzzlement. American Home Mortgage, a leading subprime lender, had filed for bankruptcy the previous day. Countrywide Financial, another lender, was looking for a lifeline. The investment bank Bear Stearns had liquidated a pair of mortgage-focused hedge funds.
The central bank began to make it easier for strapped financial companies to borrow money, an effort that would expand dramatically over the coming years as the crisis intensified and private investors withdrew funding. “It is an interesting question why what looks like $100 billion or so of credit losses in the subprime market has been reflected in multiple trillions of dollars of losses in paper wealth,” Mr. Bernanke said at the meeting, referring to the decline of global financial markets.
The first steps seemed relatively modest. The Fed cut the interest rate on loans from its discount window by half a percentage point, to 5.75 percent, and allowed banks to borrow for up to 30 days, rather than reapplying every day. Then it arranged for four of the nation’s largest banks — Bank of America, Citigroup, JPMorgan Chase and Wachovia — to take what it called symbolic loans of $500 million. Three days later, the Fed moved from puzzlement to action.
Mr. Bernanke was eager to avoid broader action, according to the transcripts, because he did not want to give the impression that the Fed was engaged in a bailout of investors, banks or borrowers that had made bad decisions. It acted again the next week. There was, Mr. Bernanke said on a conference call on Thursday, “a certain amount of panic, a certain amount of markets seizing up, with good credits not being able to be financed, and a good deal of concern that there is a potential for some downward spiral in the markets that could threaten or harm the economy.”
“My own feeling is that we should try to resist a rate cut until it is really very clear from economic data and other information that it is needed,” Mr. Bernanke said. “I’d really prefer to avoid giving any impression of a bailout or a put, if we can.” The Fed’s response was relatively modest. It cut the interest rate on loans from its discount window, at which banks borrow from the central bank, by half a percentage point to 5.75 percent, and let banks borrow for up to 30 days rather than reapply daily. Then it arranged for four large banks — Bank of America, Citigroup, JPMorgan Chase and Wachovia — to take what it called symbolic loans of $500 million.
JPMorgan and Wachovia returned most of the money the next day; Bank of America and Citigroup, already in trouble, kept the loans for a month. But banks did not begin borrowing on a large scale until the following year. Mr. Bernanke wanted to avoid cutting an interest rate that banks paid each other, according to the transcripts, because he did not want to give the impression that the Fed was engaged in the rescue of investors, banks or borrowers that made bad decisions.
Private funding sources were beginning to dry up. The premium banks paid to borrow from other banks, without pledging collateral, widened from 0.1 percentage point in mid-August to 0.85 percentage point by mid-September. “My own feeling is that we should try to resist a rate cut until it is really very clear from economic data and other information that it is needed,” he said. “I’d really prefer to avoid giving any impression of a bailout.”
And the broader economy also was beginning to show signs of weakness. Employment declined in August, the first monthly fall in seven years. At the end of the month, Mr. Bernanke used his annual speech at the Fed’s conference in Jackson Hole, Wyo., to declare that the central bank “stands ready” to do more. But private sources of financing were drying up. The premium banks paid to borrow from other banks, without pledging collateral, widened to 0.85 percentage points in mid-September from 0.1 percentage points in mid-August.
Three weeks later, the Fed did, opening a second front in its expanding campaign. The central bank announced that it would reduce its benchmark interest rate for the first time since 2003. To punctuate the decision, it cut rates by half a percentage point rather than the more typical quarter-point cut. In September, after the government announced that employment had declined in August, the first monthly fall in seven years, the Fed announced that it would reduce its benchmark interest rate for the first time since 2003. To punctuate the decision, it cut rates by half a percentage point rather than the more typical quarter-point cut. This time, it mentioned the housing crisis.
And this time the Fed mentioned the housing crisis. But the Fed’s biggest steps did not begin until December, when it created the Term Auction Facility, the first of several programs intended to pump money into the financial system, and arranged to put dollars into the European financial system in partnership with the European Central Bank.
The policy-making committee cut rates by another quarter point at each of the two remaining meetings in 2007 even as its members began to divide over the need for a stronger response. Some, like Frederic S. Mishkin, a Fed governor, argued that the Fed was moving too slowly. Others argued that the Fed was overreacting. Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, dissented from the decision to cut interest rates at the October meeting of the policy-making committee. By then the Fed had cut rates at three meetings in a row, but the disruption of financial markets was only getting worse, and the economy was showing strain.
But by December there was a growing consensus within the Fed that stronger action was needed. When the committee voted to reduce rates again at its final meeting of the year, there was another dissent, this time from Eric S. Rosengren, president of the Federal Reserve Bank of Boston, but this time in favor of even stronger action. The Fed’s own staff still forecast that the economy would avoid a recession.
The Fed still was far from grasping the coming crisis. In January 2008 it cut interest rates by 1.25 percentage points in a pair of dramatic actions. But that was also the month Bank of America announced its acquisition of Countrywide Financial, the nation’s largest mortgage lender. A few months later, the Fed gave its blessing. “We came up with this projection unimpaired and on nothing stronger than many late nights of Diet Pepsi and vending-machine Twinkies,” David Stockton, a Fed economist, said as he presented the forecast in December.
Over the course of the following year, the financial system would crash and the economy would plunge to recession before the Fed helped to arrest the fall. Mr. Geithner said it was time to prepare for a crisis. “I don’t think the past four to six months have been kind to those who have argued that this was just a mild and transitory bump,” he said.
Still, events ultimately would bear out the Mr. Mishkin’s predictions in a speech at the Jackson Hole conference in August 2007. He warned that the housing crash could cause a broader crisis, but also offered a note of hope. “Monetary authorities,” he said, “have the tools to limit the negative effects on the economy.” The economy might still grow, but it seemed increasingly likely “that we have a deep and protracted recession driven as much by financial headwinds as by other fundamentals,” Mr. Geithner said. “There are good arguments for the former, the more benign scenario, but we need to set policy in a way that reduces the probability of the latter.”

Annie Lowrey contributed reporting from Washington.