Binyamin Appelbaum and David Cho at WaPo:
Just as the Fed had failed to protect borrowers from the consequences of subprime lending, so too had it failed to protect banks.
The central bank’s performance has sparked a great debate about its future as a regulator, pitting those who want to expand its role against those who want to strip its powers. It also has come under pressure from politicians seeking greater oversight of its primary job, adjusting interest rates to moderate economic growth. The battles have complicated Bernanke’s bid for a second term as chairman. The Senate Banking Committee voted to approve Bernanke 16 to 7 on Thursday, setting the stage for a January battle on the Senate floor.
The Fed’s failure to foresee the crisis or to require adequate safeguards happened in part because it did not understand the risks that banks were taking, according to documents and interviews with more than three dozen current and former government officials, bank executives and regulatory experts.
Regulatory agencies exist to lean against the wind. But rather than looking for warning signs, the Fed had joined — and at times defined — the mainstream consensus among policymakers that financial innovations had made banking safer. Bernanke said the economy had entered an era of smaller and less frequent downturns, which he and others called “the great moderation.”
The consequences of this miscalculation can be seen in the stories of three large banks the government ultimately rescued from collapse.
The Fed let Citigroup make vast investments without setting aside enough money to cover its eventual losses. The company would need more than $45 billion in federal aid.
The Fed watched as National City made billions of dollars in subprime loans that were never repaid. Regulators would arrange its sale to a rival, PNC.
I would add that the suits at the banks did not really understand the risks they were taking, either. This is a key point of the first chapter of Unchecked and Unbalanced. Where there was power, there was not knowledge. The concentration of power in an age of dispersed knowledge is what the book is trying to highlight and to combat.
Read the whole story. My favorite anecdote concerns a colloquy between Ben Bernanke and Richard Dekaser, a bank economist who worried about house prices in California in 2005.
“They have been saying that about California since I bought my first house in 1979,” Bernanke replied.
It was myopic enough to believe in 2005 that housing wasn’t overpriced on a nationwide basis. But to specifically dismiss concerns about California even though it had been in the trough of a housing crash a mere 10 years earlier? That’s just willful blindness.
Dean Baker at American Prospect:
Let’s put this so that even a Washington Post editor can understand it. Suppose someone gets a garbage mortgage for $200k on a $200k home. Suppose the mortgage resets to a level that they cannot pay. The homeowner then loses the home. if the bank then has to resell the home, then it will lose roughly 25 percent, or $50k, on its investment, if the home is still worth $200k. This is bad news, but loses of this magnitude on $1.6 trillion or so of subprime and perhaps another $800 billion of Alt A would not have been that big deal. They certainly would not have sank the economy.
The reason that the economy and the financial system sank is that the homes plummeted in value as the bubble collapsed. This meant that the $200k home might be worth $150k or even $100k in some markets. The loses in these cases could easily be 50 percent or even 75 percent of the initial mortgage. More importantly, there were huge losses even on prime loans as tens of millions of prime borrowers also fell underwater.
It is important to keep saying that the problem was the bubble, both so that we have a clear understanding going forward and also so that everyone understands how badly Greenspan and Bernanke messed up. There was no need for any sophisticated understanding of complex financing on their parts. They just needed to know simple arithmetic to recognize a bubble and then to act on this knowledge.
But the bigger point is that a piece openly critical of the Fed’s performance, and one that puts Bernanke in the spotlight, is running while his confirmation is still in play. This appears to be further confirmation of the observation made by Politico last week, that the enthusiasm for him is waning. That does not mean he will not be confirmed in the end (as much as we think it would be salutary; as one reader pointed out, any replacement would be sorely aware of the fact that the Fed was being called to conceive of its constituency more broadly than it has of late). But it does signal that his confirmation is not a done deal.
This whole episode makes me think considerably worse of my former department head.
UPDATE: Free Exchange at The Economist:
I think it’s important to ask why there is a difference in attitude. An easy explanation, and one often given, is that the Fed is a creature of the banking industry, and the banking industry dislikes inflation and likes a lax approach to regulation. That oversimplifies matters somewhat, but it’s not too far off the mark.
A follow-on question would then be: is there any way to make the Fed as concerned about the safety and stability of the financial system as it is about inflation. I think not. The Fed has enough trouble trying to balance the price stability aspect of its mission with the full employment aspect. It would be better to give responsibility for financial stability to a different regulator, whose legitimacy depends upon the success with which the regulatory mission is carried out, just as the Fed’s credibility rides, first and foremost, on its ability to control inflation (this is not my judgment, but rather the way central bankers and markets seem to understand the central banker role).
It’s time to learn a lesson here. An institution that missed a brewing crisis of this magnitude is an institution not set up to detect and prevent a brewing crisis of any magnitude. Something else is needed.
Fed governor Daniel Tarullo, who has been appointed by President Obama to overhaul the Fed’s approach to regulation, thinks it can:
“Supervision of the largest institutions is something that’s going to be very hard to do and to do well,” Tarullo said, “and the Fed is the one part of government that has the resources and the capacity and the expertise to fill this role.”
My feeling is that he’s more right than wrong. Yes, the Fed screwed up big time over the course of the past couple of decades, essentially giving up most of its important regulatory oversight role. But at the same time it seems improbable, to say the least, that anybody else could do a better job than the Fed.
To put it another way, the Fed’s our best hope here. Its chances of becoming an effective regulator might be slim, but they’re higher than the chances of getting an effective regulator if you give the job to a different agency entirely. Either way, the most likely outcome is probably that banks will continue to act with reckless impunity. But we ought at least to try our best to stop them from doing that. And the Fed’s the only agency which has a chance in hell of succeeding.
Noam Scheiber at TNR
Pat Garofalo at Think Progress
UPDATE: Matthew Yglesias
Pingback: What We’ve Built Today « Around The Sphere