A new light on regulators in the dark
In the five years that have elapsed since the direst days of the financial crisis, we’ve learned much about how the U.S.’ high-level banking regulators worked to keep the debacle from turning into a full-blown economic depression. Tales of these herculean efforts have emerged in books by some of the major players, and in the exhaustive testimony they’ve presented before congressional inquisitors and others trying to determine what went wrong and why. Still, there is more to learn. That’s the message in the transcripts released Friday by the U.S. Federal Reserve Board, detailing the 2008 meetings of its powerful Federal Open Market Committee.
This treasure trove — almost 2,000 pages of conversation and dialogue by the committee members and other Fed officials — sheds light on the rescue of Bear Stearns, the bankruptcy filing of Lehman Brothers and the bailout of the American International Group.
My initial takeaway from these voluminous transcripts is that they paint a disturbing picture of a central bank that was in the dark about each looming disaster throughout 2008. That meant that the nation’s top bank regulators were unprepared to deal with the consequences of each new event.
Consider comments about the strength of the U.S. banking system made at the meeting on March 18, 2008. This sit-down occurred just days after the collapse of Bear Stearns and the sale of its assets to JPMorgan Chase, in a deal brokered by the Federal Reserve Bank of New York.
While most of the discussion at this meeting covered the possibility that the country had already slipped into a recession and that inflation might rear its head, the topic of whether the nation’s banks were adequately capitalized did come up. That these institutions were inadequately capitalized was already obvious to some regulators, but that was not the view of Timothy Geithner, who was then the president of the New York Fed and vice chairman of the Fed’s Board of Governors.
“It is very hard to make the judgment now that the financial system as a whole or the banking system as a whole is undercapitalized,” Geithner said, adding that “some people are out there saying that.”
He continued: “Based on everything we know today, if you look at very pessimistic estimates of the scale of losses across the financial system, on average relative to capital, they do not justify that concern.”
To Geithner, the nattering naysayers raising alarms about the financial system’s soundness were a bigger problem than the one that they were trying to draw attention to.
“There is nothing more dangerous in what we’re facing now,” he said, “than for people who are knowledgeable about this stuff to
feed these broad concerns about our credibility and about the basic core strength of the financial system.”
On Friday, Geithner did not return an email requesting comment.
To be sure, Geithner was not alone in this view. Just three weeks earlier Donald Kohn, another Fed vice chairman, told the Senate Banking Committee: “The problems in the mortgage and housing markets have been highly unusual and clearly some banking organizations have failed to manage their exposures well and have suffered losses as a result. But in general these losses should not threaten their viability.”
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Equally distressing, as the credit storm gathered strength after the Bear Stearns collapse, the minutes show little comprehension of the perils posed by two other teetering financial giants: Fannie Mae and Freddie Mac. This is odd, given that the declining financial position of these mortgage finance heavyweights — they guaranteed or issued $5 trillion in mortgages — was known at the time.
Yet the companies were barely mentioned at the meetings before the one that occurred Aug. 5. Just a month later, the companies had to be taken over by taxpayers.
Also missing from much of the discussion early in 2008 was the recognition that government rescues of reckless financial firms created moral hazard.
The March 18 meeting came just two days after the Bear Stearns rescue. But almost no concerns were raised at the meeting that by aiding this brokerage firm, other firms would assume that the government would also come to their rescue.
The Bear Stearns rescue, after all, cemented the notion that the taxpayer would be there to bail out aggressive financiers. And yet there was only one passing reference to this policy peril. It came from Frederic Mishkin, a governor who left the Fed later that year.
Outlining his bearish views on the economy and deteriorating credit markets, Mishkin noted another cost associated with the deepening financial problems.
“One result,” he said, “is that we’ve just expanded the safety net to a much wider set of institutions, and we are in a brave new world here, and it is very disturbing.”
And that was it. Nothing more about this crucial issue was said at that meeting.
Six months later, amid Lehman’s failure, they did start to talk about moral hazard.
In public statements since that time, the Fed has maintained that the government didn’t have the tools to save Lehman. These documents appear to tell a different story.
Some comments made at the Sept. 16 meeting, directly after Lehman filed for bankruptcy, indicate that letting Lehman fail was more of a policy decision than a passive one.
For example, James Bullard, president of the St. Louis Fed, noted the positive message that the decision sent to the market.
“By denying funding to Lehman suitors,” Bullard said, “the Fed has begun to re-establish the idea that markets should not expect help at each difficult juncture.”
Jeffrey M. Lacker, president of the Richmond Fed, echoed this view.
“What we did with Lehman I obviously think is good,” he said. “It has had an effect on market participants’ assessment of the likelihood of other firms getting support.”
But he added that the Fed’s public stance on Leh- man’s failure was confusing the markets. “All the language around not supporting Lehman was of a one-off nature,” he said. “So I’m not sure about the extent to which we’ve diminished uncertainty about the likelihood of support going forward, and I think that such uncertainty is likely to exacerbate financial volatility in the months ahead until we can make more progress on articulating a reasonably principled policy on when we’re going to intervene and when we’re not, or at least enhancing clarity about that.”
Lacker was right to wonder. Later that day, the government rescued the American International Group, the beleaguered insurance company, and its big-bank counterparties.