Fed Officials Saw Housing Bubble in 2005, Didn't Alter Policy

Federal Reserve staff and policy makers identified a housing bubble in 2005 and failed to alter a predictable path of interest-rate increases to slow down the expansion of mortgage credit, transcripts from Open Market Committee meetings that year show.

Led by then-Chairman Alan Greenspan, the FOMC raised the benchmark lending rate in quarter-point increments to 4.25 percent from 2.25 percent at the end of December 2004. The committee also removed uncertainty about the pace of rate increases by telegraphing that future moves would be “measured” in every statement.

The “measured” pace language helped fuel the housing boom by keeping longer-term interest rates low and was inappropriate at the time given the uncertainties about both inflation and asset prices, said Marvin Goodfriend, a professor at Carnegie Mellon University in Pittsburgh.

“It was a major mistake of the Fed,” said Goodfriend, who attended some of the 2005 meetings as a policy adviser to the Richmond Fed. “It gave markets a sense that the Fed was on top of everything to a degree that wasn’t the case. It gave the impression that this was a mechanical adjustment to normality. The market was overconfident.”

Transcripts from February show then-New York Fed President Timothy F. Geithner raising alarms about the low expectations of risk and volatility in financial markets. Geithner called the economic outlook at the time “implausibly benign.”

Photographer: Keith Bedford/Bloomberg

Alan Greenspan, former chairman of the U.S. Federal Reserve. Close

Alan Greenspan, former chairman of the U.S. Federal Reserve.

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Photographer: Keith Bedford/Bloomberg

Alan Greenspan, former chairman of the U.S. Federal Reserve.

Low Volatility

“The confidence around this view, which is evident in low credit spreads -- low risk premia generally -- and low expected volatility, leaves one, I think, somewhat uneasy,” said Geithner, who is now U.S. Treasury Secretary.

In May, former Atlanta Fed President Jack Guynn noted “white hot” residential construction in Florida as well as “continuing concern about speculation in those markets.”

Greenspan in December still argued against dropping the word “measured” from the statement “because that would imply that we’re really beginning to see developments out there that are moving very rapidly, and I think it’s too soon to conclude that.”

“Whatever froth there is in the housing market is becoming contained at this stage, and it’s getting contained largely because mortgage rates have moved up and are beginning to have an impact,” Greenspan said, according to the transcripts. “If we can contain the presumptive housing bubble, then we have a really remarkable run out there.”

Greenspan’s spokeswoman, Katie Broom, didn’t respond to an email seeking comment.

Subprime Mortgages

Subprime mortgage origination to borrowers with little or damaged credit histories rose to $625 billion in 2005 from $100 billion at the start of the decade, according to data from Inside Mortgage Finance.

Weak lending standards raised questions about the quality of credits in financial institution portfolios, causing runs against firms such as Bear Stearns Cos. that spread into a financial panic. Contracting credit by banks and lenders helped sink the economy into the worst recession since the Great Depression from December 2007 to June 2009.

While growth has resumed, the unemployment rate stood at 9.4 percent in December 2010. The Fed has kept its benchmark lending rate around zero since December 2008. Since that time, the central bank has expanded its balance sheet with direct bond purchases to a record $2.47 trillion.

Top Three

The top three subprime originators in 2005 were Ameriquest Mortgage Co., New Century Financial Corp. and Countrywide Financial Corp., according to Inside Mortgage Finance, a publisher of mortgage data based in Bethesda, Maryland.

Countrywide Financial was purchased by Bank of America Corp. in 2008. New Century Financial filed for bankruptcy in 2007.

“We were aware of the nature of the risks,” Richmond Fed Bank President Jeffrey Lacker told reporters today after a speech in Richmond. “With hindsight, things turned out at the bad end of things we thought were conceivable.”

In June 2005, the FOMC heard presentations from staff economists, with some raising concern about housing markets, the transcript shows. Those warnings didn’t translate into a more aggressive policy. The committee raised the benchmark lending rate a quarter-point at that meeting and said “policy accommodation can be removed at a pace that is likely to be measured.”

Highly Leveraged

“An estimated 4 percent of borrowers are highly leveraged and could lose all of their home equity if house prices were to fall 10 percent,” Andreas Lehnert, now the deputy director of the Office of Financial Stability Policy and Research at the Board, told the committee. “One might wonder if financial institutions and investors have, in the face of the continuing housing boom, dropped their defenses against the mortgage losses that would accompany a house-price bust.”

New York Fed researcher Richard Peach dismissed press reports describing a housing bubble.

“Hardly a day goes by without another anecdote-laden article in the press claiming that the U.S. is experiencing a housing bubble that will soon burst, with disastrous consequences for the economy,” Peach told the committee.

“Housing-market activity has been quite robust for some time now, with starts and sales of single-family homes reaching all-time highs in recent months and home prices rising rapidly, particularly along the East and West coasts of the country,” he said. “But such activity could be the result of solid fundamentals.”

Greenspan’s Questions

Greenspan followed the presentation with questions about the effect of underlying land prices in housing indexes, and the quality of data on whether home purchases were for investment or residences.

“There was a fundamental failure of economic analysis to understand what was going on in the potential for house prices to stop rising,” said William Poole, the former St. Louis Fed president who attended the meetings in 2005. “The high degree of assurance that we all felt that house prices could not decline on a national average basis in a fundamental way -- that was a significant mistake.”

House prices in the last decade peaked at a 15.7 percent year-over-year gain in the first quarter of 2005. By the first quarter of 2009, prices were falling at a 19 percent year-over- year rate, according to the S&P/Case-Shiller U.S. Home Price Index.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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