Fed Officials Saw Start of Subprime Crisis in August 2007

Federal Reserve officials in August 2007 saw the beginnings of the crisis in subprime mortgages and concluded that the U.S. economy would be able to withstand it, transcripts from their 2007 meetings show.

“Well-capitalized banks and opportunistic investors will come in and fill the gap, restoring credit flows to nonfinancial businesses and to the vast majority of households that can service their debts,” Donald Kohn, then vice chairman of the board, said in Aug. 2007 according to transcripts of the Federal Open Market Committee meetings released today in Washington.

The transcripts show the committee’s slow grasp on the enormity of contagion that was to spread throughout global markets as a result of billions of dollars in low-quality housing assets that had been securitized into bonds and sold to banks and investors worldwide.

“The odds are that the market will stabilize,” Bernanke told the committee in Aug. 2007, according to the transcripts from that year. “This restrictive effect could come in various magnitudes. It could be moderate, or it could be more severe, and we are just going to have to monitor how it adjusts over time.”

Concern about capital losses from toxic mortgage securities froze interbank lending markets and prompted runs against major investment banks. The Fed and JPMorgan Chase & Co. (JPM) rescued Bear Stearns Cos. in March 2008, and Lehman Brothers Holdings Inc. collapsed into bankruptcy that September. Both Goldman Sachs Group Inc. and Morgan Stanley converted to bank holding companies to access backup funding from the discount window.

Rate Unchanged

U.S. central bankers kept their benchmark lending rate unchanged at their regularly scheduled meeting on Aug. 7, 2007, saying in their statement that “the predominant policy concern remains the risk that inflation will fail to moderate as expected.”

Fed officials did have a legitimate inflation worry in 2007. Revised data shows the personal consumption expenditures price index rising at a 3.5 percent rate for the year ending that December. The unemployment rate hit a low of 4.4 percent in March and May. Still, financial markets were beginning to unravel.

To contact the reporter on this story: Craig Torres in Washington at 1220 or ctorres3@bloomberg.net

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

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