Fed Slow to Grasp Crisis in 2007 as Yellen Sounded Alarm

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, even as some Fed members warned that it could trigger a downturn, 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 of 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. Several FOMC participants such as then-San Francisco Fed President Janet Yellen sounded alarms in the first half of 2007. Still, the FOMC focused on the economy’s performance and showed reluctance to alter policy until August.

“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.”

The transcripts mention the word “recession” four times in January, three times in June, once in August, and 27 times in December.

Toxic Securities

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. 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 Fed’s discount window.

U.S. central bankers kept their benchmark lending rate unchanged at their regularly scheduled meeting on Aug. 7, 2007, saying in a statement “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.

Participants at the first FOMC meeting of 2007, on Jan. 30-31, saw signs the economy was improving and recession risk diminishing.

‘Possible Recession’

Dallas Fed president Richard Fisher noted at the meeting that MasterCard Inc. reports suggested a “pickup in consumer activity” during the holiday shopping season and showed “much less ‘noise’ about a possible recession.”

Economic growth was “not as bad as we thought” and that the “risk of recession has become much slimmer” and there was greater risk of price increases, Fisher said. He cited a report by Anheuser-Busch Cos., the St. Louis-based brewer of Budweiser beer, that it had raised prices 2 percent to 3 percent.

Yellen said at the January 2007 meeting that “prospects for a really serious housing collapse that spreads to consumer spending have diminished substantially.”

Atlanta Fed President Dennis Lockhart attended his first FOMC meeting in March 2007. His memory of that gathering was “pretty vivid” because he was a new Fed official, when central bankers struggled to understand the economy, he said yesterday.

Connecting Dots

“We were having trouble connecting the dots in real time as to what exactly was happening,” Lockhart said in a Bloomberg Radio interview. “The general tone in the meeting was that the economy would continue in a very positive direction, very positive momentum, and that turned out by summer not to be the case at all.”

The transcripts underscore how Yellen’s economic outlook darkened. In May 2007 she said contacts in the homebuilding and banking industries noted stricter mortgage underwriting standards and that “residential investment could remain a significant drag on the economy.” While a Fed staff forecast “assumes that national house prices are flat going forward, I am worried that they may actually fall,” she said.

Biggest Risk

At the next meeting, on June 27-28, Yellen said the biggest risk to economic growth was housing, which she called the “600-pound gorilla in the room.” She cited the Sacramento area, where price increases of more than 20 percent a year from 2002 to 2005 had begun to decline. Subprime mortgage delinquency rates around the California capital “rose sharply” in 2006 to become some of the nation’s highest, she said.

“The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst,” Yellen said. “Rising defaults in subprime could spread to other sectors of the mortgage market and could trigger a vicious cycle in which a further deceleration in house prices increases foreclosures.”

Several officials such as Fisher and Governor Kevin Warsh suggested the subprime crisis could rapidly get worse. William C. Dudley, a New York Fed executive vice president in charge of the open market desk at the time, presented the committee with a dire picture of strains in credit markets at the start of the Aug. 7 meeting.

Tightening Standards

“Market participants are worried about the effect of tightening credit standards on housing and about the deterioration in the market function in structured finance, which could broaden and be self-reinforcing, ultimately damaging the macroeconomy,” Dudley said.

The market for asset-backed commercial paper shrank from $1.2 trillion at the time of the Aug. 7 Fed meeting to $774.5 billion at the end of the year.

On Aug. 10 and Aug. 16, the FOMC held emergency meetings by conference call as money markets began to tighten. Just nine days after their regular meeting they ripped up their previous outlook and said, “downside risks to growth have increased appreciably.”

The Fed Board announced a half percentage point cut in the discount rate Aug. 17 to 5.75 percent, and the following month cut the federal funds rate by a half percentage point to 4.7 percent. Dudley told the committee Aug. 16 that money markets were beginning to seize up and warned of a larger impact on the overall economy.

‘Market Turbulence’

“The intense market turbulence has caused investors to become more worried about the downside risk to the economy,” Dudley said.

August 2007 stands out as one of the biggest policy flip-flops in Chairman Ben S. Bernanke’s tenure and shows the policy inertia on the FOMC.

At the time, Ken Thomas, a retired lecturer in finance at University of Pennsylvania’s Wharton School, called Bernanke’s Aug. 7 decision a “rookie mistake.”

“I took a whole lot of heat” for the comment “but I absolutely stand by it,” Thomas said in a Jan. 7 e-mail. “There is no getting around the fact that he grossly underestimated how bad the situation was in August 2007.”

Bernanke was in his second year as chairman.

There were signs of excessive risk in financial assets related to housing before the Fed meeting.

Disrupted Markets

New Century Financial Corp., once the second-largest U.S. subprime mortgage lender, filed for bankruptcy in April 2007, followed by American Home Mortgage Corp. on Aug. 6. Bear Stearns Cos. liquidated two hedge funds that invested in mortgage securities in July, and BNP Paribas Investment Partners temporarily suspended net asset value calculations for some funds in August due to disruptions in asset-backed securities markets.

The Fed also had supervisors in the largest U.S. banking companies, which were also taking on more risk. “Citigroup retained significant exposure to potential losses on its” collateralized debt obligation business, “particularly within Citibank, the $1 trillion commercial bank whose deposits were insured by the FDIC,” according to the Financial Crisis Inquiry Commission report released in Jan. 2011.

Originations of non-prime mortgages rose to $1 trillion in 2006, up from $395 billion in 2003, according to data from Inside Mortgage Finance, a Bethesda, Maryland firm that publishes data and analysis on housing finance.

Damaged Credit

Delinquencies on the loans to borrowers with damaged or limited credit histories rose to 17.3 percent of total loans by the fourth quarter of 2007, up from 13.7 percent in the first quarter, according to data from the Mortgage Bankers Association. They jumped to 27.2 percent in the first quarter of 2010 after home prices fell by about a third from their 2006 peak, according to a home price index tracked by CoreLogic Inc. in Irvine, California.

The Financial Crisis Inquiry Commission’s 545-page report said regulators took “little meaningful action” against the threats of financial calamity.

“The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudential lending standards,” the report says.

Fed officials were gathering information on mortgage markets. In May 2006, the Fed Board said it would hold public hearings on predatory lending and subprime mortgage products. In July 2007, the Fed announced an unusual agreement with the Office of Thrift Supervision and the Federal Trade Commission to conduct targeted consumer protection compliance reviews of nonbank subsidiaries operating as subprime lenders.

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