Newly released transcripts from meetings among Federal Reserve Board members in the second half of 2007 show the group as a whole was slow to pick up on the cataclysmic economic storm that was bearing down on the global economy.
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In the summer and fall of that year most of America was just learning that a multi-billion dollar market existed comprised of nothing but securities built from loans given to people who probably had no business getting them.
And, more importantly perhaps, that those securities were the foundation for a housing bubble that had prompted millions of Americans to wildly overextend themselves on credit.
Transcripts released Friday of meetings and phone calls from June through December of 2007, just as stock markets were beginning to respond to the early tremors, show the members just starting to connect the dots but still underestimating the devastation to be wrought by the domino effect about to kick off.
For instance, during a Sept. 17 meeting, Federal Open Market Committee member Janet Yellin said: “A big worry is that a significant drop in house prices might occur in the context of job losses, and this could lead to a vicious spiral of foreclosures, further weakness in housing markets, and further reductions in consumer spending.”
Of course, all of that would eventually come to pass.
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However, during that same meeting, William Dudley, then manager of the New York Fed’s open market operations -- and now president of the New York Fed -- told FOMC members losses in subprime mortgages for U.S. banks “will ultimately turn out to be in a range of $100 billion to $200 billion.”
Losses Proved to Be Much Higher
Those losses proved to be much higher. Banks received more than $400 billion in the Troubled Asset Relief Program approved in early 2009, and the wider impact of the crisis on household values and job losses ended up in the trillions of dollars.
Also at that meeting, Fed economists projected a 5% decline in housing prices over the next two years – 2008 and 2009. Instead, home prices across the U.S. fell about 30%, crimping consumer spending and shutting down a vital piece of the economic engine.
The transcripts show the writing was on the wall much earlier -- in June of 2007, shortly after two Bear Stearns hedge funds loaded with subprime loans began to implode, a move that foreshadowed the financial calamity to come.
During a June meeting of the Fed Dudley described the subprime mortgage space as “very unsettled.” He said it was hurt by housing market fundamentals and problems with the two Bear Stearns hedge funds. The troubled funds had sent the spread on an index that tracks credit default swaps to a new record high at 1400 basis points.
Dudley noted the “danger that forced liquidation of illiquid subprime-based securities could exacerbate the pressure on this market,” but said the problems are likely “mostly exceptional” in nature, suggesting that the problem was isolated.
But Dudley went on to tell the FOMC that there is a potential for a more widespread event of this nature to cause a cascading effect.
“There still are risks that forced selling could drive market prices down sharply, leading to lower marks for other portfolios of assets related to subprime mortgages,” he said. “This, in turn, could lead to margin calls, investor redemptions, and further selling pressure in this market.”
And, in hindsight, that became the defining theme of the subprime crisis, the way in which defaults on a bunch of bad loans to high risk borrowers spread like wildfire through the global economy and nearly brought it down.
Months of Hemming and Hawing
Dudley was also ahead of the curve on the issue of top credit rating given to these securities by the three primary ratings firms, foreshadowing another powerful dynamic that contributed to the financial crisis.
“The ratings are based on the risk of default, not the market risks associated with illiquidity. As a result, highly leveraged portfolios of highly rated but illiquid assets are subject to significant market risk that the ratings may obscure,” he said.
Notwithstanding these warnings, FOMC members spent the next several months hemming and hawing over the scope of the problem and potential solutions.
By December however the players seemed to be getting a better grasp on the coming crisis.
Timothy Geithner, then president of the New York Fed and soon to take over as Treasury Secretary, said during a Fed phone call, “I think what’s happening in markets now is very serious and really potentially very dangerous.”
Geithner also predicted the dramatic interventions by the Fed that would follow, moves that included years of historically low interest rates and trillions of dollars of asset purchases by the Fed in an effort to pump liquidity into ossified credit markets.
“I think monetary policy is going to have to bear most of the burden for both responding to the risks to the economy presented by this dynamic and arresting some of the behavioral dynamic that we see manifest in markets today,” Geithner said.