The Onset of the Financial Crisis

If the internal sense-making of the FOMC did not lead members to readily asso­ciate housing and financial markets, external events would eventually force that association on them.

While the foreclosures in the subprime markets were a significant theme be­ginning in March, the modal way in which committee members made sense of subprime was through a narrative that minimized the risks involved. Jeff Lacker captured the continued optimism of most members:

On the national level, risks seem to have risen lately, but my sense is that prospects are still reasonably sound. Subprime mortgages, obviously, have dominated the financial news in recent weeks. Concerns about the welfare of families suffering foreclosures are quite natural, and anecdotes about outright fraud suggest some criminality. But my overall sense of what's going on is that an industry of originators and investors simply misjudged subprime mortgage default frequencies. Realization of that risk seems to be playing out in a fairly orderly way so far. (FOMC, 2007a: 41)

As already stated, committee members viewed the mortgage market as a collection of distinct sectors rather than an integrated network or system. This framework led them to further downplay the risks from subprime. Thus, in March 2007, Mishkin found it reassuring that the subprime market “is a fairly small part of the overall mortgage market,” concluding, “the subprime market has really been overplayed in the media, and I do not see it as that big a downside risk” (FOMC, 2007a: 69-70).

This optimism was belied by incoming data. By August 2007, in the wake of renewed financial turmoil, the FOMC was forced to acknowledge that problems in the mortgage market had spread beyond subprime and that the CDO market was beginning to be impaired. On September 18, 2007, Chair Ben Bernanke re­ferred to the presence of a “financial crisis” for the first time (FOMC, 2007c: 93).⁹

In their presentations to the FOMC, staff also began to acknowledge the lim­itations of macroeconomic models for grappling with unfolding financial events. As staff economist David Stockton explained, also on September 18, “The finan­cial transmission mechanisms in most of the workhorse macro models that we use for forecasting are still rudimentary. As a result, much of what has occurred doesn't even directly feed into our models” (FOMC, 2007c: 20).

Despite these admissions, however, the FOMC adhered to its basic conceptu­al apparatus. For instance, participants continued to take heart from the “resil­iency” of the underlying real economy. As Philadelphia Reserve Bank president Charles Plosser explained at the September 2007 meeting,

The national economy looks more vulnerable to me than it did six weeks ago, but it would be a mistake—and I think Dave Stockton did an excel­lent job of reminding us—to count out the resiliency of the U.S. economy at this early stage. I think there can be a tendency in the midst of finan­cial disruptions, uncertainty, and volatility to overestimate the amount of spillover that they will exert on the broader economy. (FOMC, 2007c: 47)

If their sectoral thinking led committee members to minimize the economic risks posed by financial markets, their regional thinking led them to view these risks as geographically dispersed. Plosser insisted on this fact as late as Decem­ber 2007: “Based on such observations and the news that I hear from my Dis­trict, I sense that the stresses in the economy vary significantly by region, and we must be mindful that the weaknesses on Wall Street are in those states that have exaggerated housing volatility and may not be representative of the rest of the economy” (FOMC, 2007d: 56).

Once again, this optimism was wrong. Conditions rapidly deteriorated in the winter of 2007-2008. By January 2008, Sandra Pianalto, president of the Cleve­land Reserve Bank, was “detecting the first signals of a credit crunch” (FOMC, 2008a: 76). By March, Mishkin could claim, “The reality is that we are in the worst financial crisis that we've experienced in the post-World War II era” (FOMC, 2008b: 69). It was also in March 2008 that the staff's economic projections first forecasted a recession, albeit a mild one (FOMC, 2008b: 14-16).

The FOMC's chief source of concern during the winter was the development of an “adverse feedback loop” whereby tightening credit conditions restrained economic activity, which further weakened financial markets and thus further tightened credit conditions (FOMC, 2008b: 69). At the same time, participants also began to worry about the liquidity and ultimately the solvency of individual financial institutions.

At the January 29-30, 2008, meeting, William Dudley, chief economist at the Federal Reserve, connected the turmoil in the credit markets to the problem in home foreclosures:

I'll start today by noting that U.S. and global equity and fixed-income markets have behaved in a way consistent with a dark economic outlook. Market price risk has increased. The problems of the financial guarantors have been an important part of the story. In recent years, the major finan­cial guarantors have diversified into insuring structured-finance products, including collateralized debt obligations (CDOs). Currently, their expo­sure to all structured-finance products is about $780 billion.

ecaBuse the structured-finance guarantees have typically been issued against the highest rated tranches at the very top of the capital struc­ture, until recently the rating agencies did not think that these guaran­tees would result in meaningful losses. However, as the housing outlook has continued to deteriorate and the rating agencies have increased their loss estimates on subprime and other types of residential mortgage loan products, the risk of significant losses has increased sharply.

It is clear from this meeting that there was widespread concern that the fi­nancial crisis was going to be much larger than they had originally anticipat­ed. This concern rose precipitously in the wake of the Bear Stearns collapse of March 2008. The policy response to the Bear Stearns collapse was pretty much a dress rehearsal for what would happen in the fall of 2008 after Lehman Brothers collapsed. Mr. Dudley led off the meeting on March 18-19, 2008, by giving his account of Bear Stearns's demise and its implication for the credit markets:

In my view, an old-fashioned bank run is what really led to Bear Stea­rns's demise. But in this case it wasn't depositors lining up to make with­drawals; it was customers moving their business elsewhere and investors' unwillingness to roll over their collateralized loans to Bear. The rapidity of the Bear Stearns collapse has had significant contagion effects to the other major U.S. broker-dealers for two reasons. First, these firms also are dependent on the repo market to finance a significant portion of their bal­ance sheet.

The issue of the possible spillover from Bear Stearns's demise dominated the discussion at the meeting. Federal Reserve governor Kevin Warsh explained, “Over the past couple of weeks, not just in the episode with Bear Stearns, coun­terparty risk is becoming the dominant concern in markets. As has been pointed out around this table, it is increasingly difficult to separate liquidity issues from solvency issues” (FOMC, 2008b: 60). Warsh concluded, “Financial institutions, more broadly than financial markets, are having a hard time finding their way” (FOMC, 2008b: 61).

Fredric Rosengren, president of the Federal Reserve Bank of Boston, summed up the sentiment of the meeting:

News of the problems at Bear Stearns and the very fragile situation in financial markets complicate our decision today. Federal funds futures in­dicate that the market is anticipating a reduction of at least 75 basis points and probably more than that. Normally the expectations of financial mar­ket participants would not factor heavily in my decision making. How­ever, given the fragility in the market and my own expectation that, even with this move, further easing will be necessary, I strongly prefer lowering interest rates by.75%. (FOMC, 2008b: 68)

The meeting came up with a series of policy initiatives. First, the FOMC decid­ed to expand its credit lines to banks. It also agreed to begin to buy some agency MBSs for either cash or Treasury bonds in order to bolster the balance sheets of banks. The most important move was to lower interest rates by 0.75 percent.