For those of you who subscribe to the Wall Street Journal, please link on to today’s story on the book: A teaser in the form of a quote from Richard Fisher who the Journal interviewed for the article. “The book’s greatest value is in describing ‘the hubris of Ph.D. economists who’ve never worked on the Street or in the City,’ as well as flagging ‘the protected culture’ of Fed officials in Washington. Many central bankers are, ‘not going to like the book.”
Not that Mr. Fisher asked for an answer. But to those who ‘don’t like it,’ I say, “So be it.” With that, please enjoy an excerpt from Fed Up, Chapter 11: Slapped in the Face by the Invisible Hand.
“You want to put out the fire first and then worry about the fire code.” — Ben Bernanke, December 1, 2008
Among the economists at the Dallas Fed, Bernanke’s optimism prevailed. The Bear Stearns rescue was the punctuation mark that ended the paragraph. Bernanke would trim the sails to right the foundering ship.
I disagreed. The demise of the Bear was a flashing red light that shouted “danger.” My colleagues rolled their eyes.
Rosenblum treated me with a new respect. The chain of events was playing out as I had predicted. He and I began collaborating on a paper on moral hazard. It would make Rosenblum no fans at the Board of Governors.
The bailout both relieved and alarmed the financial press.
The Economist wrote that the Fed was “taking the unprecedented (and, some say, disturbing) step of financing up to $30 billion of Bear’s weakest assets. This could cost the central bank several billion dollars if those assets fall in value.”
The fear of the unknown prompted the Fed, for the first time ever, to extend lending at its discount window to all bond dealers.
Under previous rules, only institutions offering depository insurance or under strict regulatory oversight were allowed to use the discount window, paying a penalty fee for the privilege. Now any distressed investment bank, broker, or commercial bank was allowed to come, hat in hand, to use the window.
The Economist expressed skepticism at this development, saying that fear persisted because the “new Fed window is untested and the very act of drawing on it could rattle markets.” No bank wanted to be perceived as the next sick buffalo.
Inside the Fed, the academics naïvely assumed that just because the window was opened it would be used. The people who had been in the market, such as Fisher and myself, knew the stigma associated with the discount window. Borrowers might as well invite speculators into the boardroom to short their stock.
Fisher told the FOMC that if the Fed could coax some “big boys” to access the discount window, “it could be a life-changing event in removing the stigma.”
To encourage lending, the Fed at its March 2008 FOMC meeting dropped interest rates again, to 2.25 percent. Fisher dissented, as he would again in April when the FOMC again lowered rates.
Fisher wanted to raise rates instead of lower them. This got under Bernanke’s skin. Bernanke “vented” in an e-mail to Kohn the day after the 10 to 1 vote with the subject line “WWGD?”: “I find myself conciliating holders of the unreasonable opinion that we should be tightening even as the economy and financial system are in a precarious position and inflation/commodity pressures appear to be easing.”
Like Rosenblum, Bernanke had internalized Greenspan’s approach to monetary policymaking. The Fed’s tradition of consensus was so powerful “in that context a ‘no’ vote represents a strong statement of disagreement,” Bernanke wrote in his memoir. “Too many dissents, I worried, could undermine our credibility.”
But tradition be damned, Fisher refused to be a yes man. He always feared the consequences of “pushing on a string”— a phrase with a venerable history at the Fed.
In 1935, Federal Reserve Chairman Marriner Eccles testified during hearings on the Banking Act that little could be done with monetary policy to stimulate growth.
“You mean you cannot push on a string?” Congressman Alan Goldsborough said.
“That is a very good way to put it, one cannot push on a string,” Eccles said. “We are in the depths of a depression and…beyond creating an easy money situation through reduction of discount rates…there is very little, if anything, that the [federal] reserve organization can do toward bringing about recovery.”
Fisher feared the same thing was happening. In the middle of what would become known as his year of dissent, he sat down for an interview with the Wall Street Journal.
“It’s really a question of, are we getting the bang for the buck?” Fisher asked. “And clearly we’re not. The system was sputtering and I began to feel that at 3.5%. After that, that’s when I dissented,” referring to his January 2008 dissent, when the FOMC lowered the fed funds rate to 3 percent.
The problem wasn’t interest rates. Banks didn’t begin making loans because they first had to shore up their capital bases to cover potential losses from their own toxic waste.
“The U.S. economy was suffering from a breakdown of the nervous system and they wanted to use conventional macroeconomic tools,” said Rosenblum years later. “None of these people had ever been through a financial crisis. Their response was the height of tunnel vision, shortsightedness and myopia.”
The Fed’s medicine was incapable of treating the disease in the system, but they insisted on using it. By doing so, they began to cripple the very banks they desperately needed to convalesce.
In an attempt to keep things flowing, the Fed expanded the type of assets it would accept as collateral from distressed banks, reduced penalty rates to virtually nothing, and speeded up auctions of quality bonds, so banks could put those on their balance sheets and off-load the junk onto the Fed. But there was still no stampede to the discount window.
Buyers of securities had disappeared; the great derivatives locomotive had slammed on the brakes, causing the train cars behind to slam into one another, derail, and slide off the mountain.
In mid-April 2008, the IMF warned that potential losses from the credit crunch foreshadowed by Bear’s fall could surpass $1 trillion. As if on cue, Swiss bank UBS reported an $11.5 billion loss and announced that it would cut 5,500 jobs by the middle of 2009.
The bond issuers were the next to get hit. On May 13, MBIA, the world’s largest bond insurer, reported $2.4 billion in losses due to write-downs of CDSs. By early June, Moody’s announced it would probably downgrade MBIA and the second- largest player, Ambac. S& P followed two days later with a similar announcement.
If only the monoline bond insurers had stuck to their original business of insuring municipal bonds. But the potential for fee generation by selling insurance for CDOs was too tempting.
One after another, financial institutions announced deep losses. The $5.4 billion loss announced by American International Group (AIG), a massive underwater depth charge waiting to explode, was lost in the parade.
The next systemic risk flare-up came from the West Coast. On July 11, 2008, IndyMac Federal Bank, a subprime lender based in Los Angeles and valued at $30 billion, was placed in receivership by the Office of Thrift Supervision (OTS).
Inexplicably, the OTS downgraded IndyMac without informing Yellen, whose bank had been in the process of offering IndyMac loans. What did the OTS know that Yellen didn’t?
That week, Congressman Barney Frank (D-Mass.) characterized as “solid” the future prospects of Fannie Mae and Freddie Mac, the two mammoth GSEs that guaranteed three out of every four mortgages in America. And made huge contributions to his political campaigns.
Frank had blocked all attempts by the Bush administration to rein in excesses at Fannie and Freddie. “The more people exaggerate a threat of safety and soundness [at Fannie and Freddie],” Frank said, “the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially.”
But the GSEs were on a greasy slide to ruin. The companies had combined outstanding liabilities of $5.4 trillion. By early September, the Fed would be forced to take control of both Fannie and Freddie.