In FED We Trust (15 page)

With all these mixed messages, Bernanke tried to strike a balance in his semiannual report to Congress in July 2007. Distinctly more cautious than he had been, Bernanke still conveyed a generally optimistic tone. He mentioned deteriorating conditions in the subprime mortgage market, mounting mortgage delinquencies, and increased worry among investors about the risks of various financial instruments. The spread between rates on loans to shakier businesses and rates on U.S. Treasurys had widened, he said, but were still “near the low end of their historical ranges.”

To be sure, there was concern in Bernanke’s words, but his conclusions
were far from grim. “Overall,” he said, “the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.” The “downside risk,” he told Congress, was “that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer spending.” (Bad dreams
can
come true.) Still, he told Congress, the Fed saw “upside risks to inflation” — not recession or the ill effects of the bursting housing bubble — as its “predominant policy concern.”

Housing, however, was very much on the mind of the senators and congressmen who questioned him. At a July 2007 hearing, responding to a question from Republican senator Richard Shelby of Alabama, Bernanke acknowledged that there would be big losses from subprime mortgage loans that weren’t likely to be repaid and from securities linked to those mortgages. He cited estimates of between $50 billion and $100 billion, which he called “fairly significant.” That understated the problem enormously. In April 2009, the International Monetary Fund (IMF) estimated that global losses on subprime and other loans made in the United States would eventually reach $2.7 trillion — with another $1.4 trillion coming from loans made overseas.

Over the summer of 2007, the housing market continued its collapse. In June, Standard and Poor’s downgraded over a hundred bonds backed by subprime mortgages; the ratings company later placed 612 securities backed by subprime mortgages on the list of securities likely to be downgraded. Countrywide Financial Corporation, a huge California-based mortgage company, warned of “difficult conditions” as its problems with subprime mortgages spread to conventional loans. On the last day of July, the two Bear Stearns hedge funds that had been teetering for several months finally filed for bankruptcy and were liquidated.

Then, on August 3, 2007, the growing anxiety on Wall Street found a voice in CNBC commentator Jim Cramer, the lawyer turned journalist
turned hedge fund manager turned cable TV star who, according to his official biography, “believes that there is always a bull market somewhere, and he wants to help you find it.”

Responding to a question from business news anchor Erin Burnett, Cramer launched into an explosion that became a YouTube favorite. “This is about Bernanke! Bernanke needs to open the discount window! Bernanke needs to focus on this! Bernanke is being an academic. It’s not a time to be an academic. …Open the darn Fed window.”

BERNANKE’S DASHBOARD
August 7, 2007

In characteristic fashion, Cramer then began shouting and slamming his hand down. “He has
no idea
how bad it is out there! He has
no idea
! … My people have been in the game for twenty-five years, and they are losing their jobs, and these firms are going to go out of business. …The Fed is asleep Cut the rate! Open the window! Relieve the pressure! … We have Armageddon in the fixed-income markets. …We’ll spend billions in Iraq to build homes … we have thousands of people losing their homes now.”

The Fed’s discount window, the way in which it lends directly to banks,
was
open, though few banks were coming to it. But that was a technicality. Cramer’s red-faced tirade was a plea to Bernanke to cut interest rates, to pump money aggressively into financial markets as Bagehot had recommended, and to shout reassuringly that the Fed understood that Wall Street players were terrified. As loud as it was, though, Cramer’s indictment didn’t seem to make much of an impression on the man who bore the brunt of it.

Neither the Fed’s actions nor its words suggested Bernanke appreciated
how bad things were, and how much worse they would become. From his study of the Depression, Bernanke knew that a severe financial crisis could disable an economy. He could explain how it happened and how it could be cured. He simply didn’t — yet — see the subprime mortgage mess as the beginning of a crisis that had any resemblance to the one that confronted the earlier generation of central bankers whom he had criticized with such vehemence.

T
he European Central Bank is a monument to the faith that modern capitalist democracies put in central banks, the high point so far in the post — World War II effort by European nations to bind themselves together not only to avoid another intra-European war but also to build an economy big enough to rival that of the United States. Eighty-five years younger than the Federal Reserve, the ECB occupies a gleaming thirty-seven-story skyscraper in Frankfurt’s financial district. Outside the building stands a triumphant blue statue of the symbol of the euro, the multinational currency that has replaced the French franc, Italian lira, German mark — sixteen currencies in all.

Both the Fed and ECB were structured as political compromises. The Germans, surrendering the continent’s sturdiest currency, got the headquarters. The French — after tolerating an undistinguished Dutchman for a couple of years — got the presidency: Jean-Claude Trichet, a veteran bureaucrat with thick, graying hair and the demeanor of a duke. The Fed has a couple of advantages: It has only one set of elected politicians to cope with; the ECB has sixteen. All Fed officials speak English as a first language; the ECB does business in English, which is a second language for most of its leadership, and then has to translate its decisions into twenty-one other languages. The ECB has the advantage of clarity of mission: its legal mandate is to resist inflation
and ensure stable prices. Period. The Fed’s legal mandate is broader and during a crisis more flexible: maximum employment and price stability.

Both central banks are designed to be independent. The ECB’s independence is enshrined in a treaty, but it gets frequent, often hostile, public advice from European heads of state and finance ministers about what it should be doing with interest rates and whether it should be trying to talk the euro down to help European exports. The Fed’s independence is more by tradition than law, but — at least now — the president and his Treasury secretary rarely offer it advice in public.

But as central banks, both the ECB and the Fed concentrate on the same things: credit and liquidity. If the economy is a car, then credit is the gasoline that powers it, and liquidity is the oil that lubricates the engine. Although liquidity doesn’t fuel the economy, it is every bit as essential. The central bankers
knew
lubrication was essential but spent most of their time on the gas pedal, tinkering with just how much fuel to give the engine: less when they wanted to slow the economy, more to speed it up.

On Tuesday, August 7, 2007, the ECB’s monetary mechanics in Frankfurt saw a warning light flashing on their computer-screen dashboard: European commercial banks were flush with cash, yet the rates they were charging to lend to one another were rising sharply. It was a clear warning that liquidity was drying up. The mechanics sent word up the chain of command to Trichet and other officials, who shared their staff’s concern but didn’t want to overreact. Just days before, on August 2, Trichet had dismissed the market’s gyrations as a “normalization of the assessment and pricing of risks.” (Translation: Investors were coming to their senses.) The ECB officials decided to wait until Wednesday to see if markets were more normal.

Despite the situation developing in Europe, no sense of urgency was in the air as Fed officials gathered on August 7 in Washington for a previously scheduled meeting of the Federal Open Market Committee (FOMC), known as the “EFF-oh-em-SEE” to insiders. Sitting around a twenty-seven-foot-long
oval table of Honduran mahogany and black granite, beneath the twenty-three-foot ceiling of the Fed boardroom, were the six sitting governors based in the nation’s capital (one seat was vacant), plus the presidents of the twelve regional Fed banks. A never-used marble fireplace sits at one end of the stately boardroom beneath a huge bas-relief of the coat of arms of the United States, sometimes (though not during FOMC meetings) obscured by a large screen used for projecting charts. On the wall opposite is a map of the United States painted in 1937, showing the location of the district Fed banks and their branch offices.

FOMC meetings followed a nearly religious ritual. Bernanke sat at the middle of the table, as Greenspan had, with each president in the same seat at each meeting. The Fed’s influential staff, all sworn to secrecy, reported first on the markets, then on the economy. After each of the governors and Fed bank presidents added their comments on the economy, Greenspan usually would sum up, and then, after a break, the staff would outline options for moving or not moving interest rates. In this round, Greenspan almost always spoke first — and then went around the table. He always prevailed. Bernanke, in pointed contrast, let other committee members go first, then gave his views on rates last, as if to express a consensus rather than dictate an outcome.

Despite Bernanke’s attempts to stir debate, many participants stuck to prepared statements, aware that a transcript would be released five years later. At one meeting, Frederic Mishkin, the Columbia economics professor who joined the Fed board in the fall of 2006, turned to Kohn and said, “Don, this is worse than a faculty meeting.” Kohn replied, “Yeah, but it’s important.”

At these meetings the most important decision was whether to change the Fed’s most important interest rate. Like the ECB, the Fed manipulated rates up or down, based on its best guess at the future direction of the economy. Its primary tool was still the “federal funds rate,” the interest rate at which banks lend to one another. No consumer ever borrows at the overnight federal funds rate, but any change in that rate normally ripples through the economy by moving other interest rates.

To lower rates, the Fed (or any other central bank) creates money from nothing, a process called “printing money,” even though it is electronic, and uses that money to buy U.S. Treasury securities from the portfolios of the banks. The banks then have fewer securities but more money to lend. This increased supply
of money lowers the federal funds rate, the price of money. When the Fed wants to push up rates, it siphons money out of the market by selling government securities from its vast portfolio; this reduces the credit supply and raises the price of money. The Fed’s balance sheet — its portfolio of government securities and loans on one side (its assets) and the reserves of the banks and currency in circulation on the other (its liabilities) — is part of the magic of central banking. Because the Fed can create money, it can buy as many bonds and make as many loans as it wants. In August 2007, the Fed had a $900 billion portfolio, of which $850 billion was in U.S. Treasury securities of one kind or another.

At their August 2007 meeting, Fed officials discussed what was going on in Europe. They noted that housing was apt to remain a drag on growth and acknowledged the “volatility” in financial markets and the deepening problems in subprime housing. Just one day before the meeting, American Home Mortgage had joined fifty or so other mortgage lenders in collapsing into bankruptcy. Bernanke was uneasy that deteriorating financial markets might hurt the economy, and so were Geithner and Mishkin. But no one used the word
crisis
. Those who were worried didn’t have enough evidence, conviction, or time to sway the consensus behind a rate cut.

“There was an appreciation this was unusual,” remembered Eric Rosengren, the president of the Federal Reserve Bank of Boston. “It wasn’t clear how bad it was going to get. The hope was that it would be temporary and that we wouldn’t have a lot of spillover effects. And given the knowledge that we had at the time, given what had happened at times of previous liquidity problems, I’m not sure that was a bad guess at that time.”

The meeting concluded at 1:25
P.M.
, but following well-established ritual, the world had to wait another fifty minutes for a statement summarizing the meeting’s key decisions. Predictability is the mantra of modern central bankers. Thus, a few minutes before or after 2:15
P.M.
, a small band of wire-service reporters stationed a few blocks away at the U.S. Treasury flashed the news around the world: the Fed had left its target for the federal funds rate at 5.25 percent, where it had been since June 2006. Despite all that was going wrong, the words of the Fed’s statement were almost identical to the ones used in June. Altered wording would have been seen as a signal that a rate cut was imminent, and Bernanke hadn’t maneuvered the committee to that point yet.