In FED We Trust (16 page)

“Although the downside risks to growth have increased somewhat, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected,” the Fed said. (Translation: The odds of recession are growing, but we’re more worried that inflation will take off.) The statement implied that the Fed was shrugging off the unfolding credit crunch. There was no hint of Bernanke’s concern about the risks to the economy posed by disintegrating credit markets. So much for transparency.

“Sometimes the role of the release is more to placate nineteen people sitting around the Board table in Washington and less to educate the public,” said ex-Fed staffer Vincent Reinhart, who helped write the statements for six years.

The statement would quickly be overtaken by events — a reminder that behind the curtain at the Fed are a bunch of men and women, some smarter than others, trying to predict the course of an economy that stubbornly refuses to be predictable.

The day after the FOMC meeting found Bernanke occupied with ceremonial duties: a 10
A.M.
reception for graduate students in economics interning at the Fed, a 10:45
A.M.
taping for a video tribute to ailing Fed governor Ned Gramlich, an 11:30
A.M.
meeting with the Turkish ambassador and his wife, a 2
P.M.
session with consumer advocate John Taylor of the National Community Reinvestment Coalition.

At day’s end, Robert Rubin, the then-much-respected former Treasury secretary and top Citigroup executive, telephoned Bernanke. His message: you did the right thing in not cutting rates. It was classic Rubin, a reassuring call at a key moment, a genuine gesture that helped build a relationship that could be useful later.

At 8:30
A.M.
on the following day, August 9, the huge French bank BNP Paribas made a startling announcement: it was suspending withdrawals from three funds that had invested in U.S. subprime mortgages. The bank said it couldn’t put a value on the funds assets because of “the complete evaporation of liquidity in certain market segments of the U.S. securitization market.”

This news was as unsettling to investors in 2007 as it had been to depositors in 1907 when a bank shut its doors and said the cash vault was empty. Rumors circulated that other banks were similarly exposed. Banks with cash husbanded it, reluctant to lend even to other banks because they were no longer sure they would get paid back.

Investors scurried to the safety of short-term German government bonds. Liquidity lock was overwhelming the ECB’s attempts to maintain control over lending rates. Normally no more than a few hundredths of a percentage point separate the overnight rate and the ECB target rate. Suddenly, skittish European banks had pushed overnight lending rates to 4.7 percent, a huge distance from the 4 percent target. Clearly, the engine was in danger of seizing up.

The ECB had been derided for years for moving too slowly. This time, it reacted with unusual speed. At 10:26
A.M.
Thursday — 4:26 in the morning Washington time — it issued a statement to markets that it stood “ready to act.” Two hours later, at 12:32
P.M.
, it said it would lend an unlimited quantity of funds at the 4 percent rate, a sharp break from its usual practice of limiting how much it would lend at any one time. To listeners, this was a loud signal that the ECB was on high alert; it was also a way for the ECB, which has surprisingly little detailed information about European banks, to gauge banks’ appetite for liquidity.

The ECB gave banks until 1:05
P.M.
to ask for money. At 2
P.M.
, the ECB announced it was pumping 94.8 billion euros into the banking system, the equivalent of $131 billion — a stunning sum, more than the ECB had put into the markets after the shock of September 11.

The ECB told reporters in Europe and Fed officials who called to inquire that this was just “fine-tuning,” a term central bankers generally use to describe minor, inconsequential maneuvers. The Fed, though, knew better. In Washington and New York, it looked as if the ECB had panicked.

Thus began a series of extraordinary responses by central banks to extreme circumstances, the beginning of a cycle of crisis and ever-larger responses that would stretch on for more than a year. “We were the first central bank to react immediately when the international financial turbulence first appeared,” Trichet would boast repeatedly in the months that followed, especially when
the ECB was criticized for moving more slowly than Bernanke’s Fed to cut interest rates or for its reluctance to follow the Fed and the Bank of England in buying long-term government bonds to put more credit into its economy.

The ECB announced its massive cash infusion just as Bernanke was having breakfast — which happened to be his weekly breakfast with Hank Paulson, the Treasury secretary. Bernanke knew the emerging liquidity crisis in Europe was not just a European phenomenon. He saw similar strains in the American banking system. The yelps from Wall Street were growing louder. Jim Cramer’s CNBC rant looked more rational than it had the week before. Bernanke moved nearly as swiftly as his ECB counterparts, but with far less force. That morning, the Fed pumped $24 billion into the U.S. markets in overnight loans; an additional $38 billion would follow the next day.

To those who watched the Fed closely, the message was that the managers of the nation’s economy were now on alert. The old diagnosis had been that home construction and consumers would suffer a bit from the housing bust, but the overall economy would be able to move forward. That now looked questionable. Officials had also expected the strength of exports and the banking system, which they regularly pronounced “well capitalized,” to keep the economy moving forward. The early days of August had dampened that optimism as well.

“In August,
it
crossed into the banking system. That’s when things got really complicated,” said Donald Kohn, the Fed’s vice chairman, who had long taken comfort from what Greenspan once dubbed — in another automotive metaphor — the “spare tire” theory of finance.

The spare tire theory holds that when the banks run into trouble, companies and consumers can borrow directly or indirectly in credit markets where money market funds, insurance companies, pension funds, and others lend cash. Likewise, when credit markets are tight, companies and consumers can borrow from banks. Problems in one sector are offset by the other, in short, and the economy keeps right on rolling.

This theory had held up pretty well over the past two decades. In the 1980s, the banks were stingy and credit markets generous; in the late 1990s, the markets were clogged and banks generous. One advantage that the United States had over other big economies was that it relied on both banks and credit markets; economies in Europe and Asia relied much more on banks to move money from savers to borrowers and thus had nowhere to go when banks got in trouble. “The lack of a spare tire is of no concern if you do not get a flat. East Asia had no spare tires,” Greenspan had said in 1999.

Until August, spare-tire theorists thought this episode was largely limited to the markets, save for a few hapless banks. Now both appeared to be going flat — and the Fed amounted to the only available spare. The housing bust was contaminating both credit markets and banks — only the first of what would become a long list of surprises during the Great Panic.

Behind this surprise was a misunderstanding of what had been happening in the banks. The Fed and nearly everyone else had taken false comfort in labeling the behavior of twenty-first-century banks as “originate and distribute.” The notion was that by packaging loans into securities that were sold to investors all over the world, the banks wouldn’t get stuck if loans went bad.

Don Kohn, among others, had celebrated all this as a major advance that was promoting economic growth. The new financial instruments, he said in a reprise of the Greenspan years at a 2005 Fed conference at Jackson Hole, Wyoming, “enable risk and return to be divided and priced to better meet the needs of borrowers and lenders … permit previously illiquid obligations to be securitized and traded, and … make obsolete previous divisions among types of financial intermediaries and across the geographical regions in which they operate.” Financial innovation made banks and other financial institutions “more robust” and made the financial system “more resilient and flexible” and “better able to absorb shocks without increasing the effects of such shocks on the real economy.”

A more apt description might have been “originate and hide.” Banks hadn’t
distributed nearly as much risk as even sophisticated observers thought. The bad loans — and massive losses — would end up with the banks, eroding their capital cushions to the point where, eventually, their only option for survival was a government bailout.

“All of a sudden,” Kohn said months later, “it became very clear the risk had not been distributed. So all I had said at Jackson Hole about risks being distributed and people being safer and people knowing what they had and people could choose and diversify and all that — it turned out to be not entirely true.”

Citigroup had pioneered entities called “structured investment vehicles,” or SIVs. In essence, mortgage loans were sliced into pieces, with some sold and others kept in these stand-alone units. The SIVs borrowed money by selling short-term IOUs on the market, making them vulnerable to a change in investor appetite for short-term lending. And SIV loans frequently were not shown on the banks’ books. A bank has to set aside capital — a cushion to absorb losses — for every loan it makes and every bond it buys. By parking the loans and securities in SIVs off the banks’ balance sheets, Citibank and other banks that used SIVs didn’t have to set aside capital to absorb any losses. That made the potential profits far greater than if the loans had been on the banks’ books. But it also meant there was no capital cushion to absorb losses if the banks ended up taking back the losses, either because they had legal promises to the SIVs or felt maintaining reputations required them to bail out the SIVs. “We didn’t recognize how much the stuff would flow back onto the bank balance sheets,” Kohn said.

In 2006, Citibank’s off — balance sheet assets amounted to $2.1 trillion; its on — balance sheet assets were $1.8 trillion. Not only were these enormous loans hidden, but several top Fed staffers confessed later that they hadn’t even heard the term “SIV” until the end of July. Neither had some senior Fed officials — even though they were charged with being guardians of the financial system. In fact, that was typical. An astounding array of derivative products had exploded across the marketplace over the past few years. Even market sophisticates faced a steep learning curve to keep up with what was happening, and that included Citigroup’s own chief executive, Chuck Prince.

Dubbed “Prince of the Citi” by the financial press when his bank was flying
high, Prince was a lawyer who had taken over the big bank in 2003 when Sandy Weill, the financial entrepreneur, retired. Prince famously dismissed worries that his bank and others were counting unwisely on cheap and plentiful credit to make ever bigger and riskier loans. “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he told the
Financial Times
in early July 2007. It was, actually, a profound observation: a banker who didn’t dance, who didn’t make ever more risky loans, would find his bank’s market share falling and near-term profits less impressive than his competitors’. Prince was one of several Wall Street chief executives who, it turned out, didn’t understand the risks their own institutions were taking or who were powerless to stop them. Citi, it would become clear, was not only too big to fail, it was too big to manage. (By November 2007, Prince would be gone.)

Ben Bernanke soon would discover what happens when the music stops, but he had good reason to believe that his team had the experience, smarts, and tools to manage the situation.

B
y the summer of 2007, the Fed was stocked with veterans of market crises: the stock market crash of 1987, the savings and loan scandal of the late 1980s and early 1990s, the commercial banking and real estate woes of the early 1990s, the Asian financial crisis of the late 1990s, the bursting of the tech-stock bubble in 2000, and the September 11 terrorist attacks. The conventional wisdom was that crises were unavoidable despite all the best efforts at prevention. The countervailing comfort was that cleverly conceived and targeted responses by the Fed and Treasury — even if flawed in detail — could limit the economic damage from even the most frightening shocks.

The thinking wasn’t as excessively self-confident as it had been back in July 1990 when Frederic Mishkin, then a Columbia University professor, later a Fed governor, declared that: “Since 1945 … in no instance has there been a financial crisis that has had serious adverse consequences for the aggregate economy.” But within the Fed, self-confidence still ran high. No crisis was unmanageable if you had the brainpower on hand to deal with it, and the Fed had plenty of brains.