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The Fed’s 2007 crisis response: Twinkies, pessimism pills, and missed warnings

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Friday morning, the Federal Reserve published transcripts of its closed-door policy meetings in 2007, the first year of a financial crisis that remade the global economy, and a year in which the United States fell into what would become the deepest recession of modern times. It was also the year in which the Fed began an era of unprecedented activism in its efforts to keep the global financial system from unraveling.

The transcripts of eight regular meetings of the Federal Open Market Committee and three emergency videoconference calls that year, released with a customary five-year delay, paint a portrait of policymakers trying to grapple with a rapidly spreading crisis. After months in which markets lost confidence in securities backed by subprime mortgages--and, eventually, the banks that owned those securities--an all-out financial panic began in August, 2007. The Fed made its first policy change by cutting the "discount rate," an emergency bank lending rate, in an emergency videoconference on Aug. 16. It then followed up by cutting short-term interest rates in September, October and December meetings. And in December, it also launched the first of its unconventional programs to backstop the world banking system, giving foreign central banks access to Fed dollars.

The Washington Post's economics staff is reading through the transcripts and will post notable details and exchanges here as we find them. (Neil Irwin)

Lacker suggests Geithner may have discussed rate cut with banker

During the Aug. 16 videoconference, when the Fed elected to cut the discount rate for bank lending, Richmond Fed President Jeffrey Lacker suggested that Timothy Geithner, then the New York Fed president, may have allowed word of the impending rate cut to leak to one leading bank. That set up a tense exchange between the two officials.

Geithner said that the banks “obviously don’t have any idea that we’re contemplating a change in policy or what might be possible and what we might say or not say going forward.”

Lacker said, “Vice Chairman Geithner, did you say that they [the banks] are unaware of what we’re considering or what we might be doing with the discount rate?"

“Yes,” replied Geithner.

Continued Lacker: “Vice Chairman Geithner, I spoke with Ken Lewis, President and CEO of Bank of America, this afternoon, and he said that he appreciated what Tim Geithner was arranging by way of changes in the discount facility. So my information is different from that.”

Responded Geithner, “Well, I cannot speak for Ken Lewis, but I think they have sought to see whether they could understand a little more clearly the scope of their rights and our current policy with respect to the window. The only thing I’ve done is to try to help them understand—and I’m sure that’s been true across the System—what the scope of that is because these people generally don’t use the window and they don’t really understand in some sense what it’s about.” (Neil Irwin)

As recession began, optimism and Twinkies

In December 2007, the month that the recession is now known to have begun, Fed officials were working from economic projections that would prove wildly inaccurate. They forecast sluggish but sustained growth in 2008 followed by a bounceback in 2009. Staff economist Dave Stockton acknowledged that his was a more optimistic view:

"Our forecast could admittedly be read as still painting a pretty benign
picture: Despite all the financial turmoil, the economy avoids recession and, even with steeply higher prices for food and energy and a lower exchange value of the dollar, we achieve some modest edging-off of inflation."

He then joked, "So I tried not to take it personally when I received a notice the other day that the Board had approved more frequent drug-testing for certain members of the senior staff, myself included. I can assure you, however, that the staff is not going to fall back on the increasingly popular celebrity excuse that we were under the influence of mind-altering chemicals and thus should not be held responsible for this forecast. No, we came up with this projection unimpaired and on nothing stronger than many late nights of diet Pepsi and vending-machine Twinkies." (Ylan Q. Mui)

Optimism on financial system, as well

Even as the nation entered recession in December 2007, officials in Washington still seemed to believe that the crisis from the mortgage market would be contained. In a staff presentation on the deterioration in the subprime mortgage market, Bill Dudley, then the New York Fed's markets chief and now its president, said:

"So is there any good news in any of this? ... [F]ear is diminishing, which implies less risk of a crisis developing from this source.  Second, although there remain considerable uncertainties on many fronts—such as the magnitude of mortgage losses, the degree of further tightening of credit availability, and the fate of some thrifts and mortgage and financial guarantors, I believe we may have finally defined the broad dimensions of the crisis.  Most of those who are likely to be implicated may already have been identified ... The issue now seems to be shifting toward severity from dimension."

Later, Dallas Fed President Richard Fisher thanked Dudley for his presentation: "I wanted to thank you for at least raising four rays of dim sunlight." Dudley responded, "We try for balance." (Ylan Q. Mui)

Yellen and Rosengren take a pessimism pill

By December, San Francisco Fed President Janet Yellen emerged as one of the doomsayers -- who eventually would be proven right. Yellen is now the Fed's vice chairman and is mentioned as a possible successor to Fed Chair Ben Bernanke.

At the time of our last meeting, I held out hope that the financial turmoil would gradually ebb and the economy might escape without serious damage. Subsequent developments have severely shaken that belief. The bad news since our last meeting has grown steadier and louder, as strains in financial markets have resurfaced and intensified and as the economy has shown clear signs of faltering. In addition, the downside threats to growth that then seemed to be tail events now appear to be much closer to the center of the distribution. I found little to console me in the Greenbook. Like the Board staff, I have significantly marked down my growth forecast. The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real."

Boston Fed President Eric Rosengren agreed with her, saying, "I think I took the same pessimism pill as President Yellen this morning." (Ylan Q. Mui)

An optimistic Hoenig didn't take that pill

Kansas City Fed President Thomas Hoening was one of the most optimistic Fed officials, forecasting even in late 2007 that the economy would return to strength in 2008. That led him to warn of the dangers of slack monetary policy at the December meeting:

"My concern is that, if we continue to lower the fed funds rate into a rising inflation environment and the dollar continues to depreciate, these [inflation] expectations may become unhinged perhaps more quickly than we would like to think. In this environment, I think we should not lose sight of not just the downside risk to the real economy but also some very serious upside risk to inflation." (Ylan Q. Mui)

Geithner worries response is behind the curve

By September 2007, Timothy Geithner, president of the Federal Reserve Bank of New York, was growing increasingly worried that the Fed might err on the side of doing too little to stem the financial crisis. Ever since, he has always been perhaps the biggest proponent of "going big” in financial rescues – whether it was the U.S. bank bailout or Europe dealing with its own problems.

“I believe the arguments work in favor of doing more now rather than less. Policy needs to provide a convincing degree of insurance against a more adverse outcome. … [D]oing too little now would risk exacerbating uncertainty about the macroeconomic outlook, and a gradualist, tentative response would be more disconcerting than encouraging. The risk of underdoing it now is that we will ultimately be forced to do more.” (Zachary A. Goldfarb)

Bernanke sees PR fallout from helping banks

In September 2007, Chairman Ben S. Bernanke was already concerned about what eventually become a reality – the central bank’s interventions to rescue the financial rescue would be perceived as bailouts for individual banks, rather than actions to stabilize the overall economy:

“[A]s the central bank we have a responsibility to help markets function normally and to promote economic stability broadly speaking. We are not in the business of bailing out individuals or businesses. As long as we make that distinction, I think we’re fine, but it may be history that agrees to that rather than the newspapers." (Zachary A. Goldfarb)

Calm over Bear Stearns and Countrywide in August

At the Aug. 7 meeting, St. Louis Fed President William Poole asks whether the New York Fed knows "material nonpublic information about firms (in the financial sector) that would suggest that there is more difficulty than we see in the newspapers?"

Dudley replied that everything looks manageable, so far, even with troubled firms Bear Stearns and Countrywide. Recall that Countrywide would ultimately be bought by Bank of America in a fire-sale in early 2008, and Bear Stearns would receive a massive Fed bailout in March 2008.

"As far as the issue of material nonpublic information that shows worse problems than are in the newspapers, I’m not sure exactly how to characterize that because I guess I wouldn’t know how to characterize how bad the newspapers think these problems are. [Laughter] We’ve done quite a bit of work trying to identify some of the funding questions surrounding Bear Stearns, Countrywide, and some of the commercial paper programs. There is some strain, but so far it looks as though nothing is really imminent in those areas. Now, could that change quickly?  Absolutely. For example, one question that we’re following with Bear Stearns is what their clients do in terms of continuing to want to do business with them. Obviously, if people start to pull back in their willingness to do business with Bear Stearns, the franchise value of the company goes down, and that exacerbates the problem. One thing that we have heard about Bear Stearns is that they have approached a number of major commercial banks about a secured line of credit. We don’t know what the outcome will be, but they are clearly trying to get even better liquidity backstops than those they have in place today. But as far as we know, they have enough liquidity—and Countrywide as well at this moment." (Jim Tankersley)

Debate over how worried to appear

At the Aug. 7 meeting, as financial markets were becoming more volatile, there was round agreement that the FOMC should not cut interest rates. The big debate was over how concerned should the Fed appear to be about trouble in financial markets.

Participants break into two camps.

One camp says the Fed could worsen market panic by appearing too worried
about what's going on. Here's Dallas Fed President Richard Fisher on that:

"My best advice would be to recognize, to an extent, in our statement what is going on in the marketplace, what ails the marketplace. The best guidance would be that we must not ourselves become a tripwire. I think we have to show a steady hand. I rather liked the reference to the Hippocratic oath earlier, “Do no harm.” I think we can best accomplish this by acknowledging market turbulence and yet not implying that we are given to a reaction that might create a moral hazard."

The other camp says the Fed must show a willingness to do more if things
get worse. Here's Fed vice-chairman Donald Kohn:

"One word on the moral hazard and the concern about being seen as reacting: I am not worried about it. I think we have kept our eye, through the past twenty years, on the macro environment. We have adjusted policy to stabilize the economy, to bring inflation down, and we were pretty darn successful in all of that. ... I really don’t care what people say; I care about what we do, and we just need to keep our eye on those macro implications." (Jim Tankersley)

Worries about press leaks

The October 30-31 meeting began with Ben Bernanke gently chastising members for talking to the Wall Street Journal's Greg Ip (who has since then moved to The Economist). "I don’t think anybody actually leaked the story, because the way Greg Ip works is that he goes around and talks to each person and gets a little of the story and then builds it up in that way," Bernanke told the room. "Nevertheless, I think it is obviously bad for our institution when our internal deliberations become public, and so let me just ask everyone, please, to be especially careful about maintaining confidentiality." (Dylan Matthews)

Geithner worried about recession in October, Fed staff not so much.

After the October 30-31 economic projections, New York Fed president (and now Treasury secretary) Timothy Geithner weighed in with questions. "Dave, this is about the Greenbook forecast," he told research head David Stockton. "I was going to say existentialism, but I am not sure that is quite right." The room laughed. Geithner continued by asking about Stockton's projections of slowing growth in credit markets. "How does the deceleration you are anticipating look compared with a range of previous periods in which the U.S. economy was slowing significantly or periods following substantial financial distress?" he asked. "For example, if you compare it with 2001-02 or 1990-91, is it a modest deceleration in credit growth, or does it look large compared with that?"

Stockton replied that he wasn't sure about the exact comparison, but that Geithner was fretting too much: "[W]e are not forecasting a deep credit crunch…As I noted at the last meeting, even the restraint that we do have on the credit side fades over the coming year." (Dylan Matthews)

Comparing August troubles to October '87 crash

Despite mounting evidence of stress in the financial system, Fed economists
cut their growth estimates for the rest of the year by only a quarter of a
percentage point at the August 7 meeting. David Wilcox, a Fed board economist, warns board members the economy may deteriorate much more than that., In the worst-case alternate scenario, he says, "we nearly—though not quite—succeed in generating a recession despite a substantial easing of
monetary policy."

Then he goes on to say things could end up much better than predicted, too:
"One cannot rule out that, six months or a year from now, we will look back
on this episode much as we look back on the flare-up in February of this year or as we look back on the stock-market break in 1987, with a sense of surprise that the financial event did not leave a greater imprint on the real economy." (Jim Tankersley)

Prescient pessimism from Rosengren

One Fed member sounding the alarm of problems in the housing market in October 30/31 2007 was Boston Fed chair Eric Rosengren. While he conceded that there was no direct evidence of a slowdown, "the distribution of risks around that outcome for growth remains skewed to the downside." He added, "In fact, our forecast for residential investment has become sufficiently bleak that there may actually be some upside risk to it," prompting laughter around the room (again, Fed humor is strange).

Rosengren's forecast grew more and more prescient as the meeting wore on. "Particularly worrisome has been the announcement of significant downgrades of tranches of CDOs and mortgage-backed securities with large exposure to the subprime mortgage market," he warned. "Not only have the lower tranches experienced significant downgrades, but a number of the AAA and AA tranches have been downgraded to below investment grade…The number of the downgrades, the magnitude of the downgrades, and the piecemeal ratings announcements all are likely to call into further question the reliability of the ratings process."

Rosengren was the only committee member sounding the alarm about the possibility that the rating agencies were giving top grades to junk debt. Of course, that turned out to be exactly right. (Dylan Matthews)

A groaner from Fisher

Richard Fisher, the president of the Dallas Fed, expressed confidence during the October 30/31, 2007 meeting that investors were waking up to problems in the subprime market. He quoted a Financial Times article where an investor said, “Corporate treasurers are no longer buying things they don’t understand," prompting laughter around the room.

Fisher continued: "Imagine that. Investors are coming home from lala land. To be sure, we’re not out of the woods quite yet, as President Plosser and President Rosengren mentioned. The situation remains real, but we’ve gone beyond suspended reality. If you will forgive me, you might say we have gone from the ridiculous to the subprime."

Richmond Fed president Jeffrey Lacker retorted, "Let the transcript say 'groan.'" The room laughed again. (Dylan Matthews)

FOMC makes funny (sort of):

Humorous moments are few and far between at meetings of central bankers, but that doesn't mean there weren't a few over the course of 2007 FOMC meetings. Here are a few lines that evoked laughter. The nation's comedy clubs need not worry about new competition.

In a December 2007 meeting, Dallas Fed president referenced the very technical process by which one of the largest truck dealers in the country forecasted his sales for the next year: "SWAG—which is sophisticated, wild-assed guess.'"

At the same meeting, Fisher added this nugget: "Edward R. Murrow said that anybody who isn’t confused really doesn’t understand the situation. I’m confused, and I don’t understand the situation."

Here's Bernanke welcoming Eric Rosengren, the new president of the Boston Fed, to his first FOMC meeting: "I have known Eric for about twenty years. We used to be squash partners. I won’t say who won. We know who wins now."

Four years before the Lance Armstrong scandal blows up, Bernanke cleared departing FOMC economist Vincent Reinhart of (non-existent) doping allegations. Lauding Reinhart at his final FOMC meeting, Bernanke jokes: "Unfortunately, against all good advice and after only eighty-two FOMC meetings—a record which to his credit he has achieved without prompting accusations of steroid use—[laughter] Vincent is insisting upon returning to civilian life."

One of the strangest running jokes in the October 30/31 Fed meeting concerned Richmond Fed chief Jeffrey Lacker's repeated insistence that his district's manufacturing sector was larger than those of New York and Philadelphia combined. Bernanke was quick to reply the first time he said this, noting that Texas' sector was bigger, and Dallas Fed chief Richard Fisher added that California's is too. Lacker went along, and mentioned it again for good measure, citing a survey on the district's manufacturing sector, "which, by the way, is larger than the Philadelphia and New York manufacturing sector." The room laughed again. Much later on, New York Fed president Tim Geithner felt the need to defend his region's honor: "I just want to start by saying in defense of the Empire State that there is no way—the only way that Richmond could be bigger than New York and Philadelphia is if you don’t count the substantial business we have in the manufacturing of financial products." Vice chair Donald Kohn was quick with a rejoinder: "It’s a lot smaller business than it used to be." (Jim Tankersley, Dylan Matthews, and Ylan Q. Mui)

A gloomy Geithner--but not gloomy enough

Tim Geithner's October 2007 economic forecast, like everyone's, was much too sunny, but it was bleaker than that of most of his colleagues. "Growth in the United States and in the world economy in my view seems likely to slow—more here, of course, than elsewhere," he told the board. "Here, even though the nonhousing, non-auto parts of the U.S. economy don’t yet show significant evidence of a considerable slowdown of actual or expected demand, I think that still seems likely. In our central scenario, though, housing construction weakens further. Housing demand slows further because of the tightening of credit conditions. Prices fall further. Consumer spending slows a bit, and businesses react by scaling back growth in hiring and investment, and this produces several quarters of growth modestly below trend. I think that growth outside the United States is likely to slow a bit."

"Modestly below trend" would of course prove to be an understatement.

As nation entered recession, thought of doing more--and fears of doing too much

At the December FOMC meeting, several officials argued for a larger cut to the federal funds target rate than the quarter percentage point cut that was eventually approved. Fed governors Eric Rosengren and Frederic Mishkin both supported a more aggressive cut of .50 percentage points, though only Rosengren dissented from the board's final decision.

Even Fed Chairman Ben Bernanke said he was "tempted" by the larger cut, but he worried in part that such a bold move could backfire:

"If we do 50 [basis points], we may be saying to the market that we are willing to do even more than you currently expect. I think that poses some risks to inflation expectations and poses some risks to the dollar, which is a little fragile right now. Y You can imagine it even having reverse effects with respect to the economy—for example, if it caused oil prices to jump or if it caused nominal interest rates to rise, thereby raising nominal mortgage rates."

But he knew additional steps to boost the economy were likely in the pipeline: "We are not locked in," he said. "We are responsive to conditions on both sides of the mandate, and we are alert to new developments." (Ylan Q. Mui)