A History of the Federal Reserve, Volume 2 (102 page)

We seem likely to repeat these mistaken actions. In 2008, the Federal Reserve increased its balance sheet from about $800 billion to more than $2.2 trillion. Many of the assets it acquired are illiquid. The market’s demand for reserves rose because participants were frightened and uncertain, and lacked confidence that financial fragility and failure would end. Once confidence begins to return, the Federal Reserve will have to absorb a large volume of reserves. The 1970s problem will return in an exaggerated form.

Economists and central bankers have discussed policy discretion for many years. Discretion enabled the Federal Reserve to make the many mistakes discussed in this volume and to facilitate the risky loans that are the source of credit and economic problems after August 2007. The main lesson of these experiences should be that monetary policy should remain consistent with a rule, not a rigid rule but rule-like behavior that responds both to short-term fluctuations in output and employment and to maintaining low inflation. Discretion has made too many errors.

In 2008 Congress approved $700 billion for the Treasury to use to support banks and financial institutions. The Treasury lacked a coherent plan and frequently allowed its actions to differ from its statement, adding to uncertainty and lack of confidence in policy. By year-end the Treasury had helped 206 banks, and the Federal Reserve had lent $100 billion to support a large failed insurance company. At year-end, President Bush advanced loans to prevent bankruptcy by General Motors and Chrysler, and the Federal Reserve accepted GMAC as a bank so that GMAC could borrow at the discount rate. GMAC immediately offered zero percent interest rate loans to borrowers with less than median credit ratings, precisely the type of loans that caused the crisis.

Financial problems spread to many other countries. Asset owners ran to the dollar and U.S. Treasury securities for safety. This pushed Treasury bill rates to zero or slightly above and lowered longer-term rates. Managing the reversal of these flows will be a major challenge for the Federal Reserve in the future.

Current housing and credit market problems gave rise to expected new claims blaming financial deregulation and hailing the end of Americanstyle capitalism or, in more extreme instances, the end of capitalism. It is hard to ignore such comments, but it is just as hard not to laugh. Despite active criticism and frequent condemnation, capitalism in one form or an
other has become the dominant form of economic organization throughout the world because only capitalism provides freedom, improved living standards, and an ability to adapt to cultural and institutional differences.

Those who blame recent deregulation are careful not to cite examples. The most recent major change in 1999 repealed the Glass-Steagall prohibition of combined investment and commercial banking. No other country adopted that rule or had a crisis caused by failure to do so. Many years ago, George Benston (1990) showed that proponents of the rule did not make a substantive case when they claimed that combined investment and commercial banking was a cause of the Great Depression.

Members of Congress, as usual, looked for scapegoats to blame for financial failures. Others proposed new regulations to increase governmental control of financial firms. Most proposals of this kind presuppose the reason for the financial failures. In this essay, I discuss seven sources of current problems and how systemic problems can be reduced. Bear in mind that most financial firms borrow short to lend long. That arrangement means that crises will occur when there are sudden changes in the economic environment or expectations. Not all crises can be avoided. Risks will remain, but they can be reduced.

SEVEN CAUSES

Repairing the weaknesses of the U.S. financial system that contributed to the crisis requires changes in the practices of the Congress, the administration, the Federal Reserve, and managers of financial institutions. To succeed, changes must recognize the incentives they create. This section discusses seven problems that contributed to make the crisis severe. It suggests changes to reduce risk and uncertainty.

Congress
and
the
Administration

Homeownership has long been regarded as a source of social stability, a public good that Congress and administrations of both parties encourage. Intervention takes several forms. Mortgage interest has remained tax deductible through several tax reforms including 1986, when most other interest payments lost that benefit. The Community Reinvestment Act (1977) encouraged home ownership by lower-income groups. The act gave citizen groups the opportunity to pressure banks to increase inner city lending by rating banks according to how much credit they supplied to low-income borrowers. The ratings influenced decisions to permit mergers and branches. In 1995, Congress strengthened the act. The American Dream Downpayment Act (2003) subsidized credit for low-income individuals. When that act passed, President Bush said that it was in the
national interest to have more people own their home. He neglected to add “if they invested in them.” In 1999, the Federal Housing Administration introduced the down payment assistance program that permitted no-down-payment loans.

In 1931, Congress urged the Federal Reserve to help the mortgage and housing markets by buying mortgages. The Federal Reserve declined, saying that was not its responsibility. Congress then established the Home Loan Bank System and followed with other agencies to support housing and the mortgage market. The Federal National Mortgage Association (FNMA, called “Fannie Mae”) opened in 1937. Its mandate was to increase liquidity of the mortgage market by buying mortgages. It expanded in the 1960s and became a privately held entity in the late 1960s. The market treated its debt as subject to a federal government guarantee, although the guarantee did not become explicit until the Treasury replaced the management and took control in 2007. The Home Loan Banks chartered the Federal Home Loan Mortgage Corporation (FHLMC, called “Freddie Mac”) to operate like Fannie Mae. It too lacked explicit guarantee of its debt until the Treasury assumed control. In addition, the Government National Mortgage Association (GNMA) is a government corporation that guarantees mortgage securities backed by federally insured or guaranteed loans issued by government agencies such as the Federal Housing Administration (FHA) and other agencies. Unlike Fannie Mae and Freddie Mac, GNMA does not own mortgages or mortgage-backed securities. Its guarantee subsidizes homeownership by lowering the interest rate on the mortgage.

With all the subsidies and assistance, expansion of mortgages and housing should not surprise anyone. Between 1980 and 2007, the volume of mortgages backed or supported by the three government-chartered agencies rose from $200 million to $4 trillion, an unsustainable compound growth rate of 36 percent a year. As the volume rose, the quality of mortgages declined. Government encouraged this development; in 1999 the FHA introduced a zero down payment loan, as noted above. Lenders expanded subprime mortgages, mortgages to buyers with relatively poor credit histories. Soon afterward, mortgage lenders began to offer mortgages that did not require a down payment. Then they eliminated credit checks on some mortgages. Such mortgages are called Alt-A.

Purchases and support for these subprime and Alt-A mortgages put Fannie Mae and Freddie Mac at much greater risk than in the past. In December 2008 congressional testimony, the heads of three agencies explained that they were aware of the increased risk but believed it necessary to compete with the private market. They did not add that the Federal
Home Loan Banks supplied almost half the funding for two large private lenders, Countrywide and Indy Mac, that later failed. Nor did they add that Fannie Mae and Freddie Mac owned $1.5 billion in assets related to subprime and Alt-A mortgages, about half the total outstanding. Prodded by members of Congress and the Clinton and Bush administrations, they lowered the quality of their portfolios to promote home ownership. With the failure of Fannie Mae, Freddie Mac, Countrywide, and Indy Mac, taxpayers will bear a considerable loss.

Edmund Gramlich, a member of the Federal Reserve’s Board of Governors, reported on the problem but did not formally warn the Board about the deterioration of loan quality. William Poole, president of the Federal Reserve Bank of St. Louis, spoke publicly about the taxpayer’s risk and urged remedial action. Alan Greenspan warned Congress about growth of Fannie Mae and Freddie Mac. There were many other warnings including from Senator Shelby, a senior member of the Banking Committee. Congress declined to act and several members denied that there was a problem. Congressional inaction increased the incentive for Fannie Mae and Freddie Mac to accept very risky loans.

There are homebuilders, mortgage lenders, and real estate agents in every congressional district. This alone encourages support for mortgage and housing subsidies and delays corrective action. It is very likely that the government will continue to subsidize homeownership. Reform should seek to put the subsidy on the budget and subject it to the appropriation process. Government mortgage market operations were a means of hiding the subsidy and often denying it. The subsidy took the form of a reduced interest rate on Fannie Mae and Freddie Mac borrowing, and did not require off-budget finance.

Fannie Mae and Freddie Mac are in receivership and under government control. They should be liquidated and terminated. Congress should vote the subsidy directly.

After much hesitation and policy change, the Treasury used most of the money in the first half of the Troubled Asset Relief Program (TARP) to supply capital to banks and other financial institutions. No large bank was allowed to fail. Once the banks received this assistance, many in Congress wanted to influence the banks’ lending. Congress urged them to lend even if it meant acquiring risky loans with substandard repayment prospects.

A better alternative would have required bankers to borrow part, perhaps one-half, of the additional capital in the market. That would have increased a bank’s cost, but it would deter some banks from borrowing from TARP and identify banks that the market considered insolvent. Those banks should fail. Failure means that shareholders lose their investment
and management loses its job. The reorganized bank should be sold or merged.

The government and Federal Reserve treat all large banks as “too big to fail.” That encourages gigantism. Instead, policy should impose a different standard: if a bank is too big to fail, it is too big. The social cost of losses to taxpayers exceeds the social benefit of large banks. The new standard would increase the incentive for bankers to be prudent.

Role
of
the
Federal
Reserve

Many politicians, bankers, and journalists blamed the housing and mortgage crisis on the Federal Reserve. The basis of their complaint was that from 2003 to 2005 the Federal Reserve held the federal funds rate at one percent. This permitted credit expansion, much of which concentrated in the mortgage market.

During these years, Chairman Alan Greenspan believed and said that the country faced risk of deflation. That was a mistake. Deflation is very unlikely to occur in a country with a relatively large budget deficit, a longterm depreciating currency, and positive money growth. Critics are correct about this part of their criticism. Federal Reserve policy was too expansive as judged by the Taylor rule or the 1 percent Federal funds rate that held the real short-term interest rate negative in an expanding economy.

The next part is wrong. The Federal Reserve did not force or urge bankers and others to buy mortgage debt. That was the bankers’ decision. Prudent bankers avoided excessive accumulation of low-quality mortgages. Bankers could have purchased Treasury bills or other assets with lower risk. They decided to overinvest in very risky assets and to lower quality standards. They share responsibility.

One plausible explanation of the errors that many made was the socalled “Greenspan put.” Whether such a put was available, the belief was widespread that the Federal Reserve would prevent large losses, especially for large banks. Several bankers and investment bankers raised the leverage they accepted and invested in risky assets. Whether or not there was a Greenspan put, prior actions that prevented financial failures, for example protecting Long-Term Capital Management (LTCM), created moral hazard and reduced concerns for risk. Arranging the rescue of LTCM is the most recent example in a long history of preventing failures. Notable examples include First Pennsylvania Bank, Continental Illinois, and most of the New York money market banks during the Latin American debt crisis. Bankers had reason to believe that the Federal Reserve would prevent failures.

One of the criticisms earlier in this history of the Federal Reserve is that the Federal Reserve has not announced its lender-of-last-resort strategy
in its ninety-five-year history. Sometimes institutions fail, sometimes the Federal Reserve supports them, and sometimes it arranges a takeover by others. There is no clear policy, no policy that one can discern. But there was a firm belief that failure was unlikely at large banks.

The absence of a policy has three unfortunate consequences. First, uncertainty increases. No one can know what will be done. Second, troubled firms have a stronger incentive to seek a political solution. They ask Congress or the administration for support or to pressure the Federal Reserve or other agencies to save them from failure. Third, repeated rescues encourage banks to take greater risk and increase leverage. This is the wellknown moral hazard problem.

As financial problems spread in 2008, pressure built on Bear Stearns. The Treasury and the Federal Reserve arranged a takeover. The Federal Reserve contributed by buying—not lending—$29 billion of risky assets. Markets improved. Many bankers claimed the worst was over. A few months later Lehman Brothers failed. Without prior warning, the Federal Reserve and the Treasury announced that they would not prevent the failure, a major policy change. Next the Federal Reserve prevented the bankruptcy of American International Group by replacing management and providing up to $80 billion in credit.

What conclusion could a portfolio manager draw? There was no clear pattern, no consistency in the decisions. Uncertainty increased. Portfolio managers all over the world rushed for the safety of Treasury bills. A classic panic of the kind described by Walter Bagehot followed. Officials did not announce or follow a clear strategy, as Bagehot urged. Regulators reacted to each subsequent rush for safety by guaranteeing in turn bank deposits, money market funds, commercial paper, and other instruments.

Influenced by Bagehot’s (1873) criticism, the Bank of England announced the lender-of-last-resort policy that it had followed in past crises and successfully followed the policy into the twentieth century. Panics and failures occurred, but they did not spread or accumulate. The policy called for lending without hesitation in a crisis at a penalty rate against acceptable, marketable collateral. That policy induced prudent bankers to hold collateral, and it reduced uncertainty.

By guaranteeing deposits, money market liabilities, and other instruments, the Federal Reserve prevented bank runs and further breakdown of the payments system. Unlike response during the Great Depression, depositors could not demand gold from banks, but they could demand currency and use deposits to buy gold or Treasury bills with the same effect. Because banks and other financial firms were unwilling to lend to other firms, they too bought Treasury bills and held idle reserves. The Treasury
and the Federal Reserve supported these demands by paying interest on idle reserves and by exchanging Treasury bills for less liquid assets.