Dissecting the Financial Crisis

Dissecting the Financial crisisECONOMICSBRIEF

InsIde – Bloomberg Economist Josh Wright on Three Lessons from the 2008 Transcripts

– Selected Excerpts From 2008 FOMC Meeting Transcripts

– The Crisis, Visualized

– Mentions of Laughter, Recession, Depression

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02.21.14 www.bloombergbriefs.com Bloomberg Brief | Dissecting the Financial Crisis 2

The Federal Reserve’s release of transcripts from its 2008 policy meetings on Friday provide new detail on policy-makers’ thinking during this critical pe-riod. Here are three lessons the market can take away from these transcripts, which cover the Fed’s expansion of its policy tools as the credit crunch of 2007 grew into the Great Financial Crisis of 2008-2009.

Yellen’s role

Chair Janet Yellen has not just sup-ported a number of policies that defined the Bernanke Fed during and since the financial crisis — she has been an active advocate for them. The transcripts show Yellen calling for the use of forward guid-ance, better tools to resolve too-big-to-fail institutions and the use of staff economic projections as a channel for communicat-ing with the market. In December 2008, she also opposed setting a quantitative target for the Fed’s balance sheet. This reinforces the perception that as long as financial conditions remain benign, Yellen may be eager to refocus on forward guid-ance and Fed communication, rather than asset purchases.

How to exit Qe

The Fed’s experience with previous policy innovations foreshadows chal-lenges for its exit from extraordinary monetary stimulus. The most obvious example is how the justification for, and design of, asset purchases changed: Bernanke clearly stated in December 2008 that purchases were intended to target asset markets, not the Fed’s bal-ance sheet, but later rounds of purchas-es have been framed in terms of the size or composition of the Fed’s balance sheet. As with so many government pro-grams, once it starts, it’s hard to stop.

In 2008 the Fed also debated and launched a new tool for influencing short-term interest rates — paying interest on reserves (IOR) to banks — but it didn’t work out as planned. As it expanded its lending facilities, the Fed worried that it would lose control of the fed funds rate

(whose target it didn’t drop to near zero until December 2008), and it saw IOR as a key tool for maintaining control. Con-cerns about keeping a floor on rates now sound quaint, precisely because IOR never laid that hoped-for floor, and the Fed had to settle for targeting a range for the fed funds rate in lieu of a specific level.

The Fed continues to struggle with these markets, which will be crucial for its exit. Just last fall, it unveiled the latest in a string of innovations to enhance its control over short-term rates, the fixed-rate, full-allot-ment overnight reverse REPO program. Thus, while tapering asset purchases and adjusting forward guidance will be delicate enough, draining bank reserves and actu-ally raising rates may prove still more chal-lenging. The good news is that Yellen seems likely to recognize this: Already in December 2008, she acknowledged that the Fed’s experience with IOR had been humbling.

Contentious Meetings

Finally, the Fed policy meetings re-mained contentious even under the unify-ing force of the Great Financial Crisis,

which is a bad sign for those hoping for clarity and consistency from the Fed in coming months. To some extent this re-flects healthy debate under conditions of unavoidable uncertainty. At the same time, it also underlines the challenge for the Fed as it contemplates altering its forward guidance: There is an inherent tension between the markets’ need for clarity and policy-makers’ need to retain flexibility to respond to evolving conditions.

The debates of 2008 also parallel the current difficulty of setting a policy whose effects are measured in months for a market that moves in much shorter intervals. Even in September 2008, the Fed was still talking about inflation and doubting signs of a recession, just as the minutes from the Fed’s most recent Janu-ary meeting and recent data have left a lot of people wondering if Fed policy and the recovery are moving forward or slid-ing backward today.

INtrOduCtION COMMEnTaRy By JOSh WRighT, BLOOMBERg ECOnOMiST

transcripts Show Yellen Advocated Forward Guidance, Faces tough Exit

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*Cumulative Purchases

Fed Transcripts show evolution of Policy Towards Qe

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YEllEN WAtCh

But I tend to think this risk is manageable. … As I have said before, I view inflation as less persis-tent now than it once was, tending to revert fairly quickly to its longer-run trend.”

On long-term projections (June 24): “I welcome greater transparency about our long-term objectives. I think that would be beneficial, and there is a good reason, as you have articulated, to try to do that now, given that for many of us — certainly for me — 2010 is not long enough for me to project that the economy will have converged to a steady state.”

On supervision (June 24): “What is going on raises fundamental issues about how we conduct consolidated supervision. Even if all the systemically important institutions were primary dealers or mortgage companies within bank holding companies that currently we do have umbrella supervision over, I am not at all convinced that the way we are carrying out supervision now would have prevented a Bear Stearns-type of episode within an institution that is currently solidly under our supervision.”

On supporting banks (July 24): “I support extending the TSLF along with the PDCF, and I am also supportive of the proposal to auction options on TSLF draws. I think we do continue to have money market stress, particularly at quarter-end, and it strikes me as a well-targeted program that might have some success in addressing the strains. On the proposal to extend the term of the TAF loans to 84 days, I do have some qualms, and they have been heightened by our own recent experience with a failing bank and my sense that the most recent bank failure is not going to be our last.”

On supporting banks (Aug. 5): “Although the real funds rate remains quite accommo-dative by the usual metrics, we are clearly not in a business-as-usual situation. We are in the midst of a serious credit crunch that has, again, worsened during the intermeet-ing period, as exemplified by the develop-ments at Freddie and Fannie and the other things that many of you have pointed to in our last round. We are likely seeing only the start of what will be a series of bank failures that could make matters much worse. Given these financial headwinds, it is not clear to me that we are accommodative at all.”

On labor markets (Jan. 9): “I also find the labor market developments worrisome. I try not to put too much weight on any single monthly observation, but I find it entirely believable and consistent with everything else we are seeing that we have entered, at best, a period of slow employment growth. It is something that we have been expect-ing all along. It helps to resolve some of the puzzles we have been discussing about why labor markets have been so strong relative to goods markets. It is true that consumer spending has been amazingly robust so far, but I find it unimaginable that it can continue when slow growth in disposable income is added to everything else that is weighing on households, particularly rising energy prices, accelerating declines in house prices, and falling stock prices. It seems to me that, with the stagnant or contracting labor market, the odds of a recession — and, as you argued, a potentially very nasty one — have risen.”

On term securities lending facility (March 10): “I strongly support the proposed term securities lending facility. I certainly agree that we face a situation in which systemic risk is large, and it’s escalating very quickly. A dangerous dynamic has set in. … I think financial stability is truly at stake here, and although there are financial and reputa-tional risks in pursuing this approach, it is a creative and well-targeted approach, and it is worth taking these risks to try to arrest the downward spiral in market conditions.”

On inflation (March 18): “These data raise the issue of whether cutting rates as much as needed to fight a recession may risk persis-tently higher inflation and inflation expectations.

On adverse feedback loop (Sept. 16): “The interaction of higher unemployment with the housing and financial markets raises the potential for even worse news — namely, an intensification of the adverse feedback loop we have long worried about and are now experiencing.”

On credit markets (Oct. 7): “We’re witness-ing a complete breakdown in the functioning of credit markets, and it is affecting every class of borrowers. The financial devel-opments are dangerous and are having a pronounced impact on the economic outlook. The outlook has deteriorated very sharply, and even so, I still see the risks to the downside. Moreover, recent data on con-sumer and capital spending and on housing confirm that a sharp contraction in domestic demand is under way. As far as I’m con-cerned, for the reasons you gave, inflation risks have diminished markedly.”

On Japan (Dec. 1): “I believe that there could be significant benefits to communicat-ing effectively the FOMC’s intentions to hold the target funds rate at a very low level. The Japanese experience at the zero bound suggests that this is one channel that can work, and the evidence suggests that our own guidance that began in 2003 similarly influenced longer-term rates.”

On recession (Dec. 16): “Cumulative reces-sionary dynamics are deeply entrenched, with mounting job losses leading to weaker consumer spending, tighter credit, more job losses, and so on; and this nasty set of eco-nomic linkages is gaining momentum.”

On inflation (Dec. 16): “Developments since our October meeting have again lowered the outlook. I’m particularly concerned about the disinflationary effect of actual and prospec-tive economic slack. ... Given that in each of the next two years the unemployment rate is predicted to average at least 8 percent, it seems quite likely that by the end of 2010 core inflation will have fallen at least 1½ percentage points. That creates a very real risk of deflation.”

Janet Yellen, now Federal Reserve Chairman, strongly supported then-Chairman Ben Bernanke’s policies throughout the finan-cial crisis. Excerpted here are some of her comments on labor markets, transpar-ency, regulation, and bank failures. On inflation, she is con-sistently dovish.

Yellen Sees labor Market troubles Early, de-Emphasizes Inflation Concerns

Janet Yellen

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9/17: SEC announces temporary emergency ban on short selling of all financial stocks

1/30: FOMC meeting - Fed reduces target rate by 50 bps to 3 percent and primary credit rate by 50 bps to 3.5 percent

10/7: Unscheduled Fed Meeting - Fed announces creation of CPFF; FDIC increases deposit insurance coverage to $250,000 as authorized by EESA

9/16: FOMC Meeting - Fed authorizes NY Fed to lend up to $85 bln to AIG; net asset value of Reserve Primary Money Fund breaks the buck

9/21: Fed approves applications of Goldman Sachs and Morgan Stanley to become bank holding companies

tIMElINE

7/31: Bear Stearns liquidates two hedge funds that invested in risky subprime mortgage securities

1/22: Fed announces Fed funds target cut by 75 bps to 3.5 percent

9/7: FHFA places Fannie Mae and Freddie Mac in government conservatorship

10/6: Fed announces it will pay interest on excess reserves

10/14: Treasury announces TARP, makes available $250 bln to U.S. financial institutions; nine large financial institutions announce their intention to subscribe to $125 bln in total

4/30: FOMC meeting - FOMC votes to reduce Fed funds rate to 2 percent; reduces primary credit rate to 2.25 percent

12/16: FOMC Meeting - Fed votes to establish target range for Fed funds of 0-0.25 percent

10/29: FOMC Meeting - FOMC reduces target rate to 1 percent; IMF announces short-term liquidity facility for market-access countries

nOv. dec.

Jul. Jan.

9/15: Bank of America announces it will purchase Merrill Lynch for $50 bln; Lehman Brothers files for Chapter 11

3/24: NY Fed announces it will provide $29 bln of term financing for JPMorgan Chase to acquire Bear Stearns

7/13: Treasury announces temporary increase in credit lines of Fannie Mae and Freddie Mac and temporary authorization to purchase equity in either GSE

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11/18: Ford, GM and Chrysler executives testify before Congress requesting access to TARP

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We took the transcripts from 2008 Federal Open Market Committee meetings and conference calls, as published on the Federal Reserve’s web-site, and created word clouds of the most common terms for each month. To read all of the transcripts, see http://1.usa.gov/1f5bmq6. Word cloud source: Tagxedo (http://www.tagxedo.com).

Visualizing the Most Common Words in FOMC Meeting, Conference Call transcripts

http://1.usa.gov/1f5bmq6

http://www.tagxedo.com

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JANuArY

calls to much larger national companies are decidedly more pessimistic.”

Timothy Geithner (Jan. 29): “In the financial markets, I think it is true that there is some sign that the process of repair is starting... The main risk, as has been true since Au-gust, is the dangerous self-reinforcing cycle.”

Kevin Warsh (Jan. 29): “The transmission mechanism between credit markets and the real economy, whether it be through the credit channel or other channels, while imperfectly understood, is having very negative effects on the cost and availability of credit for real busi-nesses and households, with the risks there to the downside. If the U.S. financial institu-tions were an economy all to themselves, they would probably already be in a recession.”

randall Kroszner (Jan. 29): “I liked Nellie’s very politically correct phrase, “unplanned asset expansions.” That’s a very nice way of putting like, “oh, my goodness, something is suddenly on the balance sheet that we didn’t expect”—SIVs, asset-backed commercial paper, and so forth. I think people are still waiting for the other shoe to drop, and the other shoe certainly could drop.”

Ben Bernanke (Jan. 29): “A phrase you might have heard, which is getting great

Ben Bernanke (Jan. 9): “I think the down-side risks to the economy are quite signifi-cant and larger than they were. Speaking as a former member of the NBER Business Cycle Dating Committee, I think there are a lot of indications that we may soon be in a recession. I think a garden variety recession is an acceptable risk, but I am also con-cerned that such a downturn might morph into something more serious. ... We had a meeting over the weekend in Basel between the central bankers and about 50 private-sector representatives. The thrust that I got was that things are going to be pretty tight. ‘We are going to meet our regular customers’ needs, but all of this is conditioned on no re-cession.’ As one banker put it in our meeting, ‘There is no Plan B.’”

richard Fisher (Jan. 9): “The mood that the market is in, as one of my friends put it, we give the market a gift of a rate cut and then they burst into tears and run outside the room after they have unwrapped the package.”

William Poole (Jan. 21): “Whenever we act between meetings, we set a precedent... this action will not be viewed in the marketplace as anything other than a direct response to the stock market.”

Kevin Warsh (Jan. 21): “My judgment would be, if we chose not to act today, that we would in all likelihood not make it until next week.”

William Poole (Jan. 29): “The general tenor of comments that I hear from our direc-tors and people around the Eighth Federal Reserve District—these are the community bankers and smaller firms—is that things are slow but not disastrously slow. The com-ments that I hear from a series of phone

currency among bankers, is “jingle mail.” Jingle mail is what happens when otherwise prime borrowers decide that the value of their house is worth so much less than the principal of their mortgage that they just mail their keys to the bank.”

donald Kohn (Jan. 29): “We need to think about the circumstances under which we would begin to take back the easing...One point that I took from President Evans’s discussion was that there might be a risk in talking about taking it back right now be-cause it would undermine the effects of the ease you put in place.”

Jeffrey lacker (Jan. 29): “You spoke several meetings ago, I think a year or two ago, Mr. Chairman, about our need to retain a con-cern about inflation but not be seen as infla-tion nutters. I think we need to care about financial fragility but not be fragility nutters.”

Timothy Geithner (Jan. 29): “What we face now is not the choice, as I think President Poole said, between a mild recession now and higher-than-expected inflation over time. The risk we face, as the Chairman said several times, is the choice between a mild, short recession and a deeper, more protracted outcome.”

The Federal Reserve called two inter-meeting conference calls in January and cut rates twice. Transcripts reveal that the Fed wanted to get out ahead of declining markets and was “taking out insurance” against an “adverse feedback loop” between credit markets and the economy. Transcripts also reveal that while FOMC mem-bers were concerned about inflation and the appearance of panicked decision-making, they generally believed combatting a slowdown in growth to be more important.

Fed Cuts rates twice in Effort to Stave Off Crisis

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Lehman Collapse

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Monetary Policy response during Financial crisis

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MArCh

Japan. The sooner appropriate stimulus is put in place, the less likely it is that policy will end up facing very unpleasant conse-quences of essentially reaching the zero bound in this case because of a prolonged and severe recession. I’d like to see the funds rate moved down to where it needs to go sooner rather than later.”

eric rosengren (March 18): “As concerns with liquidity rise, we are once again seeing renewed pressure on the asset-backed commercial paper market. The rise in credit default swaps for companies like Washing-ton Mutual and Lehman Brothers indicates increased concerns for the solvency of other large financial institutions with large exposures to mortgages. The potential for a further episode of financial market dysfunc-tion and for runs on additional financial firms is significant.”

sandra Pianalto (March 18): “I can’t recall a single conversation that I have had with my business contacts recently that hasn’t touched on the increasing cost pressures that they are facing.”

Frederic Mishkin (March 18): “The reality is that we are in the worst financial crisis that we’ve experienced in the post-World War II era. I don’t think we should be shy about

Janet Yellen (March 10): “I strongly support the proposed term securities lending facility. I certainly agree that we face a situation in which systemic risk is large, and it’s escalat-ing very quickly.”

charles Plosser (March 10): “I can go along with this proposal; but to be honest, I am concerned about the exit strategy here. Mr. Chairman, you said that we would stop when the markets were no longer impaired. I’m not exactly sure how we would define that at some point.”

Jeffrey lacker (March 10): “I think we should view opening up this sort of expansive inter-pretation of the act as a relatively irreversible step because it will be next to impossible to put this interpretation back in the bottle and argue that the act prevents us from holding particular mortgage-backed securi-ties outright. Setting this precedent is going to measurably weaken our ability to resist congressional proposals to use us and our balance sheet for off-budget fiscal policy.”

donald Kohn (March 10): “We’re not ad-dressing the solvency issues that are to a certain extent at the heart of this. But I do think liquidity and solvency are interacting in a particularly difficult and vicious way right now.”

William dudley (March 18): “In my view, an old-fashioned bank run is what really led to Bear Stearns’s demise.”

Yellen (March 18): “Since we met at the end of January, there has been an utter dearth of good news concerning both the real and the financial sides of the economy. On the real side, I just can’t recall any intermeet-ing period in which nearly every single data point was dismal. ... I agree with Governor Mishkin’s comments about the lessons of

saying it. We are in a financial crisis, and it is worse than we have experienced in any other episode of financial ‘disruption,’ which is the word I use. I will not use ‘financial crisis’ in public. ‘Financial disruption’ is still a good phrase to use in public, but I really do think that this is a financial crisis.”

Timothy Geithner (March 18): “Some of you at this table may believe that we are losing credibility, and you may be losing confidence in the capacity of this Committee to mitigate the risk to our long-term inflation objectives. If you say that in public, you will magnify that problem, and just because you believe it does not make it true.”

Ben Bernanke (March 18): “I do think that the downside risks are quite significant and that this so-called adverse feedback loop is currently in full play. At some point, of course, either things will stabilize or there will be some kind of massive governmen-tal intervention, but I just don’t have much confidence about the timing of that. ... I think we are getting to the point where the Federal Reserve’s tools, both its liquidity tools and its interest rate tools, are not by themselves sufficient to resolve our troubles. More help, more activity, from the Congress and the Administration to address housing issues, for example, would be desirable.”

As Bear Stearns was bought by JPMorgan with support from the Fed, a March confer-ence call discussed whether to implement the term securities lending facility. Concern was expressed about exit strategy, foreshadowing a later debate over Fed asset purchases. The need for intervention on the fiscal side as well as the monetary side was mentioned. Inflation concerns remained even as more FOMC mem-bers acknowledged the potential of a serious recession. A comparison was made with Japan.

Fed Acknowledges Increasing Probability of recession, Mulls Bear Stearns deal

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Inverted Yield Curve

Source: adapted from Miskin and Estrella (1995); Bloomberg

Positive-Shaped Yield Curve

Yield slope curve and Probability of recession

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APrIl

I think the perception that we included this and maybe added some other securities as a fig leaf sets just a disastrous precedent.”

Ben Bernanke (April 29-30): “This is a once-in-a-generation chance to modern-ize our system. It is a relic that we use a quantity-based management of the fed-eral funds rate. So I think option 1 [pay interest on reserve requirements and, at a lower rate, on excess reserves] should be a fallback if we can’t make something else work, but we should try very hard to see if we can find a system that will let us manage the funds rate tightly, even as our balance sheet expands and contracts, and so on. Option 4 [pay interest on reserves set by a floor with high balances] seems a lot like Friedman’s optimum quantity of money: You just throw out money until the transaction cost on margin is zero. That’s basically what it is. I don’t, frankly, fully understand what the implications would be for the federal funds market—whether the federal funds market is just a shoe-leather cost or whether it actually has some useful functions, including price discovery, credit risk management and counterparty discipline. There may be some functions of that market that are important, and even if it still existed, if its liquidity were greatly reduced so that it wasn’t functioning in a normal way, it could be a question. To

Janet Yellen (April 29-30): “I definitely sup-port a 25 basis point cut. ... I think a further easing in financial conditions is needed to counter the credit crunch, and I believe that a cut in the federal funds rate will be efficacious in easing financial conditions. ... With respect to market and inflationary psychology, I also can see a case for doing less than markets expect. … Perhaps a pause would counter any impression that we have become more tolerant of inflation in the long run.”

Ben Bernanke (April 29-30): “The pro-posal is to increase the range of collateral to include AAA asset-backed securities, which include credit cards, auto loans, and student loans — basically mostly consumer-oriented credit. I think it makes a lot of sense in the context of what we have been doing. There are some political and public relations complications. The student loan market has been dysfunctional, and we have received requests — perhaps you have as well — to do ‘something’ about this problem. ... We wrote back to Senator Dodd and his col-leagues last week and told them ... the real problem with the student loan situation is on the legislative side. ... If we take this action ... we would get, I would call it for short, a Wall Street Journal editorial that the Federal Reserve is once again the craven cur and the spineless lackey of the Congress by accommodating this request. I take that seri-ously. On the other side, I suppose that there would be what I could call the USA Today editorial, which is, ‘Why won’t the Fed, which is bailing out Wall Street left and right, in-clude asset-backed paper in their facilities?’”

Jeffrey lacker (April 29-30): “I think the political concern you raised and described is a very, very serious one for this institution. Even if we thought of this ourselves before Senator Dodd and others wrote to us — and apparently it is true that we did — we are never going to be able to convince a broad array of observers that this was not a direct response to a senatorial request. Given that,

my mind, that is the main question we have to understand as we think about option 4.”

Jeffrey lacker (April 29-30): “Recent experi-ence has brought dramatic revelations about the informativeness or lack thereof of credit agencies’ ratings of asset-backed securities. Its revelations would seem to warrant fairly dramatic shifts in investor portfolios, just as a matter of Bayesian updating. These chang-ing expectations in light of recent information revelation are just as much a change in fun-damentals as the invention of the light bulb.”

William dudley (April 29-30): “The Libor indexes took a jump upward following a Wall Street Journal article that alleged that some of the 16 Libor panelists were understating the rates at which they could obtain funding. The British Bankers Association reacted by threatening to throw out any panelist that was not wholly honest in its daily posting of its costs of obtaining funds at different maturity horizons. The BBA announcement appears to have provoked an outbreak of veracity among at least some of the panel-ists. As shown in exhibit 12, the Libor fixing rose nearly 20 basis points in the few days immediately after the article. ... There is considerable evidence that the official Libor fixing understates the rates paid by many banks for funding.”

In April the Fed voted to reduce the federal funds rate by 25 basis points to 2 percent and discussed modernizing its policy tools by pay-ing interest on bank reserves. Members began voicing concerns about the political backlash amid the growing public perception it was bail-ing out Wall Street.

Concerns turn toward libor Accuracy, Political Backlash for Perceived ‘Bailout’

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s&P 500 stabilized Briefly in april Before decline resumed

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arthur angulo (June 24-25): “If you look at Lehman, with its capital raise, their tier 1 risk-based capital would be 12.5 percent. There may be some range around that. There are certainly questions about how ac-curately Bear’s capital was stated. But as a rough measure, I think it would be difficult to say that Lehman would be a 4 or a 5, look-ing at it from a solvency perspective. They’ve bolstered liquidity. As I said, it started to crack, but it never really shattered.”

Timothy Geithner (June 24-25): “We want this set of firms to get themselves to the point where, in the eyes of the market, they have a more conservative mix of leverage (appropriately measured) and funding risk so that they are less likely, even in a pretty ad-verse shock, to need to finance illiquid stuff with their central bank as a defense against that liquidity pressure. We’re trying to do that without forcing a level of deleveraging that would be adverse to our broader objectives of trying to get markets back to some point where they’re functioning more normally. We’re not going to get that perfect.”

Janet Yellen (June 24-25): “Even if all the systemically important institutions were primary dealers or mortgage companies within bank holding companies that cur-rently we do have umbrella supervision

Janet Yellen (June 24-25): “The adverse fundamentals are still with us and in some part are worsening. Evidence that the credit crunch is ongoing is all too clear. Bank asset quality continues to deteriorate. Banks con-tinue to deleverage, and they are tightening lending standards as they do so. The market for private-label securitized mortgages of even the highest quality remains moribund.”

Ben Bernanke (June 24-25): “I do not agree that systemic risk has gone away. I think it is in abeyance. There is perhaps, if anything, excessive confidence in the ability of the Fed to prevent a crisis situation from metasta-sizing. Even if we don’t have a failure of a major firm, we still have the possibility of a significant adverse feedback loop as credit conditions worsen and banks come under additional pressure.”

Janet Yellen (June 24-25): “Higher oil prices and interest rates and lower housing prices have led me to modestly reduce my forecast of growth in the second half of this year and next year. My forecast is predicated on fed funds rate increases that begin in December of this year, gradually bringing the funds rate to 4¼ percent in 2010.”

Janet Yellen (June 24-25): “On the is-sue of long-term economic projections, I welcome greater transparency about our long-term objectives. I think that would be beneficial, and there is a good reason, as you have articulated, to try to do that now, given that for many of us—certainly for me—2010 is not long enough for me to project that the economy will have con-verged to a steady state.”

Janet Yellen (June 24-25): “I certainly favor keeping these facilities in place beyond September. Even if their use diminishes, I agree with the point that it doesn’t neces-sarily indicate that they are not playing a tremendously important role.”

over, I am not at all convinced that the way we are carrying out supervision now would have prevented a Bear Stearns-type of episode within an institution that is currently solidly under our supervision.”

Ben Bernanke (June 24-25): “There clearly is a lot of dissatisfaction among all of us about the ad hoc nature of the way we had to deal with the crisis in March. We would all like much more clarity about our authorities, the limit of those authorities, and the match between our responsibilities and our authori-ties; and, as we go forward, we will try to get clarification on that. At the same time, we also want to take steps to try to increase the resilience of the system and reduce the risk that we will be in the same situation again in the future.”

Ben Bernanke (June 24-25): “On the long-term projections, I think there’s consensus that we should just go ahead and have a trial run. The staff should review the tran-script and make gold out of straw there. We should consult with the subcommittee, and we should think about maybe even a couple of alternatives. Maybe we could try a couple of alternative ways of doing it in October. Let’s go ahead and do something along those lines and keep thinking about how best to do it.”

After expanding its list of eligible collateral and increasing TAF auctions to $75 from $50 billion in May, the committee found itself facing concerns about worsening economic funda-mentals, excessive leverage, and the reliability of bank accounting. Even so, the central bank voted to maintain its target for the federal funds rate at 2 percent.

Economic Fundamentals Continue to Worsen, leverage Fears Mount

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Source: Bloomberg GS/BOFA/JPMCC/WELLFARGO CDS SR 5Y INDEX<GO>

Banks’ cds narrowed Briefly Before Widening again in June

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Janet Yellen (July 24): “Troubled banks can be downgraded and fail very rapidly. They may be deemed eligible to borrow under pri-mary credit and participate in TAF auctions when in reality they are near failure.”

Janet Yellen (July 24): “It is true we have discretion to judge whether or not to allow an institution to participate in auctions and can exclude an institution that we don’t consider in sound financial condition. But, in reality, we deal with hundreds and potentially thou-sands of banks at the discount window and can’t monitor and make independent judg-ments on the health of all those institutions on an ongoing basis. We do have to rely on primary supervisors for assessments. If we act on our own hunches, we are substituting our judgment for that of primary supervi-sors. If we decided we wanted to do so, we would be truly taxing the resources of our colleagues in BS&R beyond their capacity to deal with these institutions.”

Janet Yellen (July 24): “I know that this ap-plies, we hope, to a handful of institutions and not to most of them; but I don’t think that IndyMac is going to be the last failing bank. I do think that this would have worked very badly in that case, and so it does give me qualms about the proposal.”

William dudley (July 24): “I think we have seen a couple of quarter-ends over the last year that have been problematic and more difficult. Certainly, the September quarter-end was difficult, and the year-end was difficult. March somewhat less so, but that was a little colored by the fact that the Bear Stearns resolution happened just before the March quarter-end. June was actually pretty manageable. But we have definitely seen more stress over those periods.”

Janet Yellen (July 24): “I support extending the TSLF along with the PDCF, and I am also supportive of the proposal to auction options on TSLF draws. I think we do con-tinue to have money market stress, particu-larly at quarter-end, and it strikes me as a well-targeted program that might have some success in addressing the strains.”

charles evans (July 24): “I wonder a bit about how confident we are about what the market reaction to the introduction of these pretty complicated programs is going to be. Are they going to wonder about what we’re looking at versus what they’re looking at? These are supposed to be temporary; but the way we add more to it, it seems as if it’s going to be more difficult to take this away, at least in terms of the expectations of our borrowers and the markets. We have been doing this as we make comparisons to the ECB and the Bank of England, and they have been doing this for some time. It sort of suggests that this is something that we’re going to do for a longer period of time.”

William dudley (July 24): “‘Have things deteriorated?’ I would say ‘yes and no.’ They haven’t deteriorated in terms of term fund-ing pressures by looking at the Libor–OIS spread being worse. But what has deterio-rated is that the markets think these strains are going to last a lot longer.

Ben Bernanke (July 24): “With respect to the extension of the TAF terms, my sense is that this would be a productive thing to do from the perspective of markets. I agree with President Geithner that the markets are still quite stressed and that this would be helpful. It has the additional sort of multiplier effect that, if we extend to three months, the ECB will auction $60 billion to three months as well, to give some ad-ditional impetus in Europe.”

Frederic Mishkin (July 24): “I just don’t see the stress dissipating. I’m getting ready to go back to academia, and it’s going to be a much quieter life for me. I really am extreme-ly nervous about the current situation. We’ve been in this now for a year; but boy, this is deviating from most financial disruptions or crisis episodes in terms of the length and the fact that it really hasn’t gotten better. We keep on having shoes dropping. So although there’s an issue that we’re going to need to get out of many of these facilities, the reality is that we’re in this, and I’m not anticipating that this is going to go away quickly. I hope that it will. I just don’t understand the argu-ment that actually thinking of more ways to be on top of this and being creative about it will indicate that we want to do something permanent. I just don’t see that.”

As market volatility increased, the central bank authorized the New York Fed to lend to Fannie Mae and Freddie Mac. Meanwhile, the SEC issued a temporary ban on naked short-selling in securities of Fannie Mae, Freddie Mac and primary dealers at commercial and investment banks. The Housing and Economic Recovery Act gave Treasury Secretary Paulson a number of other tools to support Fannie and Freddie.

Increase in Market Volatility Pressures Fed to Act Further

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Source: Bloomberg SPX, VIX INDEX<GO>

Lehman Collapse


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concern about downside risks to economic growth and slightly allayed my concern about upside risks to inflation.”

Janet Yellen (Aug. 5): “Higher headline infla-tion could undermine our credibility and raise inflation expectations. If the public concludes that our implicit inflation objective has drifted up, workers may demand higher compensa-tion, setting off a wage–price dynamic that would be costly to unwind. Fortunately, the reports I hear are consistent with the view that no such dynamic has taken hold. My contacts uniformly report that they see no signs of wage pressures. They note that high unemployment is suppressing wage gains.”

randall Kroszner (Aug. 5): “I continue to see that the situation is quite brittle and that small pressures potentially can lead to large and rapid responses. The ‘severe financial stress’ alternative simulation in the Greenbook is certainly not my central tendency one, but I think that we can’t dismiss it too easily because there still could be another — what I have now taken to calling, since I chair the supervision and regulation committee — flare-up with one of my problem children.”

William dudley (Aug. 5): “In my view, the legislation has helped to avert — at least for now — a meltdown in the agency debt and

James Bullard (Aug. 5): “My sense is that the level of systemic risk associated with financial turmoil has fallen dramatically. For this reason, I think the FOMC should begin to de-empha-size systemic risk worries. My reasoning is as follows. Systemic risk means that the sudden failure of a particular financial firm would so shock other ostensibly healthy firms in the industry that it would put them out of business at the same time. The simultaneous depar-ture of many firms would badly damage the financial services industry, causing a substan-tial decline in economic activity for the entire economy. This story depends critically on the idea that the initial failure is sudden and unex-pected by the healthy firms in the industry. But why should this be, once the crisis has been ongoing for some time? Are the firms asleep? … My sense is that, because the turmoil has been ongoing for some time, all of the major players have made adjustments as best they can to contain the fallout from the failure of another firm in the industry.”

James Bullard (Aug. 5): “Let me stress that, to be sure, there are some financial firms that are in trouble and that may fail in the coming months or weeks depending on how nimble their managements are at keep-ing them afloat. This is why many interest rate spreads remain elevated and may be expected to remain elevated for some time. These spreads are entirely appropriate for a financial system reacting to a large shock. But at this point, failures of certain financial firms should not be regarded as so surpris-ing that they will cause ostensibly healthy firms to fail along with them. The period of substantial systemic risk has passed.”

Janet Yellen (Aug. 5): “Developments during the intermeeting period have heightened my

agency MBS markets. But the passage is no panacea for ensuring the viability of Fannie Mae and Freddie Mac or in enabling the two firms to provide significant support to the U.S. housing market.”

William dudley (Aug. 5): “We continue to press for legislation that would accelerate the timing of the Federal Reserve’s author-ity to pay interest on reserves. Being able to pay interest on reserves would put a floor under the federal funds rate. In this case, an inability to drain additional reserves from the banking system would not result in the federal funds rate collapsing toward zero.”

Janet Yellen (Aug. 5): “Our forecast for weak second-half growth reflects not only the unwinding of fiscal stimulus but also adverse financial sector developments. The credit crunch appears to have intensified since we last met. ... Risk spreads and the interest rates charged on a variety of private loans, including mortgages, are up notice-ably, and lending standards have tightened further. Credit losses have risen not only on mortgages but also on auto loans, credit cards, and home equity lines of credit. As a consequence, the list of troubled depository institutions is growing longer. IndyMac and First National will not be the last banks in our region to fail.”

In light of the legislation to support Fannie and Freddie, the calm before the storm set in, and policymakers debated the level of systemic risk. Some saw financial market stress as a sign of persistent fragility while others believed the system was adjusting to risks at specific institu-tions. Under the latter view, healthy institutions would not face contagion after the failure of unhealthy ones.

Discussion of interest on reserves suggested some foresaw the potential for the Fed balance sheet to expand.

Policy Makers disagree on Crisis’ Magnitude, duration

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Source: Bloomberg GS/BOFA/JPMCC/WELLFARGO CDS SR 5Y INDEX<GO>

Lehman Collapse


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Ben Bernanke (Sept. 16): “Bill, if we were going to take action today, what would you recommend in terms of counterparties? Should we say an unlimited amount? Should we specify an amount? Can we leave the time open? What are your recommendations on all those dimensions?” William Dudley: “Certainly you want to make it pretty broad. You want to make it to the Bank of England, Switzerland, the ECB, the Bank of Japan, potentially Canada. I would leave it to their discretion if they would like to participate. I would make the offer to them; and if they want to participate, then we should be willing to do that. In terms of size, I think it is really important that you don’t create notions of capacity limits because the market then can always try to test those. Either the numbers have to be very, very large, or it should be open ended. I would suggest that open ended is better because then you really do provide a backstop for the entire market.

Janet Yellen (Sept. 16): “The interaction of higher unemployment with the housing and financial markets raises the potential for even worse news—namely, an intensification of the adverse feedback loop we have long worried about and are now experiencing.”

William dudley (Sept. 29): “Our strat-egy all along has been not to prevent

Jeffrey lacker (Sept. 16): “What we did with Lehman I obviously think is good. It has had an effect on market participants’ assessment of the likelihood of other firms getting support, and I think you would have to attribute at least some of the changes in equity prices to that. We’re likely to see a lot more disruption this week and in the days going forward than we’ve seen so far. I don’t want to be sanguine about it, but the silver lining to all the disruption that’s ahead of us is that it will enhance the credibility of any commitment that we make in the future to be willing to let an institution fail and to risk such disruption again.”

William dudley (Sept. 16): “Lehman’s experience suggests to me that, if we can contain the broad parameters of this crisis so that it doesn’t spread much further, then we can keep the tri-party repo investors from bolting because they don’t really have a huge amount of risk as long as we are there behind them to take them out when their overnight obligation comes due the next day.”

William dudley (Sept. 16): “The AIG problem is at least starting as a liquidity crisis… So AIG is running into two problems: One, they are unable to roll their commer-cial paper and, two, as their ratings are downgraded… they have to post a lot more collateral against their derivatives exposures and also with respect to their GIC (guar-anteed investment contract) business. So AIG is in a situation in which the parent is basically going to run out of money—today, tomorrow, Thursday, or very, very soon. Now we say it’s a liquidity thing, but a lot of times when people look closer at the books they find out that the liquidity crisis may also be a solvency issue. I think it is still a little unclear whether AIG’s problems are confined just to liquidity. It also may be an issue of how much this company is really worth.”

the deleveraging or the unwinding that developed earlier but to stretch it out a little so fewer things break. The swap lines are just one more tool to help that process unfold without severe systemic consequences occurring. Obviously, things are breaking, even with all the tools that we’ve rolled out. So I think that just suggests that more force needs to be ap-plied. Clearly, confidence in the markets is extraordinarily poor and fragile, and that’s another reason that an escalation in the authorizations is important—to reas-sure people that the central banks are prepared to be there, if necessary.”

Ben Bernanke (Sept. 29): “We have been very constrained throughout this entire crisis, as you know, by the existing facili-ties for dealing with failing institutions and mergers being one of the only tools we have. Going forward, I think there is some hope in the near term under the new TARP, which would allow resolutions using capital injec-tions basically without necessarily doing a merger. Then subsequently, I think it’s very important, as we look toward restructuring our financial regulatory system, to develop good resolution mechanisms and to think about the issues of concentration and too big to fail.”

The Sept. 16 meeting was consumed with an initial assessment of Lehman’s failure, money market mutual funds, the tri-party repo market and AIG. Yellen spoke very little, aside from some colorful anecdotes about the retail side of deteriorating sentiment.

Lacker concluded, just two days after the fact, that letting Lehman fail was the right decision.

Fed Focus turns to lehman’s Failure, liquidity Constraints

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Source: Bloomberg FARWRPAG, FARWTAC, FARWOL , BFCIUS INDEX

Lehman Collapse

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point that it felt it couldn’t lower the federal funds rate any further, be that zero or some higher level. One would be communications that suggest to market participants a willing-ness to hold short-term rates at very low levels for a very long period of time.”

Jeffrey lacker (Oct. 28-29): “My understand-ing is that economists such as Woodford and others who have studied this believe that, by using monetary assets to purchase other assets, we can make the price level and thus the inflation rate higher than it otherwise would be. Is that a fair understanding?”

Ben Bernanke (Oct. 28-29): “I don’t think that’s right. I think the thrust of the elementary approach to quantitative easing is the old Mil-ton Friedman idea—that changing the com-position of money and other assets changes relative returns. So it’s a way to bring down returns on other assets and create stimulus even if the policy rate is down to zero.”

Jeffrey lacker (Oct. 28-29): “The mecha-nism Friedman sketched ultimately produces a proportionate increase in the price level, doesn’t it?”

Ben Bernanke (Oct. 28-29): “Eventually, but through the aggregate demand mechanism.”

Jeffrey lacker (Oct. 7): “Bill, you said you were struck by the feeble reaction of markets to expanding our credit programs?”

William dudley (Oct. 7): “Yes. The markets didn’t take as much solace as I would have hoped, given the degree of escalation of those provisions.”

Jeffrey lacker (Oct. 7): “Could it be that some fundamentals are going on there that market participants don’t view it as address-ing?” William Dudley (Oct. 7): “Well, a fair point is that the Federal Reserve cannot by its actions solve the balance sheet con-straints of the U.S. banking system. The Federal Reserve by its actions cannot create capital for banks, and that’s obviously one of the problems at the core of what is going on in the financial system.”

Ben Bernanke (Oct. 7): “I want to say once again that I don’t think that monetary policy is going to solve this problem. I don’t think liquidity policy is going to solve this problem. I think the only way out of this is fiscal and perhaps some regulatory and other related policies. But we don’t have that yet.”

Janet Yellen (Oct. 7): “In my opinion, a larger action could easily be justified and is ultimately likely to prove necessary. We’re witnessing a complete breakdown in the functioning of credit markets, and it is affect-ing every class of borrowers. The financial developments are dangerous and are having a pronounced impact on the economic outlook. The outlook has deteriorated very sharply, and even so, I still see the risks to the downside.”

Brian Madigan (Oct. 28-29): I would say that there are a number of strategies that the Committee could think about if it were at the

Jeffrey lacker (Oct. 28-29): “Well, the rea-son I ask all of this is that, with an interest rate on reserves above zero, that’s effec-tively equivalent to a zero lower bound on nominal interest rates. So we are effectively doing this quantitative easing.” Bernanke (Oct. 28-29): “We’re pretty close, yes.”

elizabeth duke (Oct. 28-29): “I was shocked when I was looking at the Bluebook at how short a time has passed since the meltdown of all these major financial institutions—Fan-nie, Freddie, Lehman, AIG, WaMu, and Wa-chovia. There is a sense among those who were affected, who lost from it, that they just really didn’t see it coming, at least not at this speed, and that all of them had adequate regulatory capital, and the bankers at least were used to watching a sort of gradual burndown of that capital before institutions failed. They had a sense of being unable to predict who was going to be saved, who was going to get whacked, and who would be the winners and the losers. So subsequently both the banks and their customers froze.”

Janet Yellen (Oct. 28-29): “Frankly, it is time for all hands on deck when it comes to our policy tools, and the fed funds rate should be no exception.”

On Oct. 7 the Federal Reserve held a special meeting specifically to discuss coordinated mon-etary policy action with five other central banks.

The regularly-scheduled Oct. 28-29 meeting, at which the FOMC decided to lower interest rates by an additional 1 percent, also included discussion of what policy may entail going forward, including reducing rates to zero and possibly conducting quantitative easing. The FOMC adopted a “whatever it takes” principle.

Policy Makers Implement Coordinated Policy response to Contain Crisis

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Janet Yellen (Dec. 15-16): “As to the level of the lower bound, my default position is that we should move the target funds rate all the way to zero because that would provide the most macroeconomic stimulus. For ex-ample, every 25 basis point cut in the target typically takes about 25 basis points off the prime rate and associated borrowing rates. The institutional concerns about Treasury fails and Treasury-only money market funds merit consideration, but I don’t consider them serious enough to ban lowering the target to a very low level.”

Janet Yellen (Dec. 15-16): “Looking ahead, I believe that there could be significant benefits to communicating effectively the FOMC’s in-tentions to hold the target funds rate at a very low level. The Japanese experience at the zero bound suggests that this is one channel that can work, and the evidence suggests that our own guidance that began in 2003 similarly influenced longer-term rates.”

James Bullard (Dec. 15-16): “Let me talk briefly about purchases of agencies and lon-ger-term Treasuries. In general, I think this is okay, but I do not think we should expect a lot of impact from this. I think the effect will be marginal. I might remind the Committee that the famous Operation Twist from the 1960s was generally judged to be ineffec-

James Bullard (Dec. 15-16): “Then I just want to understand – on exhibit 2 you said something about a fully discounted default rate last seen in the Great Depression. What did you mean by that?”

William dudley (Dec. 15-16): “Well, if you basically take that 21 percent and compare it with the default rates in the Great Depres-sion and write down some numbers for recoveries, if you had a default rate equal to the Great Depression default rate and you had a 20 percent recovery, you’d actually do pretty well owning high-yield debt at these levels right now. So the level of yields fully discounts horrific default rates.”

Ben Bernanke (Dec. 15-16): “In fairness, these are junk bonds. These are low- rated companies.”

William dudley (Dec. 15-16): “Well, yes. It is possible that we could have default rates greater than those of the Great Depression. I’m just saying that these levels discount that kind of outcome. Obviously, the high-yield debt market today is different from general default rates. Yeah, I think that’s a fair point.”

Ben Bernanke (Dec. 15-16): “What we need to do is to come together and decide what policies we want to pursue and then col-lectively take responsibility for those policies and communicate them in a coherent and consistent way to the broad public. That is the responsibility of all of us, and I hope we can work together to provide everybody with the information that they need to do that effectively. In particular, I am going to say that, given the state of confidence in the markets and in the economy, I hope whatever disagreements we may have that as much as possible we can keep them within these walls. With respect to the public, we need, as much as possible, to communicate a clear strategy going forward.”

tive, and that is why I think the central banks did not, generally speaking, play games on the yield curve in the past. I guess I would prefer agencies to the longer-term Treasuries because of the more direct correlation with the mortgage markets. I think that might help our case a little in this current situation, but I wouldn’t expect a lot out of that policy.”

Ben Bernanke (Dec. 15-16): “I think that the great majority of the Committee is comfort-able with MBS and Treasury purchases. At least that’s what I heard. I took a majority to be in favor of, or at least accepting, the credit facilities that we have. There were requests for more metrics, more explanation, more criteria, more exit strategies, and so on, and I think those were all valid points.”

Jeffrey lacker (Dec. 15-16): “Given the dis-mal state of the economy, and with the funds rate averaging around 1/8 percent anyway, I don’t see any reason to wait to bring the fed funds rate down to effectively zero. I agree with the staff analysis that any dislocation of the money funds is likely to be minor. My board put in for a 75 basis point cut in the discount rate. When I looked over at my small bankers, I was afraid one of them was going to throw a shoe at me.”

After the October 28-29 meeting, the FOMC didn’t meet again until Dec. 15 and 16, at which the committee voted to establish a 0-0.25 per-cent target range for the fed funds rate. Mem-bers were also concerned about the increasing threat of deflation. This meeting also laid the groundwork for the Fed’s use of forward guid-ance and the expansion of its long-term asset purchases and quantitative easing programs.

As deflation threat Mounts, Fed lays Groundwork for QE Expansion

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FOMc Members Increasingly Worried about Outright deflation

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thE lIGhtEr SIdE By JOShua ZuMBRun

will keep asking for more and more. We have to quit feeding them.”

richard Fisher (March 18): “Mr. Chairman, today is my 59th birthday, and I can’t think of a better group of people to spend it with — or a less happy time to do it.” randall Kroszner: “We sure know how to take the punch bowl away from this party.”

richard Fisher (March 18): “When I was nine years old, three-month Treasury bills were trading where they are today.”

Janet Yellen (Oct. 28-29): “In the run-up to Halloween, we have had a witch’s brew of news. Sorry.”

richard Fisher (Jan. 29): “I experienced a different kind of price shock two weekends ago, when I went to buy a television so I could watch President Rosengren’s football team demolish President Yellen’s.”

Janet Yellen (Sept. 16): “My contacts report that cutbacks in spending are widespread, especially for discretionary items. For exam-ple, East Bay plastic surgeons and dentists note that patients are deferring elective pro-cedures. Reservations are no longer neces-sary at many high-end restaurants. And the Silicon Valley Country Club, with a $250,000 entrance fee and seven-to-eight-year waiting list, has seen the number of would-be new members shrink to a mere thirteen.”

Ben Bernanke (Aug. 5): “We saw growth of about 2 percent in the second quarter, which suggests a campaign slogan for the Republi-cans: ‘The Economy: It Could Be Worse.’”

charles Plosser (Jan. 29-30): “Listening to the staff discussion I have certainly come to understand why everyone continues to believe that economics is a dismal science.”

charles Plosser (March 18): “I’ve been sup-portive of the steps we’ve taken to enhance liquidity in the markets through the TAF, the TSLF, the PDCF, or whatever.” Ben Bernanke: “AEIOU.” Timothy Geithner: “Don’t say IOU.”

richard Fisher (March 18): “I think 75 basis points, Mr. Chairman, is way too much. My thought is that it encourages the financial markets. They’re not going to be satisfied. I said this last time. It’s Jabba the Hutt. They

Kevin Warsh (Jan. 29-30): “I ... think where the rating agencies are now is trying to come up with cleaner boxes and better gov-ernance — Sarbanes-Oxley types of struc-tures, ombudsmen, liaisons, Chinese walls. The core issues that Mike and his team bring up seem highly resistant to change, but you know, there will be nothing like three months of public hearings, if not hangings.” Frederic Mishkin: Torture works.

Ben Bernanke (Oct. 7): “Vice Chairman Geithner, you had a two-hander?” Timothy Geithner: “I just wanted to point out that I have assembled a historic coalition in New York of hawks on both sides of me today in support of your proposal. They have agreed to join me here in New York as a gesture of support for your proposal.”

Ben Bernanke: “Somebody send me a photograph.”

richard Fisher: “Mr. Chairman, we enjoy visiting Third World countries.”

charles Plosser: “We just thought we would outflank him, but we haven’t succeeded.”

Janet Yellen (March 18): “As a final an-ecdote, a banker in my District who lends to wineries noted that high-end boutique producers face a distinctly softening market for their products, although sales of cheap wine are soaring.”

How is a recession like a bad joke? Bernanke couldn’t stop either in 2008. Even in the grimmest of times, Federal Reserve officials maintained a sense of humor, regaling their colleagues with jokes about their spouses, eating habits and grammatical errors. Still, the jokes were less fre-quent as the financial crisis deepened. A search of 1,865 pages of transcripts for 2008 released today found an average of 25 references to laughter per meeting of the Federal Open Market Committee, down from about 45 in 2007. Here are some of the best jokes — and a few of the worst.

Fed Officials Kept humor in dark days of 2008 With Jokes, Jabs

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Source: FOMC, Bloomberg

The Word ‘depression’ entered the Fed’s vocabularyMirthful Moments declined as crisis Took Hold

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Dissecting the Financial Crisis

Economy & Finance

Transcript of Dissecting the Financial Crisis