Top Federal Reserve officials were haunted by an imaginary inflation epidemic during eight months preceding the cataclysmic 2008 Lehman Brothers bankruptcy. While much of the central bank's top policymaking committee was focused on a phantom menace, officials who recognized the true danger -- a banking crisis -- frequently underestimated the scope of the problem, relying on poor information and neglecting the Fed's leverage over troubled firms as the world’s lender of last resort, newly released transcripts show.
The documents, made public Friday after their customary five-year lag, reveal Fed officials’ distrust of financial institutions and skepticism of the government’s ability to spot risks. Some central bank officials worried their tools to pump money into the economy ultimately would have little effect. Others were concerned that the Fed was artificially propping up prices of various financial assets and simply acting on the whims of Wall Street traders.
In a sign of Fed officials' priorities, the word "inflation" appears more than 1,500 times in transcripts of the central bank's Federal Open Market Committee meetings in 2008. But in those months preceding Lehman's collapse, the word “crisis” garners about 50 mentions.
Some of the more vocal committee participants, such as James Bullard, president of the Federal Reserve Bank of St. Louis, argued in 2008's pre-September months there was little, if not “zero,” systemic risk in the financial system. Others, such as Harvey Rosenblum, a top official at the Dallas Fed, worried about the damage to the Fed’s reputation if it was found that the Fed had helped financial institutions, on preferential terms, “that everybody who reads The Wall Street Journal and The New York Times and looks at the Internet knows was in trouble.”
Taken together, the transcripts provide the most detailed record to date of what senior Fed officials thought as they grappled with a burgeoning crisis that began the previous August following mortgage market turmoil. It intensified in March with the failure of investment bank Bear Stearns, then climaxed in September as the federal government allowed investment bank Lehman Brothers to fail, and bailed out housing giants Fannie Mae, Freddie Mac and insurer AIG. That fall, actions of the officials may have rescued the entire U.S. financial system.
That August, internal Fed studies predicted financial institutions would eventually record some $900 billion in losses, the transcripts show. By that point, U.S. and European financial institutions had already written down the value of their assets by about $400 billion. Kevin Warsh and Randall Kroszner, then Fed governors based in Washington, doubted the health of financial institutions and their ability to weather losses. Dennis Lockhart, president of the Atlanta Fed, suspected European banks were masking losses by playing games with their balance sheets.
The hesitancy by senior Fed policymakers, which some of them attributed to lack of clear data on the health of financial institutions and their skepticism of other regulators’ abilities to properly oversee the companies under their watch, help explain why Fed officials that year appeared to lurch from crisis to crisis, without a firm understanding of what they were doing, the ultimate effects of their actions, or whether they’d actually be able to jolt the then-moribund economy back to life.
In other words, senior Federal Reserve officials doubted their power to help, just as the world increasingly relied on their ability to act.
“I really am extremely nervous about the current situation,” Frederic Mishkin, then a Fed governor, said that July, according to a transcript. “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.”
Mishkin’s worries were echoed by Ben Bernanke, then Fed chairman; Janet Yellen, then president of the San Francisco Fed and Bernanke’s successor; and Timothy Geithner, who at the time led the New York Fed. Geithner left the Fed after newly elected President Barack Obama tapped him for treasury secretary.
Doubts about the health of major U.S. and European lenders and investment banks persisted, despite the Fed's status as the nation’s most powerful regulator, as officials appeared reluctant to leverage the institution's powers to overhaul bad banking practices or secure better data about exposures and risks.
For example, Yellen said the Office of Thrift Supervision, a federal regulator that Congress dismantled in 2010, didn’t tell the Fed that it had downgraded IndyMac, a California thrift that was borrowing from the Fed in order to stay in business. Jeffrey Lacker, Richmond Fed president, said his bank examiners often were more critical of the health of financial institutions than were OTS officials.
Lacker told Bernanke, “I think it is outrageous that the OTS downgraded [IndyMac] and didn’t inform the San Francisco Fed. I hope, Mr. Chairman, that the unacceptability of that sort of behavior is communicated at the highest levels to the OTS.”
Still, even though the Fed initiated unprecedented programs to flood the financial system with easy money, divisions among policymakers appear to have tempered the Fed’s actions.
“I think it would be wise ... to take a newspaper across the snout and call for a 25 basis point increase,” Richard Fisher, president of the Dallas Fed, said that August in calling for the Fed to raise its main interest rate by 0.25 percent. “We’re always talking about tightening at some point. I think it just becomes increasingly difficult to take that first step. I grant you that the economy is weak. The financial situation is brittle. That hasn’t changed in my view, but the inflationary behavioral patterns that I’m beginning to hear about reinforce my concern[s].”
At the time, Fed officials outside Washington and New York reported hearing from contacts in the business community that prices were rising, inflation was looming, and the Fed’s credibility to maintain stable prices may be in question.
In one notable exchange, after Fisher ticked off a list of “chilling anecdotes” about coming inflation, Bernanke asked him what he said was a “very innocent question.”
“Official statistics just don’t show anything like that outside of oil, gas, gasoline, and the direct commodity price increases. Do you believe that the [government’s consumer price index] is not an accurate measure?”
Fisher responded that what he heard was consistent with the data, but that he was “just trying to report what I’m hearing from the field.”
In addition to preoccupation with what proved to be phantom problems, misjudgments over the scope of the crisis were routine, transcripts show. In September 2008, a few days after U.S. officials, including those at the Fed, decided to let Lehman Brothers fail -- a decision viewed by some as among the major policy errors of the crisis -- Bernanke told colleagues, “I think that our policy is looking actually pretty good.”
In the weeks after that, the Fed grew more aggressive, culminating in a December decision to drop its main interest rate almost to zero, where it has remained.
Bernanke, who at times has been criticized for public statements in which he underestimated the crisis, comes across in the transcripts as doubtful about the strength of the economy, worried about the financial system’s ability to heal and almost dismissive of inflation fears.
He often was joined by Yellen, who has been praised for the foresight she appeared to possess in 2007 as the mortgage market began its collapse. In August 2008, in response to statements by other Fed officials that the Fed was unjustified in its attempt to prop up the economy, Yellen said: “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.”
Despite those concerns, the Fed as an institution underestimated the weakness of the economy and the looming disaster that would play out in financial markets. In the months leading up to September and the bailouts that would ensue, some at the Fed thought there was little it could do to alleviate the real-world consequences of weaker financial institutions.
“At the end of the day, no matter where policy comes out in terms of regulatory policy from the Fed and other bank regulators or accounting policy from the [Securities and Exchange Commission] or [Financial Accounting Standards Board], it strikes me that those changes in policy are less determinative of how things shake out,” Warsh warned that August. “That is, management credibility is so in question that the cure is not likely to come from accounting rules or regulators but from the markets’ believing that what management says is what management believes and will act on it. As a result, I think that many of these financial institutions are operating in a zero-defect world, which is posing risks to the real economy.”
Others, such as Charles Plosser, president of the Philadelphia Fed, warned his colleagues during the same meeting against propping up the financial system for no better reason than to benefit Wall Street.
“We must be cautious in using monetary policy or other tools at our disposal as a form of forbearance that delays the necessary adjustments in the pricing of various financial claims,” Plosser said. “I think we need a high hurdle ... before we intervene to stem liquidity desires on the part of traders or attempt to influence the price of specific asset classes.”
Plosser was joined by Lacker, who said, “I believe what we’ve done has been to subsidize selected borrower classes and prop up prices of various financial assets, and I think the problem we face now is the tremendous dependency of financial institutions and markets on our credit.”
To this day, the Fed continues to be dogged by criticisms that its actions have mainly benefited big banks and Wall Street.
As rescue operations intensified in 2008, Geithner suggested in June that the Fed seriously consider what role it wanted to play as a regulator in the future. Several Fed officials suggested expanding the scope of the Fed's authority, giving it more scrutiny over investment banks and other financial firms. Then and now, the Fed shared regulatory powers with other banking and securities regulators.
But Yellen stood out by noting that the central bank was doing a lousy job with the companies it already had authority over.
"What is going on raises fundamental issues about how we conduct consolidated supervision," Yellen said that June. "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."
Yellen was among the most attentive Fed officials concerning regulatory matters, joining then-St. Louis Fed President William Poole (who preceded Bullard) in January 2008 to suggest that banks were rewarding excessively risky behavior with expansive pay packages.
Citing a 2005 paper by economist Raghuram Rajan, who has since become India’s top central banker, in which he noted the misaligned incentives between managers of financial institutions and investors, Yellen said, “I don’t know what they were thinking, but everybody was rewarded for the quantity and not the quality of [mortgage] originations. He warned us before any of this happened that this could come to no good, and I think he did have some suggestions about compensation practices. These were not popular suggestions."
Yellen then suggested that the Fed reform its rules on pay for bank executives and traders.
"I think this is worth some thought," Yellen said. "I don’t know what the answer is in terms of changing these practices. Maybe the market will attend to them, but it seems to me that we have had an awful lot of booms and busts in which this type of incentive played a role."
But Geithner, then leader of the New York Fed, an institution often viewed as the link between the Fed’s Board of Governors in Washington and financial firms on Wall Street, quickly pushed back.
"When you think about what you can do through supervision and regulation, to affect that stuff is hard," Geithner said.
Geithner appeared in the early months of 2008 to be among the most optimistic Fed officials when assessing the overall strength of the financial system.
In March, days after he helped arrange and subsidize JPMorgan Chase's bargain-basement acquisition of Bear Stearns, Geithner continued to believe the banking system had enough money to weather the coming storm.
"It is very hard to make the judgment now that the financial system as a whole or the banking system as a whole is undercapitalized," Geithner said. "Some people out there are saying that. ... But based on everything we know today, if you look at very pessimistic estimates of the scale of losses across the financial system, on average relative to capital, they do not justify that concern."
Geithner’s then-upbeat outlook appeared to have reflected an uneasiness in acknowledging that the financial system was hurtling toward collapse. At least one of his colleagues, Mishkin, was afraid to publicly admit the truth.
“I don’t think we should be shy about 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,” Mishkin said that March. “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."
The Fed would eventually pump trillions of dollars into the financial system to help banks, investment firms, industrial companies and other institutions that had never before so relied on a taxpayer-funded safety net. Congress would authorize the Treasury Department to spend more than $700 billion to bail out U.S. banks, insurers, auto companies and other firms.
The U.S. economy would lose some 8 million jobs. Millions of families would lose their homes due to widespread foreclosures. The effects of the recession, which began in 2007, would be magnified by the financial crisis, leading to government spending to cushion the blow that produced record federal budget deficits and in turn prompted U.S. officials to limit aid to the poor.
Leading economists, such as Larry Summers, Obama’s chief economic adviser during the early years of his presidency, now worry of permanently reduced U.S. economic growth.