We put together an extensive list of quantitative targets and deadlines, and within three weeks, all fourteen firms had signed a letter with solid commitments, such as a 30 percent reduction of their backlogs within four months. We made the targets more ambitious over time. By 2008, after a lot of pressure and attention, the backlog of unconfirmed credit derivatives had been reduced by 92 percent, even though the volume had tripled. Electronic processing of equity derivatives had increased from 34 percent to 94 percent. All kinds of bad surprises would emerge during the financial crisis, but a malfunctioning back-office derivatives infrastructure wouldn’t be one of them. As Lee Sachs said, it was one dog that didn’t bark.
I don’t want to overstate the importance of these reforms. The Wild West with better plumbing was still the Wild West. Large banks and nonbanks had a mutual interest in upgrading their derivatives infrastructure, so we managed to persuade them to upgrade it. But we couldn’t persuade enough of them to reduce their leverage or manage their risks more carefully, because they didn’t think that was in their interest. That was the real danger to the system.
OTHER THAN my anxieties about the future of finance, I felt comfortable in New York. My family and I moved to the small bedroom community of Larchmont, near where I had lived during junior high, and we built a nice life there together.
Carole took on a fulfilling job as a grief counselor for the Bereavement Center of Westchester, working with kids and adults who had experienced a major loss. Elise and Ben seemed to thrive in the local public schools. I woke up every morning at 5:15 to work out, finishing in time for breakfast with Carole and the kids. That early workout—a triathlon rotation of running in my neighborhood or on a treadmill, swimming at the YMCA or the middle school pool, or riding my stationary bike in front of a training video—was really the start of my workday, my time alone to think. It also helped keep me centered at the office, more focused, less frustrated. I’ve always been calmer in motion than in repose.
The Fed’s security officers drove me to and from work, which was an amazing luxury, an extra two or three hours a day to read five newspapers, catch up on my Fed paperwork, and talk on the phone in privacy. At first, the drivers sometimes used their sirens to get me around traffic, even on my way home at night, but I ended that New York Fed tradition, too.
Before long, the Fed started to feel less strange and I felt less like an interloper. I resumed my old habits of walking around the office in my socks, popping into colleagues’ offices to talk instead of summoning them to my executive suite. I was gradually discovering more young talent, while trying not to alienate the old guard. I found close advisers such as Meg McConnell, a wonderfully smart and impertinent economist in our research department, and Mike Silva, the excellent attorney and manager who became my chief of staff. I also got to hire a new head of our markets group, Bill Dudley, an economist and Goldman Sachs managing director who would later succeed me as president. I liked my colleagues. They were talented, dedicated, and good company. I even played some basketball in the bank’s rec league, which was a lot of fun, though a bit awkward for my staff. I came home after my first game and told Carole, with some pride, that I had shot three for four. She scoffed: They’re not going to play defense against their boss.
As I had warned the board, Carole and I did the minimal amount of Manhattan socializing I thought necessary to do my job properly, including a few awkward birthday celebrations for our modern-day tycoons at various museums in Manhattan. I ate at home most nights, watched the previous evening’s Daily Show, and went to bed by 10 p.m. All in all, it was a comfortable way to live, apart from the dread and burden of responsibility for a financial system that was defying gravity.
IN EARLY 2007, I had a meeting in Beijing with one of China’s top financial regulators. I was generally treated with a fair amount of respect and deference in China, in part because of my father’s connections to its government elite. But I had not met this official, and he was unusually arrogant and derisive of America.
“Nin de xitong hen luan,” he remarked.
“Your system is somewhat complex,” his translator repeated.
My Mandarin was rusty, but I knew luan did not mean “somewhat complex.”
“No,” I told the translator. “He said, ‘Your system is wild, chaotic.’ ”
He had a point. Our system was kind of chaotic. We had a dizzying array of regulators, and a political climate in which some of them could pose for official photos with regulation-slashing chain saws. We also had all sorts of regulatory gaps, with nobody responsible for the entire system. And Wall Street, as President Bush later said, had gotten drunk. Financial firms were chasing higher returns through increasingly leveraged and risky trades even though they knew they were racing to the bottom; as Citigroup CEO Charles Prince memorably explained, “as long as the music is playing, you’ve got to get up and dance.”
When a top Morgan Stanley executive named Vikram Pandit left the firm in 2005, we had lunch and he passed along the not-so-novel wisdom that the shift from private partnerships to public companies had poisoned the culture of Wall Street, encouraging executives to focus on quarterly profits and the exorbitant stock options that came with them. He thought our financial system had gotten too risky, and it was hard to disagree. Hank Paulson, the head of Goldman Sachs, also shared his concerns with me before he became President Bush’s Treasury secretary, especially his view that excessive leverage was building up in the financial system.
That was the crux of the chaos. The entire system—really, the entire nation—was in the midst of a borrowing frenzy. In 2005, Lee Sachs and Stan Druckenmiller both began bringing me charts tracking the growth of credit in the U.S. economy. The rise was so sharp that Lee and I began calling them the Mount Fuji charts. I remember in August 2006, when I snuck out of the Fed’s annual economic summit in Jackson Hole, Wyoming, to go fly-fishing, my guide was a mortgage broker; his horror stories of sketchy loans to homeowners with sketchy credit were a stark real-world supplement to the academic debates at the central banking summit.
Borrowing frenzies are prerequisites for financial crises, and too many Americans were using credit to finance lifestyles their salaries couldn’t support. From 2001 to 2007, the average mortgage debt per household increased 63 percent, while wages remained flat in real terms. The financial system provided this credit with enthusiasm, even to individuals with low or undisclosed incomes, then packaged the loans into securities that were also bought on credit. The financial sector now held $36 trillion worth of debt, a twelvefold increase over three decades. The federal government was also in the red; the unfunded Bush tax cuts, Medicare expansion, and wars in Iraq and Afghanistan had turned the large Clinton budget surpluses into larger budget deficits. And our trade deficit was at a record high, as we borrowed foreign capital to finance our consumption of imports.
“Mount Fuji”
Ratio of Household Debt to GDP
Lee Sachs and Stan Druckenmiller both periodically brought me versions of this chart while I was at the New York Fed, to warn me about the rapid growth of borrowing in the U.S. economy. Lee and I called it the “Mount Fuji” chart, and its steep slope tracked the credit boom.
Source: Federal Reserve Board (represents household and nonprofit credit market instruments).
“These imbalances—fiscal and external—cannot be sustained indefinitely,” I said in a speech to the Economic Club of Washington.
A credit boom can’t happen without plenty of money sloshing around the economy, and monetary policy was historically accommodative when I joined the Fed. As vice chairman of the Federal Open Market Committee, I worked closely on interest rates and other monetary issues with the Fed chairman—Greenspan until January 2006, then Ben Bernanke, a former economics professor from Princeton. We would discuss strategy and review draft decisions and statements before every FOMC meeting, along with the wise Fed vice chairman Don Kohn, and we would meet in the chairman’s office during breaks to discuss last
-minute adjustments. I supported every monetary policy decision during my time at the Fed, so let me explain what we were thinking.
The Fed has a dual mandate to keep unemployment low and inflation stable, which it executes by adjusting the “federal funds rate,” the short-term interest rate that banks use to lend to one another. In general, lowering rates (or loosening policy) is how the Fed steps on the gas when it believes the economy needs help, expanding the money supply to try to lower unemployment. Raising rates (or tightening policy) is how the Fed steps on the brakes when the economy seems overheated, contracting the money supply to try to keep inflation in check. The heads of the twelve reserve banks all sit at the table during FOMC meetings, but they have only five votes that rotate among them; New York is the only reserve bank with a permanent vote. The seven presidential appointees on the Fed’s board of governors also have votes. In practice, decisions are made by consensus, with the chairman the dominant voice, and committee members dissenting only if they feel strongly.
When I started at the Fed, the federal funds rate was just 1 percent, the lowest it had been since the fifties. Greenspan had responded to the LTCM crisis, the dot-com bust, and September 11 with aggressive blasts of liquidity, prompting criticism that his predictable interventions to refuel markets whenever they sputtered were creating a bad moral hazard precedent. The argument was that the “Greenspan Put”—a put is a contract that pays off when an asset’s value declines, providing insurance against bad outcomes—encouraged investors to take too many risks, because they figured the Fed would create a soft landing for them if they encountered turbulence. With the Fed’s rates so low, and spreads—the difference between interest rates on riskier securities and super-safe Treasuries—so narrow, investors were certainly “reaching for yield,” taking on more risk and leverage in search of better returns.
The Fed stayed the monetary course during my first six months on the job. But in June 2004, we felt the economy was strong enough to start tightening policy, so we started raising rates a quarter point at every Fed meeting. Greenspan once called me to say he was nervous we were being too predictable in our tightening, encouraging too much confidence about the path of policy. I shared his concern that telegraphing the pace of our tightening in advance might be making the markets too comfortable with high levels of leverage and risk, but we didn’t have a better alternative. We didn’t think it made sense to create more uncertainty about the path of monetary policy just to keep investors guessing and induce more volatility.
That concern grew when our gradual increases in the short-term federal funds rate failed to boost long-term interest rates, a situation Greenspan dubbed “the conundrum.” Bernanke, then a member of the Fed board of governors, called this the consequence of a “global savings glut,” explaining that a flood of money from newly opened markets with lots of savings, such as China, was holding down borrowing costs, offsetting our efforts to shrink our own money supply. That seemed right to me. The Fed wasn’t fueling the credit boom with loose policy anymore—we raised rates to 5.25 percent by 2006, well above the underlying inflation rate—but there was still an awful lot of money sloshing around. In many other countries, interest rates were below zero when adjusted for inflation, so the United States, and particularly its high-flying housing market, seemed like a relatively attractive place to invest extra cash.
We spent a lot of time back then trying to figure out how far the credit and housing booms were going to go and how they might end. A lot of internal Fed work and academic studies suggested that the run-up in home prices was justified by economic fundamentals, and that in any case sharp nationwide price drops had little historical precedent. In December 2004, the New York Fed’s research division produced a paper titled “Are Home Prices the Next Bubble?” that concluded they weren’t. It conceded the possibility of corrections along the coasts, but noted “regional price declines in the past have not had devastating effects on the broader economy.” Six months later, in a presentation to the FOMC, Fed economists projected that even if there were a 20 percent nationwide decline in housing prices, it would cause only about half the economic damage of the bursting of the dot-com bubble.
Everyone could see there was “froth” in some housing markets, as Greenspan put it. We all knew lax lending standards were helping families buy more expensive homes with less money down. Other families were staying put, then using their existing homes as ATMs by borrowing against their soaring home values. I had seen in Japan and Thailand how lavishly financed real estate booms can end in tears. But I took too much comfort in analyses downplaying the risk of large nationwide declines, which hadn’t happened in the United States since the Depression. We didn’t even think the direct financial effects of a large decline would be that scary.
“We believe that, absent some large, negative shock to perceptions … the effects of the expected cooling in housing prices are going to be modest,” I said during a rate-setting meeting in 2006.
With a hint of mischief, Bernanke then asked me for a report on crazy Manhattan co-op prices, and the committee laughed.
“I guess some people say that you can see a little of the froth dissipating,” I replied. “But I don’t think the adjustment is acute.” At the time, it wasn’t.
The conventional wisdom in central banks was that the blunt instrument of monetary policy was an inappropriate tool for trying to deflate credit bubbles or asset price bubbles. I shared that view and still do. In January 2006, I said in a speech that it would be irresponsible and ineffective to try to use monetary policy to pop bubbles. By that time, the Fed had been tightening steadily for a year and a half. But the idea of slowing down the entire economy faster than we otherwise thought necessary just to try to push down home prices or stock prices seemed like amputating an arm to fix a wrist injury. I didn’t think we could be sure when prices were truly unsustainable, or even that tighter monetary policy would dent real estate prices.
Central bankers did not have a good record of identifying bubbles in advance, and neither did bank supervisors. In my early years at the Fed, I looked back at past episodes when U.S. bank examiners had issued cautionary guidance to try to tame excesses in credit growth and lending practices. The record was not encouraging. Typically, the guidance was issued at the peak of the boom or later. In 2006, the Fed conducted a review of commercial real estate lending across the banking system, which showed we were once again late to the party. Community banks had already built up huge concentrations of loans to developers, several times larger than their capital buffers. The bank supervisors issued some sensible guidance, and the bank examiners worked to limit additional lending. But the damage was already done.
AROUND THE time I was getting my stern luan lecture in Beijing, the subprime mortgage market, one of the wildest sections of our system, began to lurch downward.
New York was not the epicenter of subprime lending—that honor belonged to California, Florida, and other so-called sand states—but it was the epicenter of the business of packaging subprime loans into securities for sale to investors. In a March 2007 speech in Charlotte, I gave several reasons why everyone involved with subprime mortgages, as well as securities backed by subprime mortgages, ought to be concerned about “what we might call the adverse tail, or the negative extreme.”
I noted that subprime lenders, who by definition targeted borrowers with less than stellar credit, were often rewarded according to the volume rather than the quality of the mortgages they generated. They had little financial exposure to the consequences of a default, which had ominous implications for lending and underwriting standards. I also warned that the firms that ended up with subprime exposure would find it even harder than usual to assess their risks, because of the complexity and the newness of the financial instruments into which the mortgages were sliced and diced. And I explained that the drift of risk from simple loans in traditional banks to structured products in leveraged nonbanks increased the danger of a “ ‘positive feedback’ dyn
amic,” a vicious cycle that could amplify a crisis. If asset prices fell, firms and investors would need money to meet margin calls, prompting fire sales that would drive asset prices even lower, and so on.
But March 2007 was pretty late in the game to be warning about subprime. And my view was that the only effective way to reduce the risks ahead was for supervisors to make sure significant financial firms had enough capital and liquidity to survive a crisis. “The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system,” I said. My conclusions about the tremors in subprime, while valid at the time, were too reassuring: “As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole.”
Those signs would be everywhere in a few months. But the Fed staff’s analytic work didn’t flag subprime as a major systemic risk, which is why Ben suggested later in March that its impact “seems likely to be contained,” a quote his critics have recycled ever since. Hank Paulson, the former Goldman Sachs head who became President Bush’s Treasury secretary, made similarly optimistic statements even later that spring. Subprime was only about one-seventh of the mortgage market, barely $1 trillion out of the nation’s $55 trillion in financial assets, and it didn’t appear to be infecting the rest of the credit boom. “In fact, delinquencies and loan losses on consumer lending continue to run at quite low rates,” my staff reported that March. “Signs of strain in the subprime area have continued to increase, but appear to remain contained to this sector.” On April 18, 2007, my Financial Risk Committee presented an analysis concluding that if the entire subprime industry suffered losses of 14 percent, only two major banks, Wells Fargo and HSBC, would lose more than 10 percent of their high-quality capital.
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