Friday, January 20, 2012

Where the Fed Went Wrong or How They Missed The Housing Bust

I realize that the subject of this posting was covered in the mainstream media, but I wanted to do my own take on things since, as my readers may have gathered, unlike Mr. Bernanke, it is my impression that members of the Federal Reserve Board of Governors are mere mortals.  Just like the rest of us, they put their pants/pantihose on one leg at a time and just like all of us, they make mistakes.  Unfortunately, when you and I make mistakes, the collateral damage is generally very limited.  When the Fed makes a mistake, the world's economy pays and millions (perhaps billions) suffer.  This was very clearly illustrated with the recent release of the Federal Open Market Committee's (FOMC) minutes from their meeting on January 31st, 2006.  As I will note later, I picked this meeting for a particular reason.

In January 2006, the American economy was running on all cylinders.  Unemployment was low and house prices seemed to be on a never-ending climb upwards although the most recent GDP numbers showed that the economy was slowing.  Consumer spending was strong and rising and real GDP was expected to grow at 3.9 percent in 2006.  On the downside, the price of oil had climbed about $20 per barrel over 2005 and was trading above $65 per barrel, a new nominal high.  That said, there were warning signs in the economy.  I can recall many analysts stating that the status quo was not going to last much longer, most particularly the gentlemen at Financial Sense.  I can recall reading many, many of their postings outlining how the real estate market in certain parts of southern California was not sustainable.  They were warning that Americans were using their homes as ATMs, increasing their household debt load by borrowing against the seemingly never-ending rising value in their residences or the additional real estate that they had purchased.

Let’s open by looking at where the housing market stood at the beginning of 2006 compared to where it is today:

With that in mind, let's take a look at what the FOMC was up to on January 31st, 2006.  Here is a two page screen capture showing who was in attendance:

You will notice that Ben Bernanke was Vice Chairman at the time and Allan Greenspan was the Chairman, his last meeting in that position prior to his retirement.  In fact, Mr. Bernanke’s tenure as Chairman of the Fed began the very next day.  That is the main reason why I picked this meeting; with the both the past and future Chairmen of the Fed in the same room, one would think that one of them would have shown some concern about the overheated housing market.  But, as you'll see, apparently the obvious was not all that obvious.

Here is a screen capture showing the first page of the transcript:

You'll notice that the FOMC is composed of quite a number of jokers.  I counted 6 separate occasions where [laughter] was recorded in the first minute of the meeting.  For a meeting of the minds that are really in control of the American economy, there certainly appears to be a lot of laughter!  Perhaps they really do know something that we don't.

One of the first items the participants at the meeting discussed was the yields on two and ten year Treasury notes.  Yields had been rising on two year notes and yields along the curve were starting to converge and flatten.  The flattening or inversion of the yield curve, where interest rates for short-term investments are either the same (flat) or higher than (inverted) yields on long-term investments, is often used as a predictor of recession.  Here's what Mr. Dino Kos, Manager of the System Open Market Account had to say about the yield curve during the meeting:

"If the shape of the U.S. yield curve is bearish for the economy, there is no shortage of indicators pointing the other way....In this cycle, these other indicators are not flashing warning lights just yet." (page 8)

Here is a tiny sample of what Mr. Greenspan, at his most prescient, had to say in response:

"We have enough trouble forecasting nine months.  [laughter]". (page 11)

I guess that pretty much says it all, doesn't it?  Those present at the meeting decided that the yield curve was most likely flattening because pension fund managers required longer dated bonds to better match assets and liabilities.  This pushed longer dated bond prices up and yields down.

Let's move to what the FOMC said about the American housing market.  Here's a quote from Dave Stockton, a Fed economist:

"The principal source of slowing in aggregate activity in our forecast continues to be the housing sector, the subject of exhibit 3. The accumulating data have made us more confident, though far from certain, that we are reaching an inflection point in the housing boom. The bigger question now is whether we will experience the gradual cooling that we are projecting or a more pronounced downturn. I’ll be interested to hear your reports this morning. As for the recent data, sales of existing homes (the red line in the top left panel) have dropped sharply in recent months and by more than we had expected. New home sales (the black line) have also moved off their peaks of last summer but are more consistent with our expectation of a gradual softening. That expectation receives some further support from the more-timely mortgage bankers’ purchase index—plotted to the right. Purchase applications also are off their highs but are not indicating any sharp retrenchment through January.

With respect to house prices, the recent data and anecdotes also have pointed to some weakening. As a result, our forecast of a sharp deceleration in home prices— shown in the middle left panel—seems less of a stretch than it did a while back. As shown to the right, the bottom line is that, after contributing importantly to the growth of real GDP over the past four years, residential investment is expected to decelerate sharply this year and to turn down a bit in 2007. As we have noted before, our house- price forecast also has implications for consumer spending. Slower growth of house prices is the chief factor causing the wealth-to-income ratio (the black line in the bottom left panel) to drift down over the projection period." (page 18)

Here is a part of the response to Mr. Stockton's comments by President Santomero of the Federal Reserve Bank of Philadelphia:

"I wanted to go to the housing issue. In the projection in the Greenbook, as I understand it, you’ve got housing prices going up at about a 51⁄2 percent rate as compared with last year’s number, which I think is 12 percent. We’ve been looking at the sensitivity of what happens to our GDP growth rate in ’06 and ’07 to the extent that housing prices stay flat. Our numbers suggest that a flat housing price associated with the decline in residential investment would shave about 1⁄2 percentage point off GDP in ’06 and about 0.6 or 0.7 if you add the consumption effects." (page 27)

In response, Mr. Stockton stated that flattened housing prices would only shave off one-quarter to one-half percentage point off of GDP.  Oops!

Here's a quote from Governor Ferguson:

"I don’t doubt that the housing market is slowing somewhat, but I do wonder about the impact of a slowing of house prices and wealth extraction on household saving and consumption. Here I pick up where Dave left off, which is that the models take a historical norm. Let’s say we’re at about the 3 percent that Dave indicated. I think there’s possibly a greater risk, for reasons that Dave has already indicated, that we may find a much stronger impact on the global economy, certainly on the U.S. economy, based on a slowing of housing prices. And here, though I recognize their economies are different, I am still somewhat troubled by the experience in the United Kingdom, Australia, and the Netherlands, all of which had an unexpectedly large impact, from a GDP standpoint, from a relatively slow flattening of house prices. I recognize that these other economies are different from ours, but I’d also say that we’ve seen even in our own economy some nonlinearities that have emerged—for example, as asset prices moved down relatively rapidly—that might have surprised us in the past." (pages 60 and 61)

Lastly, here's a quote from Governor Bies:

"The one area—and I want to second Dave Stockton’s remark—of main concern is the housing market. Let me talk about it a little differently from some previous comments today. When we look at the aggregate levels of debt that households have and relative prices, one of the things as an old lender I worry about is the ability to service the debt and the discretionary spending that households have. While 80 percent of mortgages are fixed rate, 20 percent are variable. Starting in 2002, we saw a jump in ARMs, taking advantage of the very steep yield curve at the time. We now are in a period when not only the fancy option ARMs, the exotic products of the past eighteen months, but also the 3/1 ARMs and the five-year ARMS that became very popular in 2002 and 2003 are repricing.

If interest rates just hold where they are right now, we estimate that the monthly debt service cost is going to go up by at least 50 percent on that 20 percent of mortgage portfolios. If you look at the Greenbook, you’ll notice that the financial obligation ratio rose quite substantially in the past six months. It is now back to the peaks of 2001 and 2002, and we have a lot of mortgages still to reprice. We also know that some of these exotic mortgages don’t amortize, but they will kick in and start amortization and that will also pull cash out of discretionary spending."  (pages 65 and 66)

At least some of those sitting around the table were concerned about potential flattening of the housing market.  What they so obviously were not concerned about was the potential for a one-third decline in the average value of an American home, something that had not been seen since the Great Depression, even though the subject of housing booms and busts was the subject of Mr. Greenspan's Doctoral thesis and the Great Depression was the subject of a book of essays written by Ben Bernanke.   Neither the current nor the future Chairman of the Federal Reserve made one single comment about the housing market stresses that were becoming quite obvious in at least some of the Districts.

In closing, let's take a look at two additional exchanges (Reader warning – If you find sucking up to the boss objectionable and distasteful on moral grounds, the following exchanges may test your gag reflex):

"MR. POOLE:  ...Mr. Chairman, many around the table have commented about their experience serving here. I will, of course, echo those. I would like to put a little different angle on it. Of the people who have had a major impact in my life, you are certainly one. I mark on the fingers of one hand the people who have had extraordinary influence on me. You have influenced me mostly in my professional life but also in many aspects of leadership that go beyond economics and policy in a narrower sense. So I thank you for that. I am also looking forward to continuing to learn from you. I understand that you have some books, at least in your head. And given my interest in making sure we have clear communication, I have a suggestion for a title for your first book. And it is in line with some books by your predecessors. So I suggest “The Joy of Central Banking.” [Laughter] And I suggest that your second book be “More Joy of Central Banking.” [Laughter]

CHAIRMAN GREENSPAN. “How to Be a Joyous Central Banker, Even Though We Don’t Have Hearts.” [Laughter] Can we end the speculation on the title? [Laughter] Thanks very much, Bill. President Stern."

...and one last suck up for the record:

"VICE CHAIRMAN GEITHNER. Mr. Chairman, in the interest of crispness, I’ve removed a substantial tribute from my remarks. [Laughter]

CHAIRMAN GREENSPAN. I am most appreciative. [Laughter]

VICE CHAIRMAN GEITHNER. I’d like the record to show that I think you’re pretty terrific, too. [Laughter] And thinking in terms of probabilities, I think the risk that we decide in the future that you’re even better than we think is higher than the alternative. [Laughter]"

...and that's enough of that.

It is interesting to read through the minutes of this meeting.  Those in attendance seemed most concerned about keeping inflationary pressures under control and whether or not they should raise the federal funds rate by one-quarter of one percent.  In reading through the reports from the Governors of most of the Federal Reserve Banks, it is quite apparent that they were caught in a case of clusterthink (aka a cranial circle-jerk).  There were very few dissenting viewpoints on the economy as a whole and the housing market in specific, save that of Governors Bies and Ferguson as I noted above.  They seems to be the only members present that were concerned about the impact that a moderation in the housing market could have on the American economy and even then, they understated the danger.

As I posted here, the IMF also missed all of the economic signs that pointed to the impending Great Contraction of 2008 - 2009.  At least now we know that the IMF was in good company.


  1. @PJ, Do you have a recommendation for a article length discussion of what caused the mortgage crisis and how that triggered the wider economic crisis? It's so hard to sort out the spin. (I feel a bit foolish, like I'm writing to Dear Abby for wonks. But please, Abby, help me.)

  2. MP

    Have you read Michael Lewis's "The Big Short"? It's an excellent but somewhat technical look at the origins of where things went wrong.

    IMO, the whole thing started when Mr. Greenspan used a prolonged period of low interest rates. That, along with banks creative mortgage financing (teasers) and Wall Street's creation of exotic products that were linked to mortgages and their underestimation of default rates, started the ball rolling.

    See if you can find a copy of Lewis's book. It really is an eye-opener.

  3. I don't accept the idea that these folks did not know that a crash had to occur based upon the easy money loans they permitted. They are economists. They knew that houses had appreciated far above the sustainable. That was a public record. They were not going to admit they were in on the housing bubble.

    I suggest that Greenspan, knowing the central bankers don't have a heart, admitted as much as he dared admit.

  4. I remember a discussion (more like an argument) with a colleague of mine in 2003, that the latest reduction in interest rate was a mistake. Greenspan had at that time cited the low consumer inflation to justify the rate reduction. My position was that it was a mistake since we cannot just look at the price of consumer goods to calculate inflation. As somebody who needs a house to live in, the increase in the home prices and the resulting mortgage ought to figure in the inflation rate calculation. By that token, inflation was not coming down but actually accelerating. Being a very famous economist, Mr. Greenspan should have figured it out - more so, when a nobody saw that. But I suspect that they do live in ivory towers and not on Main street as the rest of us folks.