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In Fed We Trusted

Question: Did Bernanke’s mantra of “whatever it takes” lead us astray?

David Wessel: I think that a “whatever it takes” approach got us through this crisis but has a number of enormous risks.  One of them is that it can justify almost anything.  If you don’t have a set of principles that you can explain for what you are doing, then how can anybody know what you’re going to do next? In fact, one of the problems in this crisis was that the rules kept changing.  If you were a preferred shareholder at Fannie Mae and Freddie Mac, you got wiped out.  But if you were a preferred shareholder at Bear Stearns, you didn’t.  If you were a bond holder at Washington Mutual, you got largely wiped out, but if you were a bondholder of AIG you didn’t get wiped out.  If you were a bondholder of Lehman Brothers though, you got devastated.  And so this kind of shifting the rules of the game makes life kind of difficult. 

I think that, in my view, one of the things that Bernanke and Hank Paulson, and Tim Giethner did that, in retrospect was a mistake, was wasting the time after Bear Stearns, which occurred in March, 2008, and not coming up with a more articulated game plan for what they would do if they had to cope with a collapse with another financial institution.  Of course one of the biggest criticisms of Mr. Bernanke is that he didn’t do whatever it takes and he let Lehman Brothers fail.  He says he didn’t have any other choice under law.  We at the Wall Street Journal surveyed four dozen economists on Wall Street and by 3 to 1; they said they didn’t believe him.  That had there been a will to save Lehman Brothers, there would have been a way. 

I do think that the AIG bailout is one that is getting a lot of scrutiny for exactly the right reasons.  And the question really is, was it necessary to pay the counterparties of AIG, Goldman Sachs, Deutsche Bank, UBS, the big names of global finance, 100 cents on the dollar in order to protect the financial system?  Admittedly, the Fed and the Treasurer were making decisions under a lot of pressure.  That was a very busy week in September, 2008.  But with the benefit of hindsight, it looks like they did themselves a lot of damage, politically, and it hurt their credibility when it looked like only the big guys, Goldman Sachs and Deutsche Bank and so forth got 100 cents on the Dollar and everybody else has to take a haircut.  So, one can understand why they did it, and it’s clear that they did not have enough tools to deal with a collapse of an institution other than a bank.  That’s why Bernanke, and Geithner, Paulson, George Bush, and Barack Obama, have all asked Congress to change the rules so that when something like Lehman Brothers, or Bear Stearns, or AIG gets into trouble in the future, the Federal Government will be able to treat them the way it treats a bank.  Say, “Okay, you screwed up, you’re mine now, we’ll decide who gets paid and who doesn’t, and we have a system for doing that.”  There is no system.  There was no system then, there is no system today, a year later, for dealing with an AIG or a Lehman Brothers.  So, the tools that the authorities had were unfortunately limited.  They weren’t up to the task. 

Question: DEAN BAKER, BEAT THE PRESS: How did the Fed fail to see a trillion dollar housing bubble?

David Wessel: I think that when you go back and look at what was going on inside the Fed, there were people who warned that this was a housing bubble.  But, they were not convincing and the reigning view at the Fed was, even if it is a bubble, we shouldn’t interfere with it.  We should let the markets do their thing and if it bursts, it will be as Bernanke and Paulson said in late 2007 even, it’ll be contained.  And they were comforted by the fact that when the tech stock bubble had burst earlier in the 2000’s, it had done a lot of damage to people who had bought a lot of internet stocks, but it hadn’t really done a lot of damage, lasting damage, to the economy.  And so they looked at it as they looked at that.  So, it was not only a failure of analysis, it was failure of ideology in the best sense, a world view that led them to believe that even if there was a housing bubble, they shouldn’t do anything. 

Now, Greenspan went around saying, “You can’t have a national housing bubble.  Real estate is local, housing prices are local, you can have froth,” he said, “in some markets.”  And it’s very late in the rise in house prices where he kind of throws in the towel and says, “I think we have a big problem.”  So, he was just wrong, and because he had been right so often, people kind of believed him. 

Question: DEAN BAKER, BEAT THE PRESS: Does this raise questions about the Fed’s competency?

David Wessel: Sure.  But who was more competent?  The rest of the bank regulators were just as bad.  I think as a result of this, we have every right to expect the Fed to be much more thoughtful about asset markets and to be more open and to think about how it can use it’s weaponry to let a little air out of any bubble before it bursts.  I think they are not yet convinced they can or should do that, but I think that’s the right debate to have. 

I think some of it had to do with the fact that the financial system had evolved and a lot of the mortgages were being made in institutions that were not under the Fed’s jurisdiction.  And the Fed, like a lot of bank agencies said, “We’re responsible for this set of people and someone else is responsible for other people and it’s their problem.”  But some of these mortgages were made by affiliates of banks, and the Fed could have pushed harder into those affiliates to see what they were doing, but Greenspan didn’t think it was a good idea. 

Greenspan says that he was caught by surprise by the surge in sub-prime lending in 2006 and 2007, that when he first saw reports in trade publications that there had been this big increase in sub-prime lending that he didn’t believe the number because he didn’t believe that the situation could change so rapidly and that was something where he just made a bad judgment.  When the official numbers came in, it turned out that these earlier reports from mortgage trade publications were right.  But in 2005 and early 2006, there wasn’t yet as big a sub-prime problem.  It’s really 2006 and 2007 when sub-prime mortgages take off and where everybody begins to say, “Whoa.  There’s a problem here.”  And then, of course, people didn’t think that housing prices could fall as much as they did, so they assumed that a lot of these mortgages would be okay because the people could refinance, or the bank could take the house and it would be worth what people had borrowed against, and that turned out just to be wrong. 

To put it another way, some of these mortgages were bad in any circumstance.  Some of them were only bad because house prices fell so much and people misunderstood how far house prices could fall.

Question: Do you see any real impetus for financial regulatory reform? 

David Wessel: Well, I think it’s kind of obvious that the financial regulatory system is broken and there is a push by the President and the Treasury Secretary, and the Fed Chairman, and Barney Frank, the Chairman of the House Financial Services Committee, to change the rules.  But they’re running into a lot of resistance and I think they are running into resistance for a number of reasons.  One is, that this is kind of hard, and Congress doesn’t like to do hard things and some people want to do a lot and some people want to do nothing, and as a result the status quo sometime prevails.  The memory of the crisis is fading enormously quickly and that means that the urgency of doing a financial regulatory reform is fading as well. 

But the other problem is that the financial reform has not good constituency.  There are a lot of individual constituencies, a lot of businesses and each one of them is attacking one piece of the bill or another, and as a result, that’s slowing it down.  The President’s strategy clearly had been to put a new consumer regulatory agency on the bill as a kind of locomotive, to pull it through Congress.  But that hasn’t worked very well.  So, we’re talking here in November, 2009, looks to me like the House of Representatives will manage to get a bill out before the end of the year, but it will be next year before we learn whether the Senate can do the same and then they’ll have to be compromised and by then the memory of the crisis will have faded so much, or the bitterness over high unemployment may be so severe that it’s difficult to get a coherent bill out of Congress. 

You know, I should say that the reason we have a Federal Reserve was because we had a financial panic in 1907, and that panic ended because of the intervention of one man, J. P. Morgan.  Everybody agreed after that, that we needed to have a better system.  But the Federal Reserve Act didn’t pass until 1913.  There were six years of arguments between debtors and creditors, farmers, and bankers, and populace.  It wasn’t until Woodrow Wilson became President and kind of showed some leadership and Louis Brandeis helped him form a compromise that got this clunky bill through Congress.  So, that was six years, it could take six years this time too. 

Jamie Dimon did not do exactly what J. P. Morgan did, the man whose name is on the bank that Jamie Dimon runs.  But in the crisis, in March, 2008, someone had to step up and take over Bear Stearns, get some money from the Feds, $30 Billion to help do it, but Jamie Dimon was that man.  And J. P. Morgan in that episode saved the day.  And they also ended up buying Washington Mutual and they play, now an important role because some banks are bust and other banks are weak and J. P. Morgan and Goldman Sachs are among the strong.  So, it is very much history repeating itself.  It’s kind of ironic, the rules are different, the circumstances are different, but the J. P. Morgan empire is once again at the center of the whole system.

Recorded on November 20, 2009

The economics editor of the "Wall Street Journal" on Bernanke’s performance, AIG’s bailout, and the ironic position of J.P. Morgan in the crisis. This series was made possible by the Charles G. Koch Charitable Foundation.

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