The Fed and the Credit Crisis 9781685854249

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The Fed and the Credit Crisis

The Fed and the Credit Crisis J. Kevin Corder

b o u l d e r l o n d o n

Published in the United States of America in 2012 by Lynne Rienner Publishers, Inc. 1800 30th Street, Boulder, Colorado 80301 www.rienner.com and in the United Kingdom by Lynne Rienner Publishers, Inc. 3 Henrietta Street, Covent Garden, London WC2E 8LU © 2012 by Lynne Rienner Publishers, Inc. All rights reserved

Library of Congress Cataloging-in-Publication Data Corder, J. Kevin, 1964– The Fed and the credit crisis/J. Kevin Corder. Includes bibliographical references and index. ISBN 978-1-58826-820-4 (hc : alk. paper) 1. Board of Governors of the Federal Reserve System (U.S.) 2. Monetary policy— United States. 3. Global Financial Crisis, 2008–2009. I. Title. HG2563.C663 2012 330.973—dc23 2012000229 British Cataloguing in Publication Data A Cataloguing in Publication record for this book is available from the British Library.

Printed and bound in the United States of America The paper used in this publication meets the requirements of the American National Standard for Permanence of Paper for Printed Library Materials Z39.48-1992. 5 4 3 2 1

Contents

vii ix

List of Tables and Figures Preface 1

How Will the Credit Crisis Transform the Fed?

1

Crisis, Critical Junctures, and Policy Learning 1 Origins of the Credit Crisis 4 The Credit Market Meltdown 7 What Options Did the Fed Have? 9 Elements of Adaptation: Mission, Expertise, and Networks 12 What Happens to the Fed Now? 19 2

Subprime Lending and the Mission of Consumer Protection

25

The Subprime Mortgage Market and Federal Housing Goals 27 The Fed and the Mortgage Market 30 The Fed and Consumer Protection 32 Regulation of Mortgage Lending After 2006 35 Why Didn’t the Fed Do More? 36 Consumer Protection After the Crisis 37 3

The Fed, Wall Street, and Housing Finance

Housing Finance, Fannie Mae, and Freddie Mac 44 Wall Street Joins the Party 46 Why Would the Fed Encourage Private MBS? 49 Problems in the Private MBS Market 52 The Housing Finance Mission of the Contemporary Fed 56 The Long-Term Challenge: Reforming Housing Finance 58 Policy Change and Learning at the Fed 60

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vi 4

Contents

Bank Supervision and the Basel Accords

63

Prudential Regulation, Basel, and the Politics of Capital Requirements 67 Regulatory Arbitrage, Credit Default Swaps, and the Growth of the CDO Market 70 Capital Requirements, Synthetic CDO, and “Super Senior” Risk 73 Risk Assessment and Rating Agencies Under Basel II 75 Basel II, Internal Models, and the Move to Self-Regulation 77 Basel and Bank Supervision After the Crisis 82 Risk Management and the Bright Light of Political Scrutiny 84 5

The Fed and the Shadow Banking System

87

Credit Market Derivatives and the Problem of Systemic Risk 89 Large Banks, Small Banks, and Bank Supervision at the Fed 94 The Shadow Banking System and Prudential Regulation 97 The Systemic Risk Mission and the Contemporary Fed 107 6

The $2 Trillion Balance Sheet

113

The Fed’s Balance Sheet After 2007 116 Fed Lending Programs: From AMLF to TSLF 118 Too Big to Fail and the Problem of Moral Hazard 122 Specialized Lending Facilities and Fed Independence 124 The Expanding Balance Sheet and the Pursuit of Price Stability 127 Crisis Termination and Policy Learning 129 7

Learning from the Crisis

131

Interests: The Face of Power—Wall Street and Large Banks 132 Mission: Making Sense of the Fed’s Role in the Economy 134 Expertise: What Went Wrong? 137 Warnings, Minority Views, and Learning from Diverse Perspectives 139 Obstacles to Learning 141 Public Scrutiny and Private Power 142 List of Acronyms and Abbreviations Glossary of Key Financial Terms References Index About the Book

149 153 157 173 181

Tables and Figures

Tables

6.1 6.2

Federal Reserve System Assets, 2007–2011 Maturity Distribution of Treasury Securities Held by the Fed, 2007–2011

116 119

Figures

1.1 2.1 3.1 3.2

Increases in Home Prices and Household Incomes Since 1991 Subprime Mortgage Originations Combined Annual Issues of MBS by Fannie Mae, Freddie Mac, and Ginnie Mae Annual Issues of Private-Label MBS

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4 28 45 47

Preface

This book came about as the result of a phone call from Anne

Khademian in the summer of 2008, as the financial crisis was unfolding but before the collapse of Lehman Brothers and the series of congressional votes on bailouts for the largest US banks. Anne organized a symposium on regulatory reform in Washington, DC, in January 2009, and her invitation to participate motivated me to learn about the Fed’s role in the crisis. I followed the work of and learned from several people who participated in the 2009 conference—Mark Cassell, Susan Hoffmann, and Mark Rom, in particular. I owe a special debt to Susan for her continued interest in the project, for permitting me to rely on her expertise in housing finance and banking, and for thoughtful comments on draft chapters. Stan Wakefield made the initial connection between my prospectus and the editors at Lynne Rienner Publishers, and Leanne Anderson was an advocate for the book. The staff at Lynne Rienner, particularly Jessica Gribble, were persistent and patient as I adapted the book to reflect the shifting politics and choices in financial regulatory reform. Ultimately, this book was inspired by my students and colleagues at Western Michigan University. I presented work on the crisis to a series of classes and seminars; the questions, suggestions, and good ideas from students and faculty shaped the way I approached the book.

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1 How Will the Credit Crisis Transform the Fed?

The United States and the global economy experienced unprece-

dented disruption in capital markets and real economic activity in 2008. A number of banks and large complex institutions failed, notably the investment banking firm Lehman Brothers and insurance giant AIG. Policymakers and regulators were surprised by the pace and breadth of the financial market crisis that led to these outcomes. The response was also a staggering shock: the US Congress authorized the extension of nearly $1 trillion in credit to financial institutions to mitigate the effects of the failures. The crisis originated in the rapid deterioration of the market for asset-backed securities and credit derivatives tied to subprime home loans. The Federal Reserve System (the Fed) was compelled to take a number of steps to contain the crisis as the subprime market disruption spread to other asset-backed securities and across the financial system—from hedge funds to commercial and investment banks. How did the Fed respond to the crisis? What are the implications of these actions for Fed performance in the future?

Crisis, Critical Junctures, and Policy Learning

The general problem of crisis, disruption, and learning by government is the focus of a broad political science literature that grapples with the evolution of political institutions and public policy. At the core of this literature is the idea that public policy changes reflect a form of social learning. Rooted in work by Hugh Heclo, the intuition is that governments, particularly public sector experts, face tremendous uncertainty as

1

2

The Fed and the Credit Crisis

they confront technically complex and challenging policy choices (Heclo 1974). Governments puzzle over how to respond to failures and adapt to new problems. Hall (1993) concludes that this form of learning is often relatively uneventful—involving modest changes in policy instruments or tools, subject to little media attention or political scrutiny. But, rarely, experts are confronted with such a radical failure of existing tools that wholesale changes (a paradigm shift) are required. These changes are disruptive, involve a host of diverse actors, and capture the attention and interest of the media and the broader public. Specific work on recent government responses to disasters offers similar expectations: disasters highlight the urgency of action for a broad set of actors and bring about positive opportunities for policy change (Birkland 1997). Some assessments of this process are pessimistic. Pierson (2004), for instance, argues that “complexity of context” and “limits of human cognition” conspire to make adjustment or learning unlikely, even in the face of policy failures. The literature on crisis response embraces elements of the competing optimistic and pessimistic views on agency learning (Boin et al. 2005). The 2008 credit crisis has the potential to be the type of event that produces sweeping change: public sector experts, elected officials, and the public are confronted with fundamental choices about how the financial sector of the economy will be supported and regulated in the future. At the center of this debate—in areas ranging from consumer protection, to innovations in structured finance, to regulation of hedge funds, to bailouts and loans for large firms—is the Federal Reserve System. The Fed’s response to the crisis—and the ways that the Fed is shaped by lawmakers’ response to the crisis—will determine whether the existing framework for regulation of financial markets and institutions will be adapted in new ways or subjected to wholesale revision. Some of the implications of the credit crisis for Fed operating practice are already clear. Beginning in the fall of 2008 the Fed created a dozen new lending programs to extend credit to a wide range of potential borrowers. At the same time, a variety of Washington, DC, actors anticipated sweeping reform of the regulatory and supervisory responsibilities of the Fed and other bank regulators. Specifically, the Fed is likely to acquire new authority that will include some level of supervision of the business of investment banking and perhaps the activities of large hedge funds. At the same time that a new and broader role is envisioned for the Fed, there has been a shift away from the extraordinary deference that Fed decisionmakers enjoyed prior to the crisis—particularly during the tenure of Chairman Alan Greenspan. Elected officials, Wall Street elites, the public, and the

How Will the Credit Crisis Transform the Fed?

3

press questioned the capacity of Fed leaders to manage financial markets and the real economy. Members of Congress supported a sweeping audit of Fed organization and governance structures at the same time that the Fed was given new powers. Several 2012 Republican presidential hopefuls were highly critical of Fed leadership for actions before and after the crisis. This broad and intense scrutiny of policy choices is a hallmark of disruptive policy change; existing instruments and arrangements proved grossly insufficient to contain and mitigate financial market problems. The Fed has clearly been challenged by the crisis—experimenting with new tools for providing capital to credit markets, letting some institutions fail while supporting others, and reluctantly reinvigorating consumer protection measures. Leaders at the Fed have confronted this challenge directly—working closely with the Treasury Department to coordinate policy responses, communicating with members of Congress about the scope and intent of Fed actions, and articulating an “exit strategy” to wind down credit and lending facilities and return to the use of conventional monetary policy instruments as the crisis eases (Bernanke 2009b). But the return to convention and normalcy may itself be problematic. Lawmakers and other actors will scrutinize the effects and implications of the new lending facilities and extraordinary expansion of the Fed’s powers. New functions related to financial stability and consumer protection innovations imply long-term changes in the mission of the Fed and the network of actors with a stake in Fed choices. The experience of other agencies during periods of stress and crisis suggests, not surprisingly, that the Fed at the end of the credit crisis may be a much different agency than it was when the crisis emerged. The Fed’s response to the credit crisis was anchored and constrained by decades of operating practice that reinforced two key ideas: first, that the principal threat to US economic stability is inflation and, second, that financial institutions are best subjected to arms’ length and unobtrusive regulation. The credit crisis challenged both of these ideas, and elected officials and the public are evaluating the capacity of the Fed to adapt tools and instruments that predated the crisis to the new problem of financial market instability. After reviewing the origins of the crisis in the housing market and the financial sector, this chapter maps out the broad policy options available to and specific choices made by Fed leadership before and during the crisis. I then outline the distinct challenges faced by the Fed as the crisis ends: new aspects of the Fed’s mission, new actors with a stake in Fed policy choices, and the need for new forms of expertise (human capital, technology, and ideas).

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The Fed and the Credit Crisis

Origins of the Credit Crisis The Housing Bubble and Subprime Lending

The root cause of the credit crisis is a prolonged (and, in hindsight, unsustainable) increase in the real selling price of single-family homes. Throughout the 1990s, home prices and household income increased at roughly the same rate. But, after 2000, appreciation of home values accelerated at a rate substantially higher than household incomes. The cumulative increase in incomes and home prices is summarized in Figure 1.1. By 2007 the median value of a single-family home in the United States had appreciated nearly 120 percent from 1991, while incomes increased by only 60 percent. The size of the disparity between income and home prices varied substantially by region—with the largest price increases on the West Coast (160 percent) and smaller increases in the Rust Belt states (95 percent). While a number of skeptics (notably economist Robert Shiller) predicted that home prices would experience a major downward correction, the amount of the decline and the broad impact of the decline on financial markets was largely unanticipated (see Shiller 2008b). As home prices began to decline in 2008, many potential sellers were faced with the stark reality that the value of their outstanding home mortgage and equity lines exceeded the value of their homes. The result was a cascade of foreclosures that triggered further declines in home values, more foreclosures, and a prolonged downward decline in home prices. Figure 1.1 Increases in Home Prices and Household Incomes Since 1991

Cumulative Percentage Change

140

Monthly US house price index (seasonally adjusted, purchase only index)

120 100 80 60 40 Median Household Income 20 0 1990

1992

1994

1996

1998

2000

2002

2004

2006

Sources: Office of Federal Housing Enterprise Oversight, US Census.

2008

How Will the Credit Crisis Transform the Fed?

5

For some, the culpability of the Fed for the credit crisis begins in the absence of a timely response to the housing bubble before 2006. The Fed could have increased the key interest rate under Fed control—the federal funds rate—to reduce upward pressure on home prices in 2003 or 2004. But, at the time, the federal government was engaged in a sustained campaign to broaden homeownership by extending credit to low-income and minority borrowers. Fed actions to counteract the housing bubble would have placed the Fed squarely at odds with this policy objective. As part of the effort to broaden home ownership, banks and other lenders substantially increased the volume of lending to risky borrowers between 2000 and 2005. The volume of loans to borrowers with weak credit, unreliable income, or poor loan-to-value ratios (a combination of what are known as subprime and alt-A borrowers) increased from about $100 billion in 2000 to over $600 billion in 2005 (Inside Mortgage Finance 2011). Problems related to the subprime mortgage market were visible from a number of sources before the major media outlets began devoting attention to the story in the summer of 2007. Decisionmakers at the Fed, notably Edward Gramlich, warned of predatory lending in the subprime market as early as 2000. The Government Accountability Office (GAO) warned in 2004 that the rapidly expanding supply of capital to finance home loans was exacerbating the decline of mortgage lending standards (see Government Accountability Office 2004). The Fed and other federal regulators chose to ignore these problems. Innovations in Finance and Financial Markets

Innovations in the operation of the financial markets—the marketing and exchange of complex financial instruments—also precipitated the credit crisis. Residential mortgage-backed securities (MBS) are financial instruments that bundle and sell the stream of principal and interest tied to a large number of residential home loans. The purchase of home loans and the creation of MBS are together known as “securitization.” MBS can be engineered (or “tranched”) in ways that permit risk-taking investors to purchase high-yield, high-risk mortgage income streams. The origin of these instruments is fairly benign. Starting in 1968 the federal government permitted firms to pool federally guaranteed mortgages and issue the debt with a guarantee from the Government National Mortgage Association (Ginnie Mae). Successful expansion of this secondary market for mortgages led Congress to later authorize two government-sponsored enterprises (GSEs) to pool privately issued mortgages not backed by a federal guarantee: the Federal National Mortgage Association (Fannie

6

The Fed and the Credit Crisis

Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). Securitization of mortgage debt has a number of desirable features: potential investors are exposed to a small level of risk because the pool of mortgages is large and diverse, capital can be directed across regions of the country so that the costs of borrowing are relatively uniform, and the total volume of capital available to finance home purchases can be increased. The housing GSEs entered the secondary market on a large scale in the 1980s, and the securities issued by the housing GSEs transformed the mortgage market, expanding the pool of private capital available to finance the purchases of homes. Until the early 1990s the housing GSEs issued most if not all MBS. Two developments fundamentally changed the market for MBS. First, MBS issued by private companies (“private-label MBS”) grew at an astounding rate—from under $20 billion in 1989 to over $1.1 trillion in 2005 (Inside Mortgage Finance 2011). Chapter 3 outlines several specific and related policy goals that led decisionmakers in the Fed to embrace this growth in private securitization: federal efforts to increase levels of home ownership, a desire to slow the growth of the housing GSEs, and insulation of the homebuilding sector from monetary policy restraint. All of these factors combined to encourage Fed leadership to promote the growing—and apparently thriving—private-label market. At the same time that private-label MBS began to expand, a second development triggered more investment specifically in subprime MBS. Innovations in structured finance led to a proliferation of new financial instruments. Investment banks created financial products that resecuritized existing MBS—packaging a bundle of private-label MBS into asset-backed security collateralized debt obligations (ABS CDO). The risky tranches of subprime MBS were particularly attractive for this type of resecuritization. Demand for ABS CDO was so strong that commercial and investment banks engineered entirely new types of investments— using a particular type of derivative—that replicated the performance of traditional cash-value ABS CDO. These new synthetic debt instruments were popular investments, but investor and industry experience with the performance of these securities was limited. The real estate finance industry—specifically the Mortgage Bankers Association—recognized in 2006 that the rapidly expanding market for synthetic ABS CDO created new and poorly understood risks for financial markets (Council to Shape Change 2006). The Fed and other bank regulators advocated minimal regulation of credit market derivatives and resisted proposals from other federal actors to restrict the growth and proliferation of these instruments

How Will the Credit Crisis Transform the Fed?

7

(for an early warning, see Government Accountability Office, 1994). The technical details of these securities, the rationale for the Fed’s regulatory approach, and the implications of these choices are explored in Chapters 4 and 5, but the general lesson is that public and private sector actors did not understand the magnitude of the risks introduced by resecuritization and credit market derivatives.

The Credit Market Meltdown Why should I care what happens to overconfident hedge funds dabbling in dark corners of the over-engineered derivatives market created in collusion with the overrated credit-rating companies?” I hear you cry. “The Dow Jones Industrial Average is at 14,000, the doom-mongers predicting recession are hushed, and my new Apple Inc. iPhone is just peachy.” (Gilbert 2007)

Financial market journalists began to discuss the prospects for credit market disruptions in the summer of 2007. Media scrutiny focused on the failure of two large hedge funds operated by the investment bank Bear Stearns. According to a 2008 Securities and Exchange Commission (SEC) complaint against the managers of the funds, both were incorporated in the Cayman Islands and, as a consequence, were not registered with the SEC in any way. The SEC charged the fund managers with a host of offenses—misrepresenting the proportion of the funds’ investment in subprime ABS CDO, misrepresenting the value of funds to current shareholders, and redeeming personal shares while recruiting new investors and falsely representing the state of the funds. Fund investors lost nearly $1.8 billion. Managers of the Bear Stearns funds were also charged with fraud by the SEC; investors were told that the funds had roughly 7 percent of subprime assets, but the stake was closer to 60 percent (Securities and Exchange Commission 2008a). The criminal complaints were dismissed in late 2009, but the SEC maintained a civil case against the managers. The failure of the Bear Stearns hedge funds could have been simply one more iconic story of fraud, greed, and hubris—with a corollary story about the failure of apathetic or disinterested federal regulators and a highly publicized investigation with compelling tales of investors who suffered large losses—much like the coverage and fallout from the collapse of the investment firm that Bernard Madoff operated. The major difference between the Bear Stearns hedge fund and the Madoff Ponzi scheme was that the Bear hedge funds were highly leveraged—

8

The Fed and the Credit Crisis

with capital from the parent company Bear Stearns and other large creditors. Cash losses attributed to Madoff, from a sprawling network of investors, totaled to about $20 billion over two decades (Reuters 2011). On top of roughly $2 billion contributed by investors, the Bear Stearns hedge funds relied on $14 billion in borrowing concentrated in a small network of major creditors, principally investment banks. One of the Bear funds was launched in October 2003, and the second, riskier fund in August 2006—so the pace and scale of the Bear Stearns losses, and the impact on major creditors, was large even compared to the Madoff fraud (Business Week 2007). It is clear from media statements and government responses in the summer of 2007 that key federal policymakers failed to understand how rapidly and broadly the financial market disruption would spread. As late as May 2007, Fed leadership was relatively unconcerned about the subprime mortgage market: All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. (Bernanke 2007b)

Fed regulators based in New York were also unprepared for the rapid deterioration of US credit markets and financial institutions. In a 2006 address in Hong Kong, the president of the Federal Reserve Bank of New York (“New York Fed”), Timothy Geithner, described the several innovations in regulation, supervision, and bank practices that enhanced the “resiliency” of the US economy after 1998. Geithner identified improvements in risk management within financial institutions, the high levels of capitalization in US financial institutions, and the salutary effects of private leveraged funds as sources of credit insurance for regulated institutions—all in all, “more efficient distribution and more effective management of risk” (Geithner 2006). From this perspective it would almost be unimaginable that, within two years of these remarks, the United States would be on the verge of a systemic financial collapse—and that the largest US financial institutions would fail or be dependent on government financing to survive. The response of federal regulators to the prospective collapse of three large complex financial institutions—Bear Stearns, Lehman Brothers, and AIG—indicates the uncertain nature of the government’s response to the

How Will the Credit Crisis Transform the Fed?

9

crisis. In the case of Bear Stearns, the New York Fed intervened to facilitate what at the time seemed to be a spectacularly large and risky transaction—the purchase of Bear Stearns by competitor JPMorgan Chase. The government role in the transaction was to accept or purchase approximately $30 billion in asset-backed securities to be held by a newly created public-private entity under the control of the New York Fed, Maiden Lane LLC. In the case of Lehman Brothers, a firm of similar complexity facing bankruptcy only months later, the New York Fed and Treasury Department officials elected not to intervene, and the firm failed in mid-September. The immediate aftermath of the failure was a precipitous increase in bankto-bank lending costs, an immediate contraction in credit and capital for business and consumers, and large disruptions in the operation of money market mutual funds. The next business day, the Fed opened an $85 billion credit line for insurer AIG. Within two weeks it was clear that broader action was required. After a tumultuous debate the US Congress acted to authorize the Treasury to lend $750 billion directly to distressed institutions under the Troubled Asset Relief Program (TARP). The debate over the TARP program and revelations about the gravity of the crisis stunned the American public—triggering a steep drop in consumer confidence. The Conference Board Consumer Confidence Index fell from an already weak 61.4 to a then-record low of 38.8, ushering in a deep recession.

What Options Did the Fed Have?

The failure of Fed leadership to anticipate and respond quickly to the credit crisis raises a number of questions about the Fed’s regulatory authority and tools for managing risks in individual banks and the broader financial sector of the economy. The Fed had at least three opportunities to preempt the financial market disruption: by regulating the terms of mortgage origination, imposing higher capital requirements for new structured finance products, or limiting exposure of regulated retail banking institutions to risks from hedge funds and investment banks. The Fed made a series of policy choices that failed to prevent the spillover of financial market disruption to the real economy. Current reform efforts and lending programs are designed to reverse these failures. What explains the failure of the Fed to identify and manage the crisis at the outset? What actions did the Fed ultimately take? How will these actions affect the mission and performance of the Fed? The remainder of the book is organized around five distinct sets of policies, ranging from mortgage origination to

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The Fed and the Credit Crisis

lending to distressed firms. The questions are introduced below, and subsequent chapters develop the answers. Mortgage Origination

Problems in the subprime mortgage business were well known to Fed leaders, community advocates, and housing policy experts. Fraud, abuse, and poor risk management at the point of loan origination laid the groundwork for the broader crisis. Unqualified borrowers ended up with loans they could not afford. The Fed and other federal bank regulators resisted federal and state-level efforts to supervise the origination of subprime and alt-A (“no doc”) loans. Why did the Fed fail to regulate the terms of mortgage origination prior to 2008? Will the creation of the Consumer Finance Protection Bureau remedy this problem? Securitization and Structured Finance

The proliferation of subprime mortgage-backed securities (and related ABS CDO resecuritizations) overwhelmed credit rating agencies and federal regulators. The growth of the private-label MBS was rapid, and the collapse of that market in 2009 was equally quick. Why did the Fed choose not to slow the growth of the market for private-label MBS? As ABS CDO began to populate the portfolios of regulated and unregulated financial institutions (and a variety of institutional and individual investors), why did the Fed choose not to impose capital requirements that would require banks to adequately manage the risks associated with these new instruments? How will the global regulatory framework—the Basel Accords— confront the regulatory challenges that these new instruments pose? Systemic Risk

The Fed was aware of the systemic risks associated with large, highly leveraged financial entities engaged in the purchase and sale of derivatives— specifically from experience based on the 1998 failure of a large hedge fund, Long Term Capital Management. The Fed had several opportunities to address regulatory shortcomings related to investment banks and hedge funds and the proliferation of credit derivatives. Why were the Fed and other regulators reluctant to extend prudential regulation to investment banks and highly leveraged hedge funds, or to specifically restrain the growth of the market for credit derivatives? Will the new Financial

How Will the Credit Crisis Transform the Fed?

11

Stability Oversight Council enhance or diminish the Fed’s ability and willingness to manage the problem of systemic risk? Lending and Credit Facilities

Confronted with the severe disruption in financial markets after the failure of Lehman Brothers, the Fed created a number of new programs. The expanding Fed balance sheet—representing extensions of credit totaling to over $1 trillion in one year—clearly alleviated some symptoms of the credit crisis. Chapter 6 reviews the scope and structure of these responses. Have these responses addressed the underlying structural problems that generated the crisis? What technical and political challenges emerged as the Fed implemented these lending facilities—particularly tools that introduced new hybrid (public-private) financial arrangements? Monetary Policy

Conspicuously absent from the policy choices above are questions about monetary policy and the federal funds rate. Should the Fed have increased interest rates in response to the housing bubble? This question is likely to receive substantial attention from economists, and the verdict is still out on the Fed’s culpability. Some observers place the blame for the run-up in housing prices and the subsequent financial crisis directly on Fed monetary policy choices. Morris (2008), for instance, describes the “wall of money” that Fed monetary policy created. Under Chairman Alan Greenspan the Fed maintained a prolonged period of very low interest rates in the face of mounting evidence of dramatic increases in asset prices. In contrast, Fed leaders portray the crisis as a function of factors outside the realm of traditional monetary policy. Chairman Bernanke specifically concluded that “the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards” (Bernanke 2010). There is no doubt that there will be reinvigorated conflict over monetary policy choices going forward—conflict that disturbs what had been a very orderly (and even somewhat boring) policy domain. Even within the Fed, disagreements emerged over the appropriate duration and size of extraordinary Fed intervention. Kansas City Fed President Thomas Hoenig dissented from Federal Open Market

12

The Fed and the Credit Crisis

Committee statements at eight consecutive meetings in 2010, sparking speculation about the impact of Fed crisis responses on the long-term inflation rate. The Reform Agenda

The policy challenges outlined above suggest that the United States will need a combination of housing finance reform and financial regulatory reform to respond to the crisis. The housing finance choices—regulation of mortgage origination and mortgage securitization—are fairly narrow decisions specific to the mortgage market. The Fed will revisit choices to support the expansion of the subprime lending market and to encourage private-label securitization in the 1990s, actions taken well before the crisis emerged. The Obama administration revealed key elements of the broader federal housing finance strategy in a report to Congress in February 2011 (Treasury, Department of, and the US Department of Housing and Urban Development 2011). The financial regulatory choices—about bank supervision and systemic risks—introduce fundamental questions about the role of the Fed in financial markets. Precrisis choices about prudential regulation—decisions about confining regulatory scrutiny mainly to retail or depository institutions and decisions about treatment of the market for credit derivatives—reflect a long-term commitment by the Fed to encourage and facilitate financial innovation. In retrospect, these choices inspired misplaced confidence in the technical ability and willingness of major financial institutions to manage risk. The direct and extraordinary intervention by the Fed to support large and distressed firms opens up new questions about the appropriate role of the Fed as both regulator and lender of last resort when financial markets are disrupted. The comprehensive financial regulatory reform passed by the US Congress, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), impacts the Fed in several ways. The focus in the chapters that follow is on both the shape of the Fed’s response to the crisis and the impact of the postcrisis reforms in housing finance and financial regulation—the supervisory authority, lending programs, and other new functions that reveal how the Fed has adapted in the face of failure.

Elements of Adaptation: Mission, Expertise, and Networks

A decade or more of historically informed work on complex policy change (in political science, loosely labeled “historical institutionalism”)

How Will the Credit Crisis Transform the Fed?

13

has highlighted the way that political choices and agency practices of the past inform or constrain contemporary policy responses. Major developments in US politics—like the expansion of the welfare state—have been the focus of work that considers the role of actors, ideas, and institutions in the sometimes disorderly and unpredictable path of public sector innovation (Skocpol 1992; Weir 2006). One persistent concept that emerges across a number of works in this tradition is layering—the idea that existing institutions are adapted to take on new and unforeseen tasks or challenges (Schickler 2001; Thelen 2004). Alternatively, Hacker (2004) describes a particular form of adaptation—conversion—to describe situations in which formal rules or laws remain fixed but internal agency practices are updated to manage new problems. The implication of both types of adaptation is that responses to public policy problems will rarely be innovative. Responses will reflect existing norms, resources, and routines. Rose (1990) poses the problem as “inheritance before choice”—elected officials approach a crisis with a set of agencies, actors, and tools at the outset. A few recent profound tragedies—the September 11, 2001, terrorist attack (9/11) and Hurricane Katrina—triggered renewed interest in the ways that state actors respond to crisis. Boinet et al. (2005) sketch out a framework for tracing the actions of government—from “making sense” of events as the crisis unfolds to, ultimately, the complex process of learning from crisis. The process of learning or adaptation proves to be highly contentious. Various actors seek to use the lessons of the crisis to advance particular solutions or policy instruments, to define a new era or signal the return to normalcy, and to balance demands for sweeping reform and more pragmatic stewardship of existing expertise and instruments to avert future crises. Birkland (2006) also pieces together the links between disasters and learning. Disasters and related media attention mobilize groups with a stake in change and, at the same time, draw attention to particular ideas that may inform solutions or reform. Carpenter and Sin (2007) explore how agency leaders can shape our understanding of tragedy and loss in ways that may translate a crisis into a policy change. That translation—from crisis to action—is not automatic or natural, but requires an actor—an entrepreneur—to construct a story that links consequences to actions: a “coherent and alluring narrative that supports particular policy change” (Carpenter and Sin 2007, 179). Stone (1997) reaches similar conclusions about the general usefulness of “policy stories” for promoting particular policy choices. Taken together, the historical institutional literature and the emerging work on crisis management help us to understand what is at stake as we observe agencies in the face of stress and crisis.

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The Fed and the Credit Crisis

When does a crisis produce meaningful policy change? What accounts for successful adaptation or innovation? The extensive literature on organizational change and organizational learning in political science and public administration suggests that three particular questions confront agencies that experience failure and face the imperative to adapt: How is the agency mission altered by the crisis? How does the crisis mobilize new interests? How does the agency integrate new skills or technology into agency routines and practice? Existing work—spanning a variety of agencies and policy domains—gives some indication of the scale of the challenges facing leadership in the Fed. Mission

The types of challenge facing the Fed are not entirely novel. Examples of agency responses to crisis provide alarming findings as well as reasons for optimism. As agencies take on new functions in response to a crisis, these new tasks may undermine performance in traditional areas of agency competence or liberate agency personnel to focus on new areas with new tools. Khademian (1995a) examines the financial and management challenges that confronted the Federal Deposit Insurance Corporation (FDIC) in the wake of the increasing number of bank failures in the United States in the 1980s. The FDIC relied on a fairly clear bottom line—the solvency of the bank insurance fund—to map out agency responses and provide evidence to external constituents (specifically members of Congress) that the agency was successfully adapting. By contrast, Derthick (1990) describes the stresses experienced by the Social Security Administration in the implementation of Supplemental Security Income in the early 1970s. The new program was fundamentally at odds with key aspects of agency norms and practice, and the result was widespread delays, unforeseen technical challenges, and an erosion of agency performance in existing well-established programs. Derthick concludes that elected officials may see capable agencies as “infinitely pliable” and neglect how new functions may complicate traditional or core agency functions. Reviewing the way that federal banking regulators responded to new consumer protection statutes, Khademian (1995b) highlights the ways that missions can be a constraint on organizations—slowing or distorting the process of adapting to new conditions or mandates. Roberts (2006) describes the varied performance of the Federal Emergency Management Administration (FEMA). Burdened with a reputation for lackluster performance for nearly twenty years, the agency

How Will the Credit Crisis Transform the Fed?

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was revitalized in the Clinton administration under the leadership of James Lee Witt. When FEMA was transferred into the Department of Homeland Security after 9/11, the mission of disaster preparedness—a hallmark of the revitalized FEMA—was subordinated to the new threat of terrorism (Birkland and Waterman 2008). The catastrophic failure of the agency to adequately and quickly respond to Hurricane Katrina was both a human disaster and a blow to the agency’s reputation. In the face of crisis and change, some agencies thrive while other agencies struggle. In all cases, agencies with multiple and competing missions are confronted with unexpected challenges, shortage of key personnel and resources, and unanticipated consequences of deliberate choices. There are examples of agency transformation that suggest change can be successful. Mazmanian and Nienaber (1979) describe a comprehensive reorientation within the Corps of Engineers to incorporate values of environmental preservation. Changes in the corps reached deep into internal agency practices and procedures. Hoffmann and Cassell (2005) describe this dynamic within the Federal Home Loan Bank (FHLB) system—to expand the mission of the FHLB to include preservation of and support for small banks. They characterize the emergence of new components of the agency’s mission as part of a “social problemsolving process” (Hoffman and Cassell 2005, 701). Constituents or Networks

Existing work on the financial sector suggests that changes in the Fed’s network of supervised institutions could have profound effects on the orientation or policy choices of Fed actors. Hoffmann and Cassell (2005) describe how changes in the membership of the FHLB directed the attention of FHLB policymakers to different types of policy problems. Specifically, a combination of changes initiated by Congress in 1999 coupled with FHLB changes to membership rules increased the number of small bank members. FHLB policymakers developed new expertise to provide assistance to these small bank members, shifting the principal mission of the FHLB from housing finance to community banking, particularly the challenges facing and tools for improving small rural banks. The obvious implication for the Fed is that as the number and size of regulated bank holding companies grows, the Fed will adapt the supervisory function to serve and monitor these large constituent firms. Before 1980, Fed supervisory authority was directed to state-chartered member banks. The Office of the Comptroller of the Currency (OCC) supervised the largest and most powerful federally chartered banks. As

16

The Fed and the Credit Crisis

financial institutions consolidated in the 1980s and 1990s and many large banks took on the status of bank holding companies, the Fed took on some types of supervisory responsibilities for large banks. The 2008 credit crisis moved the last remaining investment banks under the supervision of the Fed, leaving the Fed with some authority to supervise all of the nation’s large and complex financial institutions. The enormous economic and political power of this network of financial institutions has been directly implicated in the origins of the financial crisis (Johnson and Kwak 2010). The financial crisis highlighted both the formal links that bind together financial institutions and the wide-ranging network of federal and state agencies that oversee these institutions. Although the contemporary idea of networks is generally applied to formal arrangements partnering nonprofit and public agencies, the ties between public agencies and their private constituents has been a central concern of academic and applied work on public organizations (Landis 1960; Selznick 1949; Bernstein 1955). Described as “cooptation,” “industry orientation,” or the “institutionalization of favoritism,” the basic premise is that regulators must caution against privileging the powerful private actors they interact with. O’Toole and Meier (2004) offer a compelling empirical treatment of the network problem, demonstrating how the frequency of interaction with various types of actors affected the behavior of local school executives. The general result is that the most privileged actors in the networks gain a disproportionate share of the benefits produced by network activity. Networks are also an important part of our understanding of policy change. Hall (1993) argues that paradigmatic change involves a broader network of actors than incremental response or adaptation. Birkland (2006) claims that disasters highlight policy failures for a broad audience; this is one important source of policy change. Elaborating an “advocacy coalition framework,” Sabatier (1993) suggests that longterm policy change—and the process of learning—is best understood as a contest between a wide range of more or less attentive government, public, and private actors. A policy failure or crisis challenges the dominant coalition and can permit an opportunity for new interests or new ideas to influence policy choices. Weir (1992) is less optimistic, concluding that networks in US politics narrow the “range of ideas likely to receive a hearing” as alternatives are considered. In any case, changes in the network of actors with a stake in agency choices will clearly produce pressure on agencies to shift priorities, revisit policy choices, and accommodate new constituents.

How Will the Credit Crisis Transform the Fed?

17

The financial crisis confronts the Fed with network challenges. The transition of the largest investment banks to the legal status of bank holding companies places these firms under the supervision of the Fed, continuing a long-term shift of Fed supervisory focus from a geographically widespread network of small state-chartered banks to a geographically concentrated small number of very large financial institutions. This transition disturbs or alters the balance of power between the regional Reserve Banks, concentrating power in the hands of the Federal Reserve Bank of New York, the bank with the closest ties—spatially and ideologically—to Wall Street. Management of the crisis also highlighted the power and impact of the Federal Reserve Bank of New York, as the bank implemented many of the lending and credit facilities instrumental to the Fed response and negotiated transactions related to AIG and Bear Stearns. The Fed’s new role as market stability regulator, institutionalized in the new Financial Stability Oversight Council, also carries network implication as the Fed establishes supervisory relationships with large hedge funds, insurance companies, money market mutual funds, and any other element of the financial sector that could represent a “systemic” risk. Expertise (Skills and Technology)

How do agencies acquire the expertise to solve problems and, equally important, the discretion to apply that expertise? Carpenter (2001) highlights the way that early-twentieth-century bureaucratic entrepreneurs responded to demands for government solutions to a variety of political and economic challenges. Public sector experts identified solutions to problems that elected officials were under pressure to address, and elected officials gave these bureaucrats formal authority and power to put these solutions in place. This perspective gives us compelling contemporary insights as well. Roberts (2006) traces the precarious attempts of leaders in FEMA to link agency reputation to expertise rooted in the emergency management profession. In a similar way (and more successfully) the Fed has carefully cultivated autonomy and expertise for core monetary policy functions related to price stability and economic growth. The Fed has unique structural features that free Fed leadership from political constraints—a limited scope of political appointments and sources of revenue that liberate the agency from the congressional budget process. These political choices are reversible and contingent on the ability of Fed to deliver economic growth (and stability). The credit crisis threatens Fed autonomy if Fed leaders are unable to put the right

18

The Fed and the Credit Crisis

human capital and information technology in place to learn how to anticipate and mitigate financial crises. Boin et al. (2005) label this particular task “skill-based learning,” a form of adaptation that becomes critical when crises reveal a deficit of information or technology. The human capital and information technology resources within agencies are key components of the learning process. This insight spans work on multiple agencies in diverse policy domains. Examining the Columbia and Challenger shuttle losses, Mahler and Casamayou (2009) argue that the outsourcing of critical tasks to contractors degraded the capacity of NASA engineers to recognize and respond to risky practices. Poor communication between contractors and NASA personnel coupled with incentives for contractors to minimize risks led to poor launch choices with tragic consequences. In a blunt assessment, Mahler and Casamayou conclude that “organizational learning was compromised because information needed to identity hazardous conditions and analyze their consequences was misdirected, filtered, misinterpreted, and ignored” (2009, 163). Also focusing on decisionmaking in NASA, Vaughn (1996) describes how specific features of the organization—at the level of small engineering workgroups—led to high levels of risk associated with specific shuttle components, what she labels the “normalization of deviance.” Khademian (1995a) describes how the FDIC invested in expertise and training to reduce costs associated with the resolution of failing financial institutions, rather than relying on contractors or vendors. Case studies of disaster response find similar organizational features. One key lesson from the failure of the response to Hurricane Katrina was that emergency managers require training in collaborative management skills to better understand and deploy the unique sets of expertise in particular agencies linked in complex governance networks (see Koliba, Mills, and Zia 2011). In each case, learning hinges on the ability of the members of the organization to both integrate the collection of vital information into routine agency practice and to accommodate “dynamic problem-solving,” the incorporation of new information or the search for new interpretations of existing information (see Hoffmann and Cassell 2005). The Fed clearly needs to take a new approach to supervising banks, monitoring systemwide risks, protecting consumers, and responding to firms in distress, but the public management literature reminds us that the costs of new approaches can be large. Boyne and Meier (2009) find that organizations that “stick” with a stable internal organization weather disruption better than organizations that “twist” by restructuring. These results reflect what is known as the “liability of newness”: organi-

How Will the Credit Crisis Transform the Fed?

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zational change destabilizes internal routines and increases uncertainty (both within and outside the agency). In addition to the overt costs of additional staff and investments in technology, new tasks create new challenges in communication with critical stakeholders about the directions and pace of change. These costs increase the chances of organizational failure (Amburgey, Kelly, and Barnett 1993). The Fed faces a diverse set of new responsibilities that will require new staff, technology, and ideas; incorporation of this expertise into Fed operating practice is a crucial part of learning from the crisis.

What Happens to the Fed Now?

The policy tools that the Fed has created to manage the credit crisis are untested and reflect a departure from over fifty years of Fed operating practice. In the early 1950s, the Fed segregated the functions of monetary policy from the debt financing activity of the US Treasury; the “Treasury Accord” is regarded as an administrative and political revolution in the conduct of monetary policy. At that time, Fed Chair William Martin began a successful campaign to depoliticize monetary policy—to move the Fed away from selective credit controls and credit allocation toward the use of narrow short-term intervention in US treasury markets (see Corder 1998). The Fed engaged in more direct capital market intervention under the leadership of Arthur Burns in the 1970s, adopting strategies that led to intense congressional scrutiny of Fed behavior. Under Burns the Fed experienced a tumultuous period in which conservatives (led by Milton Friedman) and progressives (like William Greider) advocated strict oversight or constraints on Fed actions. A combination of factors—the appointment of Paul Volcker, a dramatic (and wrenching) decline in inflation, and a period of financial and economic stability that spanned nearly twenty years—muted most of these critics. During the tenure of Alan Greenspan, from 1987 to 2006, the Fed enjoyed a high level of autonomy and independence. Fed leaders routinely framed monetary policy choices as fundamentally apolitical, adjusting interest rates to bring about the widely shared goal of stable inflation consistent with long-term economic growth. During this period, Fed decisionmakers enjoyed an extraordinary deference from elected officials and adapted central bank practices in ways that inspired confidence in monetary policy choices. In what Alan Blinder labels the “quiet revolution” in monetary policy, Fed leadership responded to demands for transparency

20

The Fed and the Credit Crisis

and openness by providing more immediate access to meeting statements and minutes and took other steps to explain and clarify monetary policy choices (Blinder 2004). Many economists credit Alan Greenspan with setting the stage for the robust economic growth that the United States experienced in the 1990s (see, for instance, Blinder and Yellen 2001). Under these circumstances, neither Democrats nor Republicans in Congress advocated rules or constraints that would bring the Fed under more direct representative control. By 2000 it was inconceivable that any political actor would challenge a sitting Fed chairman or that the Fed would actually fail to solve an economic policy challenge. In a 2004 address Fed Governor Bernanke described the “Great Moderation”—how the global economy had experienced nearly twenty years of progressively more stable macroeconomic outcomes. Bernanke specifically argued that the main explanation for this success was the increasing effectiveness of monetary policy (Bernanke 2004). Looking forward from 2004 it was inconceivable that the US economy and financial markets would approach near collapse in less than five years. Now that financial markets and the real economy have suffered tremendous shocks, confidence in the Fed and deference to Fed decisionmakers has diminished if not evaporated entirely. Just as the technical environment for conducting monetary policy is becoming more complex, the political environment is becoming more hostile. As the immediate crisis in credit markets recedes and elected officials search for ways to prevent the next crisis, the Fed confronts several difficult choices. The challenges are somewhat technical as there are few guidelines for managing a $2 trillion Fed balance sheet, but the challenges are also (and more perniciously) political. The Fed has clearly lost the ability to claim superior competence and foresight in regulation of financial markets; the deference that Chairman Greenspan enjoyed has been replaced by skepticism and even scorn for Chairman Bernanke. The broader span of regulatory control outlined by the Congress in DoddFrank brings the largest and most powerful interests in the financial services sector into the regulatory orbit of the Fed. Many of these Wall Street firms have been important advocates of Fed independence, but the Fed faces new pressures to confront and rein in risky practices across the financial sector. Finally, the Fed has made clear that it has the power to pick winners and losers: members of Congress have and will press the Fed to explain why aid was directed to some firms (AIG) but not others (Lehman Brothers) and will attempt to expand the use of auction and lending facilities to direct aid to particular firms (why not lend

How Will the Credit Crisis Transform the Fed?

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to this firm—an automaker, for example—or a struggling municipal government in my district?). The credit crisis and the Fed’s initial response disrupted agency practice—and degraded performance—in several ways. Routine operating practices (federal funds rate targeting) were replaced with novel and untested tools (credit and lending facilities). The fairly stable network of traditional depository institutions and bank holding companies that was the core of the Fed’s regulatory authority was expanded to include bank holding companies with large investment banking operations. This process culminated with the designation of several large financial institutions (GMAC, Goldman Sachs) as bank holding companies in late 2008. Finally, the public confidence in the Fed’s ability to manage the crisis was undermined as the credit crisis impacted the real economy and the Bush administration turned to the secretary of the treasury to provide huge capital infusions to the financial sector under the Troubled Asset Relief Program (TARP). The mere idea that the Fed was incapacitated—that quick action by Congress was immediately necessary to prevent the collapse of financial markets in the fall of 2008—challenged our basic understanding of Fed infallibility cultivated by Alan Greenspan and his predecessors. In the chapters below, the focus turns to the response of the Fed at each stage of the crisis—the expansion and relatively loose regulation of lending to subprime borrowers, the rapid growth of private-label MBS, changes in the structure of capital requirements applied to financial institutions, the proliferation of hedge funds and other new financial entities, and the rapid expansion of the Fed’s lending and credit facilities as the urgency of the crisis became apparent. Answers to questions about the adequacy of the Fed’s response to the unfolding crisis obviously invite some scrutiny of Fed history, in order to understand how or why the Fed approached the crisis so delicately in 2007. I draw on a number of sources to frame the Fed response to the crisis: financial market reporting about the crisis (especially in the early stages), a variety of archival sources (to compare Fed responses to this crisis to earlier periods of economic and political stress), and the public pronouncements of Fed actors addressing the crisis (particularly Chairman Ben Bernanke, then-president of the Federal Reserve Bank of New York Tim Geithner, and Fed board members Donald Kohn, Randall Kroszner, and, later, Daniel Tarullo). The Arthur Burns Papers at the Gerald R. Ford Library were a valuable resource because the Fed faced similar political pressures in the 1970s—to transform regulation, to support housing finance, and to respond to financial market disruptions. Fed

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The Fed and the Credit Crisis

leadership was highly sensitive to the implications of its choices for long-term Fed independence, and the period is also a lesson in how enhanced scrutiny of the Fed can be associated with high and sustained inflation. To understand how the crisis response will impact the Fed, I draw on financial market reporting about financial regulatory reform, Fed leadership statements and actions related to reform, official reports from domestic and federal banking regulators about changes in bank supervision and consumer protection, and industry responses to proposed rules—published comments that transmit industry preferences to implementing agencies. Chapters 2 and 3 focus on the regulatory and policy choices that apply specifically to housing finance: origination and securitization of mortgages. How will the creation of the Consumer Financial Protection Bureau and 2010 housing finance reform initiatives impact the Fed? Chapters 4 and 5 address innovations in the structure and regulation of the financial sector—the growth of lending activity and credit outside of the traditional banks and the complex regulatory and supervisory choices introduced by innovations in structured finance. How will new regulatory missions—implied by the Financial Stability Oversight Council— and new international rules regarding bank capital and liquidity impact the Fed? Chapter 6 outlines the structure of the credit and lending facilities the Fed created to provide credit to specific firms, the implications of the Fed’s purchases of mortgages and commercial paper, and the huge volume of medium-term lending to depository institutions. Chapter 7 revisits the basic questions suggested by the Fed’s actions before and during the credit crisis. How do these choices reshape the mission of the Fed? How have new policy choices altered the network of actors with a stake in Fed policy choices? What types of technical challenges do the Fed’s choices introduce? How will these challenges impact the core mission of monetary policy and the mandate to pursue price stability? In short, in what ways has the credit crisis undermined or enhanced the Fed’s power and reputation? In one sense, even three years after the crisis, an attempt to answer these questions is premature. The implementation of financial regulatory reform has been slow and contested. The housing market remains extremely fragile. But one aspect of the crisis is clear: the pace and extent of government learning is slow. Any expectation of nimble and fast-paced regulatory responses to crisis has been replaced with the more sober realization that intense conflict and technical uncertainty can obstruct even basic reform and change. In just the type of instance where we might expect disjuncture, disruption, or rapid change, we observe slow, incremental, and deliberate adaptation. These

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changes nevertheless have profound implications for the Federal Reserve System. Some implications are already clear: higher levels of scrutiny by elected officials and uncertainty among investors about Fed intentions and future action. More importantly, there is a heightened sense of the tension between a legacy of unobtrusive regulation and deference to Wall Street and the types of reforms that may be necessary to prevent the next financial crisis. The credit crisis compels leaders at the Fed to refine the agency’s mission, enlist new types of skills and technology, and negotiate an increasingly complex political environment. Yet, at the same time, Fed leadership must preserve the core monetary policy function that is the heart of the Fed’s power and reputation.

2 Subprime Lending and the Mission of Consumer Protection

The business of mortgage lending underwent a signal transformation

in the 1990s. Lenders obtained better and more information about borrowers (credit scores, for instance), lenders provided borrowers with new products (introducing new terms and types of loans), and lenders targeted new markets in which to sell these products. Most of these innovations were designed to broaden access to credit and, as such, were considered to be useful tools to complement public policy goals related to broader homeownership. Policymakers anticipated that because banks could accurately price and distribute risk associated with borrowing, broader classes of borrowers could qualify for the new mortgage products—borrowers with poor credit, problematic income histories, or little or no down payments. These “subprime” borrowers were a growing segment of the market for new mortgages, especially in areas where home prices were increasing rapidly. The business of subprime lending promised to bring the dream of homeownership within the reach of low- and moderate-income households. It was no surprise that as more borrowers were provided credit to purchase homes, the number of problem mortgages (foreclosures and delinquencies) also increased. But there was a particularly large and unexpected increase in foreclosures for subprime mortgages originated in late 2005 and 2006. These problem mortgages were the immediate trigger of the financial crisis. Mortgages originated in 2005 and 2006 and mortgagebacked securities created with those mortgages continued to contribute to bank and investors losses well into 2009. Why did federal and state regulators fail to act in time to prevent the wave of foreclosures experienced in the United States in 2007 and 2008? What role did the Federal Reserve play in the erosion of loan quality? How has the Fed adapted since the credit crisis revealed problems in the mortgage lending industry? Overall, 25

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The Fed and the Credit Crisis

the Fed’s response to the erosion of lending standards was halting and limited. Despite ten years of debate and information about the potential for and the practice of predatory lending and lax lending standards in the subprime market, the Fed did not aggressively use existing regulatory authority to clamp down on subprime mortgage originations. Since the 1950s the Fed has resisted the idea and practice of selective credit control—restricting the form and type of credit available to particular classes of borrowers. The Fed has instead restricted credit in the aggregate—making credit and capital more expensive or less expensive for all borrowers through changes in the federal funds rate. The Fed’s antipathy to selective credit controls, coupled with the federal drive to broaden homeownership and efforts to deregulate financial services, made it unlikely that the Fed would champion restraints on mortgage lending innovations. Although the Fed has been formally engaged with consumer protection since at least the passage of the Truth in Lending Act in 1968, the consumer protection function is not a central focus of the Board of Governors or the Reserve Banks. Khademian (1995b) describes how staff in the Fed’s Division of Consumer and Community Affairs did develop expertise—capacity—to implement consumer protection mandates, but also describes the ongoing tension between the staff and the Board of Governors over the scope of this mission. The Board of Governors typically spends less than 5 percent of its annual operating budget on consumer and community affairs functions, focusing instead on bank supervision, research and statistics, and operations of the Reserve Banks, In 2008, for instance, the Board budget was over $700 million, with $38 million designated for consumer and community affairs. Regional Reserve Bank expenditures were much larger—over $3 billion—but it is unclear what proportion was directed to consumer protection and other compliance functions (Federal Reserve System 2009a, Appendixes C and D). As the credit crisis intensified, members of Congress looked to the Fed to scrutinize mortgage lending practices. But, given the Fed’s track record of slow and reluctant oversight of mortgage lending, financial reform efforts ultimately restructured the regulation of financial products and stripped the Board of Governors of the consumer protection mission. Congress created a new consumer protection regulator, the Consumer Financial Protection Bureau (CFPB). The new bureau is an odd creation, drawing funding from and operating within the Federal Reserve System but clearly autonomous from the Board of Governors. The new bureau consolidates consumer protection functions from the Fed and a number of other regulators and is authorized to take on functions ranging from gener-

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al financial education to specific scrutiny of financial products targeting military service members and older Americans. The new bureau liberates the Board of Governors from a role in consumer protection that is in some ways at odds with the core mission of the Fed. The Fed retains bank supervisory authority over a number of small and large institutions, but consumer protection and other compliance functions are segregated from the primary bank supervisory function. For instance, the Fed postponed new rules governing scrutiny of high-priced mortgages until the effective transfer of rulemaking authority to the new agency in July 2011. After reviewing the origins and growth of the subprime market, I outline the Fed’s role in the mortgage market. The Fed’s implementation of truth-in-lending regulations, home mortgage disclosure reporting requirements, and scrutiny of high-priced mortgages—unfolding over a twenty-year period—all suggest that the Fed is not an agency that can act as a steward for the mortgage industry. The Fed’s core mission, key competencies, and role as bank supervisor combine to ensure that the regulation of mortgage origination is subordinated to a number of other policy and regulatory functions. The outcome is a classic case of what Schickler (2001) calls “layering”—various truth in lending and disclosure requirements were layered on top of existing Fed functions, but there was little corresponding adjustment of Fed practices, goals, or staff to successfully police the mortgage market—within or outside of the depository institutions directly supervised by the Fed. Even as the Fed reluctantly accepted broader responsibility to regulate the subprime market in 2007, Fed leaders and other federal regulators acted to block similar scrutiny of other lending practices in banks (home equity loans, for instance). The creation of the CFPB eliminates some of the internal barriers to policy change or adaptation and could revitalize the consumer protection mission within the Federal Reserve System. But it remains unclear exactly what the impact of the new CFPB will be and how the new formal structure will overcome resistance within the financial services industry to greater oversight and supervision.

The Subprime Mortgage Market and Federal Housing Goals

The growth (and collapse) of the subprime mortgage market was rapid. Subprime mortgage originations grew from about $40 billion (less than 10 percent of mortgage originations) in 1990 and peaked at $625 billion (20 percent of mortgage originations) in 2005 (see Figure 2.1). Four institutions accounted for nearly one-third of the subprime loans origi-

28

The Fed and the Credit Crisis

nated at the 2005 peak: Ameriquest Mortgage, New Century Financial, Countrywide Financial, and Wells Fargo Home Mortgage. Only about $23 billion in subprime mortgages were originated in 2008, and Wells Fargo was the only major subprime lender that avoided bankruptcy as the subprime market collapsed. The most popular innovation that drove the increase—especially in California—was the “2/28” loan—a loan with a fixed rate of interest for two years that reverted to an adjustable rate loan for the remaining twentyeight years (a so-called short reset loan). These new loans did broaden access to credit; home mortgages became much more accessible to lowincome households as the subprime market expanded. Gramlich (2007) reports that mortgage denial rates for all low-income households dropped from about 40 percent in 1997 to under 20 percent in 2005. The anticipation of the lenders and borrowers was, apparently, that appreciation in price would permit a refinance within two years, avoiding the payment shock associated with the variable rate. But lenders often attached extremely high prepayment penalties to these loans, which forced consumers to absorb a high fee in order to refinance before the end of the two-year fixed period and corresponding increase in payment. Since lenders typically failed to escrow property tax and insurance in these subprime transactions, the borrowers were exposed to unexpected tax and insurance liabilities, on top of the adjustable rate payment shock after two years. These practices led to a spike in foreclosures and problem mortgages in 2007 and 2008. Twenty-

Figure 2.1 Subprime Mortgage Originations 700

Billions of Dollars

600 500 400 300 200 100 0 1990

1992

1994

1996

1998

2000

Source: Inside Mortgage Finance 2011

2002

2004

2006

2008

2010

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five percent of subprime first-lien loans originated in 2006 were more than sixty days delinquent within twenty months of origination (compared to less than 15 percent originated in 2005) (Goodman et al. 2008, 66). The Inside Mortgage Finance Large Service Delinquency Index, which tracks the delinquency rates of $5 to $7 trillion in mortgages annually, surged from below 5 percent in 2004 and 2005 to over 6 percent in 2007, over 8 percent in 2008, and remained about 11 percent in 2010. Outside of the subprime market, the serious delinquency rate for Fannie Mae and Freddie Mac mortgages drifted up from less than 1 percent in 2006 to over 2 percent in 2008 and over 4 percent by 2010 (Inside Mortgage Finance 2011). This wave of delinquencies and foreclosures undid substantial progress in increasing low-income and minority homeownership rates, undermining a major policy goal that subprime lending was supposed to support. The goal of broadening homeownership has been a cornerstone of US housing policy for nearly 100 years. In 1921 Secretary of Commerce Herbert Hoover identified universal homeownership as the key element of a broader government campaign to improve living conditions in growing US cities (Vale 2007). The federal government intervened aggressively in the residential mortgage market during and after the Depression—directing capital to homebuyers through the Federal Home Loan Banks and addressing a severe foreclosure crisis with the novel Home Owners Loan Corporation (Hoffmann and Cassell 2009a). Over time, a variety of federal housing programs—Federal Housing Administration (FHA) mortgage insurance, Veterans Administration (VA) loan guarantees, and Fannie Mae purchase programs—emerged to support the flow of capital to homebuyers, make mortgages more affordable, and make mortgage terms more friendly for consumers (Mason 2004). Federal purchases of loans on the secondary market led to common underwriting standards and increased the volume of lending by banks, thrifts, and mortgage companies. One result of these efforts was an unprecedented increase in homeownership rates in the United States—from under 45 percent in 1940 to over 60 percent two decades later (US Census Bureau 2004). Only in the late 1990s did homeownership rates begin to move upward from the plateau of 65 percent reached in the late 1950s. The growing subprime mortgage market was the principal explanation for this change. Bank lenders developed new forms of loans—initially adjustable rate mortgages and, later, higher-priced loans—to find ways to permit riskier borrowers to purchase a home. The Fed embraced these new tools to improve access to credit for marginal borrowers, specifically low-income and minority borrowers. In 2005 Chairman Greenspan

30

The Fed and the Credit Crisis

discussed the ongoing “constructive innovations” in credit risk evaluation and subprime lending: “Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately” (Greenspan 2005a). Important actors in the Bush administration shared Greenspan’s views. John Weicher, assistant secretary for housing at HUD and federal housing commissioner from 2001 until 2005, made the case for subprime lending as late as 2006. He concluded, “Subprime lenders take bigger risks and experience bigger defaults, and some take advantage of their borrowers, but by and large they have contributed to the increase in homeownership” (Weicher 2006). Goodman et al. (2008) also link regulator decisions to the broader policy objective. They implicate a combination of “pro business, pro homeownership and laissez faire” in the Fed’s choice to permit loan innovation—especially the 2/28 loans that proved so vulnerable to delinquency and foreclosures. Because the subprime mortgage market was viewed as a complement to federal homeownership goals, it is not surprising that the Fed and other regulators failed to identify and respond to problems in the subprime market. But the broader experience of the Fed with the mortgage market, encompassing policy choices made well before the subprime crisis, has never included aggressive or enthusiastic attempts to police mortgage lending practices within and especially outside of traditional commercial banks.

The Fed and the Mortgage Market

The Fed’s traditional macroeconomic challenge is to “take away the punch bowl just as the party gets going,” but the Fed has experienced unpleasant political pressure when the first borrowers to notice tightening or credit restraint are homebuyers and homebuilders. In the 1950s the Federal Reserve System was briefly charged with the responsibility of curtailing lending to potential homebuyers. At the behest of the Fed, members of Congress imposed restrictions on the terms of loans that could be extended under FHA and VA programs—maximum terms and minimum down payments. When these restrictions did not dampen the pace of mortgage lending, the Fed was given the regulatory authority to directly require larger down payments and limit loan amounts. The rationale for the restrictions was the shortage of critical supplies for the Korean

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War effort—that is, building fewer homes could free up these resources. The restrictions—implemented as Regulation X in October 1950—drew widespread criticism from the homebuilding and real estate industries. Anticipating that the VA and FHA would attempt to expand homeownership among veterans, the Fed elected to discontinue efforts to reduce bank mortgage lending after Regulation X authority was permitted to expire. The Fed recognized that resistance from prospective homeowners and homebuilders would invite congressional scrutiny of Fed actions and possibly interfere with broader monetary policy choices (Corder 1998). Political pressure from economic interests with a stake in homebuilding— real estate agents, mortgage lenders, homebuilders, building products manufacturers—could jeopardize the anti-inflation policies of the Fed. As homeownership rates stabilized in the 1950s, the Fed was somewhat peripheral in the housing policy debate, except to the extent that tight money policy and high interest rates undercut efforts to direct capital to the mortgage market. In the postwar period the interest rates on FHAinsured and VA-guaranteed loans were fixed, so Fed choices about interest rates created large fluctuations in the supply of credit to the mortgage market (Klaman 1961). This tension between monetary policy and homeownership was particularly acute in the late 1960s and the early 1970s. The Fed was implicated in several setbacks related to national housing goals, particularly during a severe contraction in credit in 1969 (see US Senate 1970). A number of federal initiatives emerged in response to this crisis: Ginnie Mae guarantees made mortgage-backed securities attractive to investors, and the Fed considered other ways to divert capital to housing. Fed decisionmakers were skeptical of efforts to insulate the housing market from monetary policy restraint, because other sectors would obviously bear the brunt of restraint and appeal to Congress for similar preferential treatment (for details about this trade-off, see Chapter 3). In the 1970s, Fed solutions to mortgage market credit disruptions typically centered on regulatory reform to permit broader lines of business for depository institutions—banks and thrifts. These reform efforts culminated in a major regulatory overhaul, the Depository Institutions and Deregulation and Monetary Control Act of 1980. The act loosened restrictions on the flow of funds across types of lending institutions and relaxed state usury ceilings—a change in practice that encouraged institutions to attract funds and expand home lending to new classes of borrowers. The elimination of state usury ceilings has been identified as the single most important legal change that contributed to the development of the subprime mortgage market (Gramlich 2007).

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The Fed and the Credit Crisis

The Fed was directly charged with homeownership goals as part of its role in bank regulation, specifically under the 1977 Community Reinvestment Act (CRA). The act requires that banks provide credit to communities that contain a high proportion of low- and moderateincome borrowers. Some observers implicated CRA requirements in the subprime crisis, concluding that pressure on banks to serve low-income households led banks to embrace and expand subprime lending. Recent work concludes, however, that investor appetite for subprime mortgagebacked securities drove subprime lending both within and outside of traditional depository institutions. The underlying attractiveness of the business, not regulatory or social incentives, drove increasing subprime mortgage origination (see Ludwig, Kamihachi, and Toh 2009).

The Fed and Consumer Protection

In the early 1970s Congress authorized a number of measures to remedy inequities in access to housing that motivated the 1968 Fair Housing Act (Lamb 2005). Federal regulators adopted a series of consumer protection measures to ensure that borrowers understand terms, fees, and penalties associated with mortgages. As a bank supervisor, the Fed ensures compliance with the truth-in-lending measures and also monitors two disclosure regimens that track mortgage origination activity: reporting requirements under the Home Mortgage Disclosure Act (HMDA) and the Community Reinvestment Act. Both HMDA and CRA were conceived as right-toknow statutes, requiring banks to publish information about aggregate loan activity. Both acts address geographic inequities in access to bank credit and require banks and other financial institutions to report the volume and location of mortgage activity. CRA adds a rating component on top of the reporting requirements; bank examiners are required to rate the effectiveness of banks in providing local credit needs (Fishbein 1992). Dodd-Frank includes a reinvigorated CRA evaluation, one of several functions that the new CFPB will undertake. The Fed played a large role in the implementation and enforcement of these consumer protection and disclosure regulations, but the Fed’s role has been more as an advocate for regulated financial institutions, rather than an advocate for consumers and borrowers. Moskowitz (1987) describes how the Fed was charged with the creation of specific language to guide implementation of the 1975 home mortgage disclosure legislation. The Fed’s ties to the financial services industry motivated Fed leaders to choose language that avoided high compliance costs

Subprime Lending and the Mission of Consumer Protection

33

and limited the appearance of and opportunities for credit allocation (preserving the “free flow of capital”). Although the Fed was the source of the most reliable information about costs and compliance alternatives, ties to industry ensured a “less than enthusiastic implementation” of the regulations (Moskowitz 1987, 104). More directly related to the subprime mortgage market, the Fed exercises an important consumer protection role through the application of Regulation Z, rules that implement the 1968 Truth in Lending Act (TILA) and apply to all bank lenders, inside and outside of the Federal Reserve System. TILA provisions apply to mortgage transactions and have been specifically tailored to inform consumers about the costs of adjustable rate mortgages and to ensure special scrutiny of “high-cost” mortgages (which can include subprime mortgages). Under 1994 legislation that expanded the Truth in Lending Act—the Home Ownership and Equity Protection Act (HOEPA)—the Fed was charged to give special scrutiny to high-cost mortgages originated by any lender. But, as new loan products and alternatives emerged on the market, there was limited supervision of the subprime market and active resistance to broader regulation. Pyle (2003) describes how the HOEPA regime balances the benefits of subprime lending (expanding credit to low-income and high-risk borrowers) with the prospects for fraud and abuse introduced by extension of credit to borrowers who are infrequent users of credit and financial services. Pyle concludes that the 1994 rules were too easy to evade. Specifically, lenders found it profitable to “flip” loans—to set up loans that include fees just under the HOEPA triggers with the intention of refinancing in the short run and charging the fees again upon refinance. A set of 2001 amendments to HOEPA closed these loopholes. Pyle concluded that the Fed is fundamentally concerned not with consumer protection but with the safety and soundness of the banking system—inspiring “foot dragging” on enforcement. Fed leaders were cognizant of the potential for predatory lending in the subprime market and considered a number of steps to reduce fraud and abuse (Gramlich 2000). But actions by regulators—in the Fed and in the Office of the Comptroller of the Currency (OCC)—blocked efforts by state governments to police mortgage lending as subprime activity increased (Office of the Comptroller of the Currency 2004). Further, a 2007 Supreme Court decision, Watters v. Wachovia, validated these federal choices, repudiating efforts by the state of Michigan to regulate the mortgage lending activities of the subsidiary of a national bank (see Miller 2008). Signals about problems related to the subprime mortgage market were visible from a number of sources before 2007. Economists at the

34

The Fed and the Credit Crisis

Department of Housing and Urban Development and analysts from Abt Associates presented loan pricing anomalies and unusually high foreclosure activity associated with subprime lending at a March 2000 HUD conference on “Housing Policy in the New Millennium” (Bunce et al. 2001). For instance, between 1993 and 1996 the number of total foreclosures in the Chicago metropolitan area increased from 2,074 to 3,964; the number of foreclosures by subprime lenders rose from 30 to 1,417, accounting for a staggering 80 percent of the increased foreclosure activity. The GAO warned in 2006 that the new “alternative mortgage products” were likely to generate higher levels of foreclosures, largely a consequence of payment shock and other poorly understood risks confronting borrowers (Government Accountability Office 2006). Years before high levels of subprime foreclosures precipitated the financial crisis, the housing policy community was well aware of the foreclosure problem posed by rising levels of subprime lending and the potential for predatory lending associated with that market. The absence of federal regulation led a number of cities and states to increase oversight of mortgage lending practices in 2001 and 2002. New York joined North Carolina, Georgia, and California to pass regulations that addressed problems of fraud and deception in the subprime market. Efforts by the New York City Council, ultimately blocked by Mayor Bloomberg, would have exceeded thresholds established by the state of New York. The Bond Market Association—which represented major investment banks including Lehman Brothers, Goldman, and Citigroup—argued that the proposed restrictions would ultimately limit the availability of mortgages for subprime borrowers (Hevesi 2002). Some of the largest subprime lenders were the subject of legal action for mortgage lending practices. Before the financial crisis, Ameriquest Mortgage paid $325 million to remedy problems with lending practices investigated by attorneys general in thirty states (New York Times 2006). Given widespread knowledge of potential and actual fraud and predatory lending activity dating from 2000, the Fed has been criticized for the slow implementation of subprime regulation. Proposals from the Obama administration to create a new consumer protection regulator noted important lapses by the Fed and other bank regulators in the oversight and regulation of new mortgage products. Mortgage origination was supervised by a sprawling and disorganized network of state licensing agencies, various bank regulators, and the Federal Trade Commission. There was no regulator with a specific charge to monitor innovations in alternative mortgage products; this mission was embedded with other competing priorities. The Treasury white paper outlining the consolidation plan highlights the com-

Subprime Lending and the Mission of Consumer Protection

35

bination of fragmented authority and fundamental concern with bank safety and soundness that reduced incentives for and the capacity of individual bank regulators to curb abusive lending practices (Treasury 2009). Considering the way these structural and mission-based obstacles to regulation are coupled in practice with friendly industry ties (highlighted by Moskowitz above), it is not surprising that regulators neglected to adequately oversee the subprime mortgage market.

Regulation of Mortgage Lending After 2006

The regulatory choices made by the Fed attracted considerable criticism from elected officials—particularly Sen. Christopher Dodd (D-CT)— but only after the spike in foreclosures attracted public attention in the spring of 2007. In a Senate hearing on the mortgage market, Dodd described a “chronology of neglect”; regulators, particularly at the Fed, were made aware of problems in the subprime market by 2004 but took no steps over the next three years to avert a foreclosure crisis (US Senate 2007). Under pressure from elected officials to respond to the unfolding credit crisis, the Fed proposed several changes to regulation and supervision to police lending practices. Although early supervisory subprime lending guidelines jointly adopted by the federal bank regulators cautioned against predatory behavior by lenders, specific consumer protection principles were not added to the guidance until July 2007 (see Office of the Comptroller of the Currency et al. 2001 for the early guidance, and Office of the Comptroller of the Currency et al. 2007 for the updated rules). Chairman Bernanke highlighted new disclosure and supervisory guidance—and expanded HOEPA authority—as part of a broader effort to coordinate more aggressive action across multiple regulators, including the Federal Trade Commission (Bernanke 2007b). The Fed and other federal regulators endorsed more restraints on mortgage origination during the crisis, but this action largely followed, rather than initiated, a reduction in subprime lending activity. The Fed modified high-priced mortgage regulation in July 2008 with the particular objective of applying uniform standards to mortgage lenders, whether the lender is a traditional depository institution or an unconventional lender. The Fed highlighted four major changes to existing regulation implemented in 2008: prohibiting loans that do not evaluate the ability of the borrower to repay the loan, requiring creditors to document income, banning prepayment penalties for loans with variable or adjustable payments, and requiring escrow accounts for high-priced mortgage loans

36

The Fed and the Credit Crisis

(Federal Reserve System 2008a). But even as the Fed outlined the new rules, state banking supervisors balked at decisions by the Fed to exempt from HOEPA scrutiny home equity lines of credit or reverse mortgages— steps the Fed took to narrow the costs of compliance for regulated banks and thrifts (Conference of State Bank Supervisors et al. 2008).

Why Didn’t the Fed Do More?

Technical innovation in the assessment of credit risk and a variety of new lending products opened up the possibility of homeownership for a wide class of borrowers. The Fed could have employed either direct regulation or moral suasion to tighten lending standards employed by banks and restrict access to credit. The Fed does influence the types and forms of credit that banks extend as it carries out the function of bank supervision. In concert with the other federal banking regulators, the Fed develops guidance for the way that particular types of loans and securities are treated in calculating the amount of capital a bank must maintain (see Chapter 4 for a detailed treatment of capital requirements). This guidance can create incentives for banks to expand or reduce particular forms of lending. Taking on the problem more directly, the Fed could also have investigated fraud and abuse in particular institutions. Fed leadership was skeptical about the ability of Fed bank examiners to uncover and remedy problems of consumer fraud. In an interview defending Fed supervisory practices before the crisis, former Fed chair Alan Greenspan concluded, “A large enough share of these cases are fraud, and those are areas that I don’t think accountants are best able to handle” (Andrews 2007). Contrary to Greenspan’s views, bank examiners—at least in some agencies—were well aware of the many risks posed by the subprime loans and new mortgage products. In a prescient 2005 review of subprime innovations, OCC Chief Counsel Julie Williams described how the failure of consumer protections could cascade into a failure of financial institutions: “credit risks and consumer risks presented by today’s non-traditional mortgage products have converged” (Williams 2005). Despite these warnings, explaining why the Fed chose to permit risky innovations in loan origination practices is not difficult, and it is naïve to expect that the Fed will adequately police the forms and terms of mortgages in the future. If the Fed had chosen to use tools like capital requirements and bank examination to limit subprime mortgage originations, the agency would have been squarely obstructing bipartisan efforts to produce gains in minority and low-income homeownership. This was especially

Subprime Lending and the Mission of Consumer Protection

37

the case because, through innovations in securitization, a huge amount of capital was available for mortgage lending, for subprime lending in particular. The percentage of subprime loans that were sold and packaged as mortgage-backed securities increased from about 30 percent in 1995 to over 80 percent in 2006 (Inside Mortgage Finance 2011). The reluctance of Fed leadership to aggressively regulate subprime mortgage originations is not surprising given the Fed’s historical experience with selective credit controls—from mortgage lending restraints attempted under Regulation X, to implementation of disclosure requirements, to enforcement of HOEPA authority, to the treatment of home equity loans under recent Regulation Z modifications. In each case the Fed focused on compliance costs—and the related interests of regulated commercial banks—rather than the benefits of consumer protection. The result was slow, weak, and halfhearted implementation of regulation of the terms and forms of loans, which ultimately worked against fundamental Fed objectives related to financial stability. Even in the midst of a crisis and the clamor for reform, the Fed acted very slowly to respond to the problems in the subprime mortgage market. As we might expect, the Fed layered the consumer protection function implied by HOEPA onto existing bank supervisory actions, reinforcing the historical prejudice against consumer protection and in favor of limited compliance costs and requirements directed at regulated institutions. In stark contrast, in areas outside of consumer protection—in constructing extraordinary lending and credit facilities designed to aid distressed institutions—the Fed was highly creative and voluntarily so. The Fed acted without specific direction from Congress, for instance, to facilitate the sale of Bear Stearns and extension of credit to AIG. But, in the areas where policy choices would impose costs, rather than benefits, on a large number of regulated institutions, the Fed rejected novel approaches to regulation.

Consumer Protection After the Crisis

The Fed has recently undergone a subtle shift in public goals related to consumer protection. In the agency’s 2003 voluntary response to Government Performance and Results Act reporting requirements, the Fed included an uninspiring commitment to consumer protection: to “implement statutes designed to inform and protect consumers that reflect congressional intent while achieving the proper balance between consumer protection and industry costs” (Federal Reserve System 1998). The Fed substantially amended that objective after the subprime mortgage debacle. The 2008

38

The Fed and the Credit Crisis

report describes the Fed’s aspirations: “Be a leader in, and help shape the national dialogue on, consumer protection in financial services” (Federal Reserve System 2008b). Whether this new performance objective and the creation of the CFPB will result in more aggressive enforcement and implementation of consumer protection rules remains unclear. Because the CFPB was not authorized to issue rules prior to July 2011, the only hints about performance of the new regulator lie in the originating statute, Dodd-Frank. The creation of the CFPB segregates consumer protection functions within the Federal Reserve System but separate from monetary policy and bank supervisory actions directed by the Board of Governors. The list of agencies with functions moving to the new agency is impressive: the Fed, the OCC, the FDIC, the National Credit Union Administration (NCUA), HUD, the Office of Thrift Supervision (OTS), and the Federal Trade Commission (FTC). Dodd-Frank stipulates that CFPB funding shall be capped at 12 percent of Fed operating expenses. This allocation is large, approaching $500 million and swamping previous Board allocations to consumer protection and community affairs. But this funding also replaces regional Reserve Bank expenditures on consumer protection, and since the agency folds in consumer protection functions from a number of other regulators, the implications of the funding cap for performance are unclear. Further complicating assessment of the impact of the new regulator, members of Congress are considering stricter, lower limits on funding, and the agency is scheduled to take over rulemaking without the appointment of a director. The CFPB does have features that suggest a revitalized consumer protection function: long-term stable financing, autonomy from the Board of Governors and industry constituents of the Board, and broad discretion and functions. But other features of the new agency suggest this function will remain vulnerable and marginalized. Consumer protection compliance will remain separate from other bank supervision tasks, the agency will function without the imprimatur and prestige of the larger banking regulators, the consolidation of authority in a single agency will permit financial services lobbying efforts to focus on the new bureau, and the presidential appointment of the director will introduce opportunities for a new president to roll back consumer protection reforms. The marginalization of consumer protection from bank regulatory decisions is not new or idiosyncratic to the United States. Commenting on the impact of consumer groups on banking regulation in the European Union, Christopoulos and Quaglia concluded that “even when consumer organizations are consulted and temporarily included in the network, their input and influence is limited by their lack of economic resources, technical expertise, personnel.” (2009, 184). Reorganization does not confront

Subprime Lending and the Mission of Consumer Protection

39

this fundamental problem of consumer protection. Further, well-documented experiences of other social regulatory agencies—such as the Environmental Protection Agency and the Occupational Safety and Health Administration—suggest that concerted efforts by an unsympathetic White House can undermine and reverse progress toward initial agency goals or objectives (Harris and Milkis 1996). Historical experience suggests that any regulator will struggle to enforce fraud and abuse legislation, especially if, in the future, monetary or other policy considerations create incentives for banks to expand lending to consumers. Lending by banks amplifies business cycles. Banks often reduce lending standards as the economy grows. By extending credit to risky borrowers and demanding less or lower-quality collateral, banks increase the pace and volume of lending, feeding the economic boom. As long as economic performance accelerates, these risky lending practices are vindicated. But if the economy slows and loans do not perform, then lending standards contribute to the contraction. As economic conditions deteriorate, only the most creditworthy borrowers with high-quality collateral are able to get credit. In the immediate aftermath of a contraction, the preferences of all of the actors—the regulators, members of Congress, and prospective lenders—will align. Regulators want tighter lending standards to address the underlying cause of the crisis, members of Congress want to demonstrate that irresponsible lenders have been punished, and lenders are unwilling to extend credit to risky borrowers as asset prices fall and the economy deteriorates. As the demand for and supply of credit expands, however, the regulators will, as in the past, face increasing pressure to permit a gradual easing of lending standards to broaden access to capital. Banks that are under supervision of the Fed will, as in the past, be under pressure to compete with unconventional lenders, creating incentives for Fed supervisors to permit more risky lending practices and turn a blind eye to the erosion of lending standards. Monetary policy considerations may also lead the Fed to conclude that the pace and extent of bank lending needs to expand in order to prevent deflation, with the implication that banks need to be willing to extend credit to broader classes of borrowers. In one sense, closer scrutiny of mortgages draws attention from the broader problems posed by the pace of innovation and change in the financial services industry. If the Fed or other regulators had adequately policed mortgage originations, bank and nonbank lenders could (and would) instead find innovative ways to extend credit to risky borrowers in the form of securitized auto loans or credit cards or extend credit to

40

The Fed and the Credit Crisis

commercial property owners. Dodd-Frank and the new CFPB reflect the realization by elected officials that the Fed is not well-suited, in terms of mission or capacity, to police mortgage origination. But it is not clear that effective regulation of mortgage origination alone would have addressed the problem of financial market disruption revealed by the 2008 crisis. Financial innovation, broadly defined, undermined the stability of the financial system even as Fed actors embraced and encouraged the rapid pace of that innovation. Subprime mortgages were just one example of a “constructive innovation” that ultimately undermined financial stability in ways that were unanticipated and poorly understood by Fed leadership and other regulators. In order to learn from the credit crisis and prevent a future financial market shock, the Fed will be forced to confront a broader set of challenges introduced by innovation, complexity, and change within the financial sector.

3 The Fed, Wall Street, and Housing Finance

Financial markets in the United States and abroad experienced

tremendous innovation and growth after 1980. Financial institutions expanded the range and complexity of instruments created and traded in global markets. Some of this innovation was triggered by statute as Congress relaxed restrictions on the range of business lines and products that regulated financial institutions could create and hold. Other innovations were technical: lending and investment instruments like collateralized debt obligations, credit default swaps, and auction rate securities created new opportunities for risk-taking and lending across the economy. Increasingly sophisticated financial engineering techniques permitted investment and commercial banks to issue a huge volume of new securities that appealed to a wide range of investors. Some of these innovations occurred directly in the mortgage market, linking together innovation and housing policy goals. For instance, by 2006 over 80 percent of subprime loans were securitized in some form—bundled and packaged together to be sold to investors worldwide (Inside Mortgage Finance 2011). These “private-label” mortgage-backed securities (MBS) were developed, issued, and marketed by private financial institutions—a combination of Wall Street investment banks and large mortgage lenders. Private MBS are distinct from “agency” issues—the safer, traditional mortgage-backed securities issued by government agencies and enterprises (Ginnie Mae, Fannie Mae, and Freddie Mac). The private subprime MBS market collapsed— spectacularly and entirely—falling from over $450 billion in annual issues in 2005 to zero by 2010. As technology and statutory change fueled innovation in housing finance in the 1990s and 2000s, federal and state agencies faced increas-

41

42

The Fed and the Credit Crisis

ingly difficult choices about how to regulate new types of securities and oversee the growing secondary market. Just as was the case with mortgage origination, the authority to monitor firms that create, market, and purchase complex mortgage-backed securities spanned several agencies: the Fed, the SEC, the OCC, and various state bank and insurance regulators. With the exception of the Fed, these various regulators had no mission or charge to maintain financial market stability. Aside from policing investor fraud and monitoring safety and soundness of individual firms, there were few tools or incentives to regulate investment and lending practices that jeopardized the overall stability of the financial system. In one sense the challenge was technical: public sector regulators and private sector rating agencies could not adapt existing tools to accurately measure the riskiness of the new securities. This problem is not new or unforeseen. For at least seventy years, economists have recognized that financial innovation will subvert narrowly tailored regulations that define permissible forms of lending and borrowing (see, for instance, Minsky 1980). Entrepreneurs in the financial services sector have powerful incentives to create novel instruments that appeal to investors; the potential financial returns for these innovations are enormous. Public sector experts, operating with fewer resources and without similar immediate financial incentives to adapt or update regulations, are at a disadvantage. The budget, expertise, and technology of the regulators cannot keep pace with private sector innovation. In addition to the challenges posed by limited resources and expertise, regulators are also vulnerable to well-known tendencies to underestimate the risks of new technology. As we now know, rating agencies, federal and state regulators, institutional and small investors, and even the issuers of the securities that fueled the financial crisis had poor information about the potential risks associated with many of the new instruments. The Fed, like nearly every other actor in Washington and on Wall Street, chose to ignore the risks associated with subprime MBS, particularly the risks that the expanding market created for core, regulated depository institutions. This represents a particular case of a very general problem: the normalization of deviance. In a compelling analysis of the Challenger launch decision in 1986, Vaughn (1996) describes how decisionmakers within NASA accepted increasingly high levels of risk associated with particular space shuttle technology. Normalization of deviance describes the idea that organizational routine conspires to limit responses to small failures or warnings. The result is familiar: a surprising and catastrophic failure preceded by “long incubation periods punctuated by signals of potential danger.” Vaughn reviews the variety

The Fed, Wall Street, and Housing Finance

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of organizational and social contexts in which this dynamic is observed and encourages a deep-seated skepticism for simple technical or organizational solutions to the problem. Work involves mistakes, accidents happen, and risky technology will be associated with unexpected catastrophic failures. Consistent with this insight, the scale of the market failure associated with private MBS was a shock to almost all of the major market participants and Fed leadership. Along with the technical challenges and organizational bias associated with uncovering risk, the Fed had a number of positive incentives to encourage the growth of private MBS. Although the most basic explanation for the emergence of private MBS was an action by Congress— the Secondary Mortgage Market Enhancement Act of 1984—decisions by the Fed and other bank regulators led to remarkable growth in privately issued MBS starting in 1999. Several related policy goals led decisionmakers in the Fed to actively embrace the brisk pace of private mortgage securitization: federal efforts to increase levels of homeownership (especially among minority homeowners), deliberate cultivation of a private market for securitized mortgages to compete with the housing-related government-sponsored enterprises (GSEs), and a long-standing effort to better insulate the construction and homebuilding industries from monetary policy restraint. These incentives to support the private MBS market are explored later in this chapter. After reviewing the growth of mortgage securitization in the 1970s and the Fed’s policy responses to this innovation, I return to the implications of housing finance reform for the Fed’s mission and performance. The financial crisis linked the Fed to the housing market in several ways. The Fed directly purchased private MBS from distressed firms, permitted private MBS to be used as collateral for emergency loans, and purchased new agency MBS to encourage lending during the crisis. Each of these steps moved the Fed closer to a new housing finance mission: directing capital specifically to the mortgage market. On top of this new role, Fed leadership will face complex regulatory decisions as the private MBS market is revived. Housing finance reform proposals that respond to the crisis—specifically the 2011 joint Treasury/HUD report—envision a wholly private secondary market, largely reconstituting the toxic mix of actors, incentives, and distortions that led to the rapid expansion and fullblown collapse of housing finance in 2008 (see Treasury, Department of, and the US Department of Housing and Urban Development 2011). How did the private MBS market grow, collapse, and become the centerpiece of housing finance reform proposals? What was the role of the Fed in the growth of this market? What will the role of the Fed be in the new second-

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The Fed and the Credit Crisis

ary mortgage market, and with what implications for the Fed’s core mission and expertise?

Housing Finance, Fannie Mae, and Freddie Mac

The federal government pioneered and nurtured the securitization of home mortgages—initially with a public-private partnership that originated in a 1968 housing act. Hoffmann and Cassell (2009b) describe how members of Congress relied on the housing finance expertise in the Federal Home Loan Banks, HUD, the Fed, and other agencies to create a secondary market for home mortgages in the early 1970s. HUD first experimented with a simple or “pass-through” security and envisioned more complex “bondlike” MBS to draw capital to the housing sector. In the initial federal program, Ginnie Mae guaranteed mortgage-backed securities issued by banks. The mortgages that backed up the securities were issued by the banks and guaranteed or insured by the federal government (by the VA, the Department of Agriculture, or the FHA). Unlike the contemporary housing GSEs (Fannie Mae and Freddie Mac), Ginnie Mae did not purchase mortgages or issue securities; the agency only guaranteed the principal and interest payments on qualifying securities. Paul Volcker, an official at the US Treasury when Ginnie Mae initiated the MBS program, was skeptical about the usefulness of mortgage-backed securities to attract capital to the conventional mortgage market and resisted the rapid expansion of MBS offerings (Volcker 1969). The two major housing GSEs, Fannie Mae and Freddie Mac, nevertheless sought authorization to securitize mortgages soon after Ginnie Mae initiated the practice. Freddie Mac, a subsidiary of the Federal Home Loan Banks, began securitizing mortgage debt in the 1970s, principally mortgages originated by thrifts. Fannie Mae was only given the statutory authority to securitize mortgage debt in 1980 (see Housing and Urban Development 1996). The annual volume of securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae is summarized in Figure 3.1. Throughout the 1980s Ginnie Mae dominated the market, but the housing GSEs grew rapidly after 2000. The housing GSEs accounted for about 50 percent of total outstanding agency MBS in 1986 but nearly 90 percent of the $3.5 trillion outstanding in 2005. The growth and vitality of the secondary mortgage market has been an important source of stability in the costs of capital for US homeowners. If banks are able to sell loans through securitization to a broad network of investors (ranging from individuals to pension funds), then the risks asso-

The Fed, Wall Street, and Housing Finance

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Figure 3.1 Combined Annual Issues of MBS by Fannie Mae, Freddie Mac, and Ginnie Mae 2,400

Billions of Dollars

2,000 1,600 1,200 800 400 0 1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Source: Inside Mortgage Finance 2011.

ciated with default or swings in interest rates are not concentrated in insured, regulated depository institutions. If banks have a network of buyers, then this steady flow of capital both lowers costs for homeowners and permits banks to continue to loan during period of stress in real estate markets. In economies where few loans are securitized—the Japanese financial sector, for instance—banks retain high levels of risk, and disruptions in home prices or interest rates can restrict bank lending activity for decades. The upside of this risk retention is that the effects of housing market disruptions don’t cascade from banks to the broader network of financial institutions (Nakagawa and Yasui 2009). The Fed is acutely aware of the link between capital for the mortgage market and homeownership rates. As suggested in Chapter 2, the Fed was under considerable pressure to accommodate housing policy goals in the late 1960s. Fed Chair William Martin faced scrutiny from members of Congress—notably Sen. William Proxmire (D-WI)—as annual housing starts dropped and FHA and VA mortgage activity stopped entirely in 1968. In Senate hearings related to findings of a 1969 Mortgage Interest Rate Commission, leadership of the National Association of Homebuilders, the National Association of Mutual Savings Banks, the Rural Housing Alliance, the National Housing Conference, the Mortgage Bankers Association of America, and dozens of other housing advocacy groups were critical of federal efforts to address the crisis—critical of the Treasury

46

The Fed and the Credit Crisis

for failing to act quickly on proposals for sale of MBS and, in most cases, critical of the Fed for failing to aggressively purchase existing agency issues from the Federal Home Loan Bank System. Most of the witnesses at the hearing advocated congressional action that would require the Fed to purchase agency MBS to support national housing goals (US Senate 1969). The Fed did recognize the need for basic reforms in the mortgage market; the policy problem was an inescapable function of US demographics. Children of the baby boom were at the stage of the life cycle where they saved little but had a large appetite for mortgage debt. The traditional US mortgage market model—financial institutions relying on deposits to fund mortgages—could not work as long as the supply of savings held in depository institutions remained low relative to the need for mortgage credit. The Fed prescribed several structural changes in the primary and secondary mortgage market to increase the flow of capital into the mortgage market for institutions outside of the traditional network of depository institutions. Fed leadership specifically envisioned bondlike instruments to attract investor capital to the mortgage market, but, like the Treasury and Paul Volcker, was opposed to Fannie Mae purchases of conventional mortgages as late as 1970 (US Senate 1970). In this sense the secondary market is a very contemporary innovation: in 1970 only 5 percent of outstanding mortgage debt was held or securitized by Ginnie Mae or the housing GSEs (Housing and Urban Development 1996). The remaining 95 percent was held on the balance sheets of lending institutions: banks and thrifts. By 2008, over 60 percent of outstanding mortgages were securitized—45 percent supported by agency issues and 15 percent by private securities.

Wall Street Joins the Party

There was a relatively steady annual production of about $400 billion in MBS from the housing GSEs throughout the 1990s, but a huge spike in MBS issues occurred after 1998. The surge in activity occurred both for the housing GSEs and new private issuers. A 1984 statute opened the door for large-scale production of private MBS; the statute exempted qualifying private MBS from state “blue sky” (antifraud) laws and relaxed other regulations that restricted the ability of banks to issue MBS. The OCC issued a series of “no objection” letters after 1985 that chipped away at Depression-era restrictions that limited banks’ ability to issue securities (Pittman 1989). These informal steps were challenged

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and reversed in federal court, but the underlying restriction that blocked the MBS transactions—the Glass-Steagall wall between investment and commercial banking—was formally abolished by Congress under the Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley). With the new statute, new technology, and high investor demand for MBS, banks began to tackle securitization of new and unfamiliar mortgage products like subprime and alt-A, as well as jumbo loans (loans that exceeded the maximum amount permitted for agency securitization). The growth of this private securitization was rapid, growing tenfold—to over $1 trillion—between 2000 and 2006. The annual volume of private issues is summarized in Figure 3.2. Industry analysts expected that the growth in private MBS reflected a “permanent change” in the secondary market as the pace of private sector innovation overwhelmed the less nimble government enterprises (England 2006). The private MBS industry linked together a fairly concentrated network of financial institutions: lenders that originated mortgages, other banks that issued MBS, other banks that underwrote MBS, and financial institutions that held the MBS. Each business—origination, issue, and underwriting—was highly profitable. As investors embraced the new securities, banks faced strong incentives to make loans available to broader and riskier categories of borrowers, reinforcing the link between securitization and the ownership society. The firms involved in the production of MBS—issuing and underwriting the securities—are now

Figure 3.2 Annual Issues of Private-Label MBS 1,400 1,200

Billions of Dollars

1,000 800 600 400 200 0 1990

1992

1994

1996

1998

Source: Inside Mortgage Finance 2011.

2000

2002

2004

2006

2008

2010

48

The Fed and the Credit Crisis

familiar names. In the peak production year for private MBS (2005), Bear Stearns, Lehman Brothers, and Countrywide were among the topfive issuers and underwriters—each underwrote about 10 percent of the total market, over $100 billion each—and Countrywide alone issued $187 billion in MBS (Inside Mortgage Finance 2011). In that year, subprime MBS accounted for nearly 40 percent of the total private volume, and alt-A (low-documentation) loans accounted for another 30 percent. Ironically, the housing GSEs were the largest consumers of private MBS. In 2007 Fannie Mae and Freddie Mac purchased a combined total of over $340 billion in private MBS, up from about $30 billion in 1999 (Inside Mortgage Finance 2011). The GSEs had two incentives to make these purchases, one related to the changing business practices in the mortgage market and a second related to federal housing goals (see Jaffee and Quigley 2010). The GSEs had a clear business incentive to expand private MBS purchases: both organizations needed to expand out of the conforming (prime) loan market as mortgage products were developed to meet the needs of unconventional borrowers. Some observers, like John C. Weicher, the federal housing commissioner under President George W. Bush, claim that the implicit guarantee of GSE debt encouraged the purchase of the new and risky private MBS: “The GSEs—because they were bigger, were required to hold less capital, and carried the implicit backing of the U.S. government—took the biggest risk and had the biggest fall” (Weicher 2008). In addition to purchasing private MBS, the GSEs also lowered underwriting standards. Alt-A loans accounted for about 10 percent of Fannie Mae’s loan guarantee business. These loans accounted for nearly 40 percent of the credit losses on its loan portfolio in late 2009 (Timiraos 2010). On top of the business incentive to purchase private subprime MBS, the GSEs had a statutory incentive: a congressional mandate to support housing finance in moderate- and low-income neighborhoods, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. Under the 1992 act, HUD set specific targets for the proportion of GSE financing activity that should be directed to needy communities. At a 2006 Fed-sponsored conference on innovations in real estate markets, John Weicher was highly critical of the GSEs’ failure to support the goal of broadening homeownership: “While home mortgages constitute most of the GSEs’ business, they do a poor job of serving first-time homebuyers, and a particularly poor job for first-time minority homebuyers” (Weicher 2006). The clear implication—articulated by Weicher only months after he stepped down as federal housing commissioner—is that

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the GSEs should purchase securities that back the nonconforming loans of low-income and minority home buyers. GSE executives, at least in Freddie Mac, did not appreciate the scope of the risk and the severity of the crisis in the subprime MBS market. As late as the spring of 2008, Freddie Mac published positive outlooks for the financial performance of subprime MBS held in its portfolio. A Freddie Mac report outlined the prospective (and limited) risk associated with the subprime portfolio: nearly all of the subprime MBS in the Freddie Mac portfolio was rated AAA, and much was insured (“wrapped”) by one of the major bond insurance companies (see Freddie Mac 2008). This development also appeared to surprise Fed leadership. The main policymaking arm of the Fed, the Federal Open Market Committee (FOMC), discussed the growth of and potential problems in the subprime MBS market as early as 2005. Fed staff directly assured the FOMC that the GSEs did not hold private MBS in their portfolios (Financial Crisis Inquiry Commission 2011, 172). But, in fact, by the end of 2005 the housing GSEs had acquired a total of more than $300 billion in private MBS, which likely included substantial investments in subprime mortgages (Inside Mortgage Finance 2011). The combination of statutory and business incentives, coupled with a poor understanding of the risk associated with subprime MBS, led to the rapid expansion of subprime MBS in the portfolios of the housing GSEs. With investors, including housing GSEs, clamoring for more product, investment banks and mortgage brokers had strong incentives to generate more and riskier subprime loans and subprime MBS.

Why Would the Fed Encourage Private MBS?

The Fed also had an important if indirect role in facilitating the private MBS market. Several distinct objectives led the Fed to embrace the rapid growth of private MBS after 1999. First, consistent with Fed support for the “constructive innovation” of subprime lending, private MBS served the needs of subprime lenders. Housing GSE and agency MBS was restricted to conventional, conforming loans. If the mortgage industry was to serve first-time, low-income and minority borrowers, then securitization activity in the private sector would have to include new loan products. This was not the only reason the Fed supported the market. Enthusiasm about the expanding private MBS market extended beyond the prospects for achieving homeownership goals in two specific ways.

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First, private MBS had the potential to extricate the government from the business of issuing (and implicitly guaranteeing) MBS. Second, private MBS could better insulate the volatile homebuilding and construction industries from monetary restraint. Fed leadership appealed to both of these factors as the market expanded. Ideology: Private Securitization and the Role of the Housing GSEs

The success of private MBS undermined the rationale for the housing GSEs. Before 1997, securitization of mortgages was largely carried out through the housing GSEs and Ginnie Mae. Ginnie Mae, Fannie Mae, and Freddie Mac each accounted for about 30 percent of total MBS, and private MBS accounted for the remaining 10 percent of the market. The total volume of mortgage-backed securities grew dramatically after 1999, expanding from less than $2.5 trillion outstanding in 1998 to over $5 trillion outstanding in 2005. Fed Chairman Greenspan suggested that the robust and growing secondary market indicated an opportunity to restrain the growth of the housing GSEs and reduce the role for government in the mortgage market. He specifically advocated stronger statutory restraints on the growth of Fannie Mae and Freddie Mac (Greenspan 2005b). Greenspan argued that Fannie Mae and Freddie Mac should only purchase and securitize mortgages that were so unattractive that private offerings would fail. The expanding private MBS market permitted, for instance, a much higher volume of securitization for adjustable rate mortgages. In 2005 private MBS backed by adjustable rate mortgages accounted for nearly 40 percent of all MBS originated in the United States. Ironically, Chairman Greenspan anticipated that the growth of private MBS would stabilize financial markets—transferring “risk from highly leveraged originators of credit—especially banks and thrifts—to less-leveraged insurance companies and pension and mutual funds, among other investors” (Greenspan 2005b). This reflects the historic justification for public (GSE) mortgage securitization: to draw in mortgage market capital from life insurance companies and pension funds and to fund mortgage lending by cashstrapped thrifts and banks. As long as the private MBS market continued to expand and tap this capital, the government could gradually withdraw from the secondary mortgage market, reducing the potential liabilities associated with the implicit federal guarantee of Fannie and Freddie obligations. Consistent with this expectation, Fannie Mae and Freddie Mac mortgage and asset security issues contracted from a peak of $2.1

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trillion in 2003 to $879 billion in 2005. Private securitization activity was actually higher than agency activity in 2005 and 2006. This outcome was exactly the result Greenspan envisioned: an expanding private MBS market eclipsing and eventually replacing entirely the activity of federally sponsored enterprise. Consistent with this goal, Fed regulatory and supervisory choices did not stand in the way of the growth of the market for private MBS. Independence: Private MBS and Monetary Policy

The mission of the Fed makes no explicit mention of mortgage or housing finance. Specifically, the plain statutory charge of the Fed is agnostic about the flow of capital to specific economic sectors: The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate longterm interest rates. (12 U.S.C. 225a)

But, as suggested in Chapter 2, monetary policy choices were tied to failures to meet national housing goals in several periods of credit restraint. Historically the housing market has absorbed much of the shock of monetary restraint: building and construction activity and related residential mortgage lending activity decline more rapidly than other sectors as the Fed increases the federal funds rate. This link between monetary policy restraint and housing policy setbacks has always been problematic for the Fed. During the housing finance crisis of the late 1960s, Sen. William Proxmire spelled out the implications for Fed leadership: “Housing constitutes 3 or 4 percent of the gross national product, but suffered 70 percent of the impact of monetary policy. This is so clearly unfair. . . . The outlook for housing is grim indeed” (US Senate 1969, 70). The particularly severe series of shocks to housing finance in 1969 and 1971 led the Fed to undertake an exhaustive study of policy options available to mitigate the impact of monetary policy choices on housing construction and finance. Although the Fed studies did not anticipate the fundamental role of mortgage-backed securities in stabilizing the flow of funds to housing, the debate over appropriate Fed responses highlighted the political pressure the Fed faced to support housing goals. Further, the staff discussion of Fed options highlighted the trade-offs or challenges that support for housing would produce.

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Less restraint on housing means more restraint on other sectors, with the inevitable result that other sectors also seek relief from credit restraint (see Gramley 1971). This concern over the impact of monetary policy on housing has not diminished over time. Remarks by Fed Chair Ben Bernanke in 2007 indicate that contemporary Fed leadership remain directly concerned with the link between monetary policy and housing. Bernanke described how the contemporary monetary policy transmission mechanism—the link between Fed policy choices and the real economy—was balanced across economic sectors and that “housing is no longer so central to monetary transmission” (Bernanke 2007c). The Fed did not need to take direct action to reduce the stress on housing and residential construction by, for instance, purchasing agency MBS. By enhancing credit flows from investors to lenders and homebuyers, private MBS cushioned the housing sector from monetary policy restraint, freeing the Fed from intervening directly to support the mortgage market during periods of general credit restraint. In this sense, the private MBS market solved a persistently challenging political problem for Fed leadership.

Problems in the Private MBS Market

The Fed obviously regarded the expanding private MBS market as a positive development. The 2007 collapse of the private MBS market suggests, of course, that enthusiastic Fed assessments of the long-term breadth and resilience of the market were radically overstated. A number of poor assumptions by private and public actors contributed to the severity of the credit crisis triggered by the collapse of private MBS. Consumers and investors underestimated the probability of a prolonged and rapid decline in housing prices. Public and private actors underestimated the vulnerability of highly rated MBS to a decline in housing prices. Public and private actors failed to anticipate the ripple effects of the plunge in the value of MBS—the deterioration of other asset-backed securities and related derivatives. The failure of the private MBS market is a consequence of business practices of the lenders that originated mortgages, the banks that issued MBS, and the rating agencies that evaluated the MBS. Three particular aspects of these practices have been implicated in the crisis: the incentives for mortgage lenders to relax underwriting standards, fraud and abuse in the subprime market, and the failure of credit rating agencies to adequately disclose risks associated with subprime MBS, in particular.

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Underwriting Standards

In one sense the availability of capital—the appetite of investors for MBS and the “wall of money” described by Morris (2008)—drove banks to increase the volume of loans, even if this jeopardized loan quality. Goodman et al. (2008) claim that the primary factors that explain the poor performance of 2006 private MBS were “unobserved” deterioration of lending standards. Observable features of loans certainly eroded: the average credit scores of borrowers fell and loan characteristics such as documentation and loan-to-value were inferior. But those factors alone don’t explain the unprecedented default activity of loans originated in 2006: as lenders pushed the envelope to underwrite more loans, the quality of borrowers declined. Much of this lending activity took place outside of the Fed’s regulatory jurisdiction. Some of the major subprime lenders—Countrywide and Washington Mutual—were supervised by the OTS, not the Fed. Similarly, the consumer lending activity of subprime lenders like Ameriquest would have been under the jurisdiction of the FTC, not the Fed, since many of these lenders were not depository institutions. As discussed in Chapter 2, the Fed had few incentives to seek broader regulatory authority to confront this problem. Fraud

The sale or issue of subprime MBS also involves several types of financial institutions, most of them outside the regulatory jurisdiction of the Fed. The top issuers of subprime MBS included several institutions that failed spectacularly as the credit crisis intensified: Countrywide, Washington Mutual, Ameriquest, Lehman Brothers, and Bear Stearns. Ameriquest had the largest market share among issuers of subprime MBS in 2003, 2004, and 2005—over $50 billion annually in 2004 and 2005. These securities sales—subprime MBS issues—would have come under regulatory scrutiny of the SEC. Similarly, investment banks that issued private MBS were outside of the Fed’s jurisdiction until 2008. The business of subprime lending drew attention to a number of problematic practices on Wall Street years before the crisis. For example, subprime lender First Alliance was investigated by the FTC in 2000 and later sued by homeowners and a number of state attorneys general for fraudulent loan practices. The firm maintained close business ties with investment bank Lehman Brothers, and that link attracted the attention of regulators before the crisis unfolded. Lehman underwrote $400 million in MBS for First Alliance, and Lehman was found to be culpable for 10 percent of a

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$50.9 million damage award in a 2003 lawsuit. In a class action verdict, a federal jury found that Lehman Brothers “substantially assisted” First Alliance in defrauding over 7,500 homeowners (Henriques 2003). The overall scope of fraud in the industry remains unclear. The SEC and the Federal Bureau of Investigation began an investigation of firms across the spectrum of the subprime industry in early 2008. A Reuters wire story (Vicini 2008) reported that the SEC opened more than three dozen civil investigations into subprime securitization practices. To date, none of the criminal cases have been successfully prosecuted, but the United States has reached settlements in several related civil cases. Investment banking giant Goldman Sachs, for instance, paid $550 million to the SEC to settle claims related to subprime MBS that were repackaged in collateralized debt obligations and sold to investors. JP Morgan paid $154 million to settle a similar civil claim. To settle civil claims related to MBS fraud, Bank of America agreed to pay more than $8 billion to twenty-two investors, including the New York Fed. Bank of America inherited much of this liability in its 2008 acquisition of Countrywide, a large issuer of subprime MBS. Credit Rating Agencies

A distinctive feature of the failure of the market for subprime MBS is the direct role of the credit rating agencies, private firms that have an important quasi-public role in bank supervision and regulation. The rating agencies have been the subject of wide-ranging criticisms after the failure of the market for private MBS. Many of the subprime MBS were rated at levels consistent with high-quality corporate and municipal debt: AAA or the equivalent. The rating agencies are somewhat unique business entities since they are private firms but also directly implicated in the public regulation of financial institutions. Regulated financial institutions are subject to specific capital requirements. The primary requirements in place before the crisis tied the level of required capital to the quality of assets held by the bank. Ratings assigned by credit agencies were the primary way that regulators evaluated the quality of bank assets. (The origins and operation of capital requirements and recent efforts to reduce the role of rating agencies are described in detail in Chapter 4.) Highly rated debt implies a AAA rating from one of a handful of SEC-designated “nationally recognized statistical ratings organizations.” In practice, three rating agencies account for nearly 95 percent of all ratings activity: Standard and Poor ’s, Moody’s Corporation, and Fitch Ratings (Inside Mortgage Finance 2011). For

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two important reasons, issuers of private MBS needed the imprimatur of these ratings. First, under the 1984 rules adopted by Congress to encourage the private secondary market, a security that could be marketed and receive preferential regulatory treatment as an MBS had to receive a high quality rating from one of the major rating agencies (see Pittman 1989). Second, issuers of MBS rely on regulated institutions ranging from banks to insurance companies and pension funds to purchase and hold those securities. The issuers need a high rating in order to market and place the securities with these regulated institutions. Issuing banks had powerful incentives to produce MBS that had features that would lead to a AAA rating. At the direction of or in coordination with the large rating agencies, investment banks that issue MBS used one or more credit enhancement strategies to secure a high rating. The issuing bank typically placed the mortgages to be securitized in a special-purpose vehicle (SPV)—a legally separate (“bankruptcy remote”) entity distinct from the issuing bank. The entire pool of mortgages was tranched, meaning that some debt backed by the pool is high priority or “senior” and other debt is subordinate (typically labeled the “mezzanine” tranche). The senior debt holders have a first priority on principal and interest income; subordinate debt holders face more risk. The issuing bank may also issue securities that are priced below the aggregate level of mortgages backing the securities (overcollateralize) or lower the yield on the issued security to create a reserve in the event of defaults (an excess yield spread). The result is that a high proportion—75 percent or more—of a bundle of low-quality subprime mortgages can be converted into AAA MBS. Despite the credit enhancements and AAA ratings, subprime MBS— particularly MBS constructed from loans issued in 2006—performed poorly. Many of the securities declined precipitously in value, and the rating agencies downgraded much of the subprime MBS to below investment grade as the crisis intensified in 2007 and 2008. Nearly 75 percent of MBS rated as AAA by Moody’s, for instance, was downgraded to junk status by 2010 (Financial Crisis Inquiry Commission 2011). Rom (2009) attributes this failure to accurately assess risk to three factors: the huge volume of new securities the rating agencies were asked to evaluate, the novelty and complexity of the new securities, and the powerful incentives to deliver positive ratings to large investment bank clients. The business model remains a troubling incentive problem. Investment bank clients can move business to another firm if a rating agency fails to deliver a AAA rating. Recognizing the failure of the rating agencies to accurately measure risk, Congress included a wide-ranging mandate in Dodd-Frank to

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eliminate the role of rating agencies in the evaluation of asset quality. Overall, the failure of the subprime and broader private MBS market implicates a number of actors: lenders, investment banks, rating agencies, and consumer protection regulators, as well as the bank regulators. The failure of the private MBS market underscores the uncertainties associated with financial innovation and the challenges of sustaining regulatory attention and expertise as markets for new products expand.

The Housing Finance Mission of the Contemporary Fed

The Fed was instrumental in supporting the secondary mortgage market after the rapid and catastrophic contraction in private securitization. Private MBS issued in 2008 totaled just over $50 billion, down from over $1.1 trillion in 2005 and 2006 (Inside Mortgage Finance 2011). Without some corresponding increase in capital from other sources, prospective homebuyers would face increasing interest rates, magnifying the slump in housing prices that triggered the crisis. One critical step taken by the Fed to respond to the urgent disruption in credit markets was a substantial purchase of MBS. The Fed directly purchased agency MBS (prime, conforming loans securitized by Fannie Mae and Freddie Mac) as part of the massive quantitative easing program undertaken to stimulate the economy. In addition to the MBS purchases, the Fed purchased nearly $100 billion of agency debt, so transactions related to the housing GSEs account for roughly one-half of the total market intervention undertaken by the Fed from July 2008 to July 2009 (Federal Reserve System 2009c). These actions, combined with purchases of long-term Treasury securities, worked to reduce mortgage interest rates to historic lows in the spring of 2009 despite the collapse of the private secondary market. As a result of the direct purchases alone, the Fed acquired over $1.1 trillion in MBS by May 2010, one-sixth of the total outstanding agency MBS in US secondary markets. The Fed reduced this commitment only marginally in 2011, holding over $900 billion in MBS in July of that year. The crisis tied the Fed to housing finance in a second and distinct way. In addition to the direct purchases of agency MBS, the Fed acquired private and agency MBS in the Maiden Lane transactions—the financial transactions that facilitated the Bear Stearns sale and the bailout of AIG in 2008 (see Chapter 6 for details about Maiden Lane). Each of the Maiden Lane transactions involved the transfer of private MBS to the Fed. The Maiden Lane portfolios collectively held hundreds of private MBS valued

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in the range of $25 billion. The Fed also created two lending facilities (the Term Securities Lending Facility [TSLF] and the Term Asset-Backed Securities Lending Facility [TALF]) that would accept private MBS as collateral. The mix and scope of Fed auction and lending facilities are discussed in detail in Chapter 6, and the TSLF/TALF transactions only account for a small proportion of Fed lending and credit activity. The lending facilities were nevertheless important indicators of the Fed’s willingness to provide funds to institutions that held private MBS. The federal government took other steps to support the secondary market and rebuild the private MBS market, using both the housing GSEs and the Fed. The housing GSEs were placed in conservatorship in September 2008—wiping out shareholders and placing the government in the position to meet the financial obligations to Fannie and Freddie bondholders. Despite this dramatic step, the housing GSEs were permitted to continue to issue MBS. The housing GSE regulator relaxed portfolio and loan limits to support agency purchases in the jumbo mortgage market, and the two housing GSEs issued over $1.1 trillion in MBS in 2008 and $1.7 trillion in 2009 (Inside Mortgage Finance 2011). The crisis response highlighted the Fed’s role as the ultimate backstop for housing finance instruments. As the private MBS market collapsed, Fed purchases lowered the cost of and supplied capital to the secondary market, permitting securitization of mortgages to continue thru Fannie Mae and Freddie Mac. The Maiden Lane transactions demonstrated that the Fed could absorb or warehouse distressed private assets during periods of credit market disruption. In addition, advances made under the extraordinary lending programs demonstrated that the Fed would lend against distressed private assets as well. The crisis made it clear that the Fed is the ultimate guarantor for housing finance instruments, whether public or private. Proposals for reform of housing finance only indirectly confront this fact. The Fed is implicated in efforts to reform the secondary market—from vague references to the Fed in the joint Treasury/HUD report to specific references to the Fed’s ability to serve as a buyer of last resort (for instance, see Pozen 2011). It remains unclear if there will be an explicit role for the Fed as lender/buyer of last resort. If there is an explicit role, then the Fed’s statutory mandate would require revision to support economic growth, price stability, and flow of capital to housing—a new mission for the Fed. The Fed has been trying to avoid this exact role for forty years, ever since the Fed’s actions were tied to the failure to reach national housing goals in 1969. If there is no explicit housing finance mission, there is little doubt that the Fed would stand in as a backstop if something like the 2008 crisis were to be experienced again. An implicit

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federal backing for MBS would be present in the form of Fed purchases of MBS or loans to firms that hold MBS. If the lesson of the financial crisis is that the Fed can take on unlimited amounts of MBS in the event of a market failure, then participants obviously have no incentive to avoid risky loans—amplifying the problems of moral hazard and the perverse incentives that the 2008 crisis revealed.

The Long-Term Challenge: Reforming Housing Finance

One set of long-term responses to the crisis—housing finance reform— implicates the Fed, both directly and indirectly, and adds to the challenges of expertise and mission clarity implied by the crisis. The actions by the Fed to support the housing market suggest that, in addition to questions about the Fed’s role as buyer of last resort, questions are unresolved about the role the Fed will take in supervision and oversight of a reconstituted private MBS market. The 2011 joint Treasury/HUD report framing the options for housing finance reform proposes a wholly private secondary market for residential MBS (see Treasury, Department of, and the US Department of Housing and Urban Development 2011). Two particular features of the market suggest that this approach will be challenging: the scale of the secondary market and persistent problems in the identification and management of risk. The US mortgage market—measured as total outstanding loans—is $11 trillion, by far the largest in the world. Annual securitization rates— capital provided in the market as a proportion of total loans originated— ranged from 60 to 80 percent in the years leading up to the crisis. In a typical year, more than $2 trillion in MBS were issued annually to support more than $3 trillion in mortgage originations. In 2006, private issues accounted for about half of the MBS market: $1 trillion. Private issues fell to absolute zero in 2008. If Fannie and Freddie are eliminated, as the joint report prescribes, then private securitization will need to return to double the volume observed in 2006. (It could be the case that the high level of mortgage origination activity observed in 2006 reflected an unusual level of refinancing, so perhaps the volume of lending activity needed to support purchases will be somewhat lower, but nevertheless quite large.) Rom (2009) highlighted the particular challenges that the sheer volume of lending activity and securitization activity—$1 trillion in private securitization in 2005 and 2006—created for regulators, issuers, and investors. If private MBS are to be used as the exclusive conduit for capital to the mortgage market, then the staffs and technical expertise of rating agencies

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and government supervisors will need to be expanded substantially. As the Fed takes on the shared role of supervising the largest institutions in the financial sector—a new role fashioned for the Fed under Dodd-Frank— the Fed would need to acquire staff and expertise to supervise the investment banks, bank holding companies, and depository institutions that issue and underwrite the new private MBS. The absence of a single regulator responsible for policing the MBS market complicated efforts to hold agencies accountable for the failure of the market in 2007. The new Financial Stability Oversight Council formally ties together each of the regulators with a hand in the oversight of mortgage securitization, but the purpose of that new entity is to stabilize markets, not to repair housing finance. Without a similar formal step to coordinate oversight of the private MBS market, the volume of securitization activity will likely again overwhelm regulators and tax the Fed in particular as it takes on oversight of the largest investment banking firms. Identifying and Measuring Risk

Critical features of the market that led to the 2008 crisis remain in place today. Many business practices (originate-to-distribute business models and executive compensation schemes), technology (pricing and risk management tools), and incentives have not changed. Dodd-Frank does include provisions to eliminate dependence on rating agencies to assess credit quality, and mandates further that banks securitizing risky loans retain at least 5 percent of the credit risk associated with the securities. Other features of the market will persist: huge financial incentives to sell loans, huge financial incentives to sell securities, weak scrutiny of mortgage underwriting (especially outside of the traditional depository institutions), and Capitol Hill resistance to consumer protection, vigorous oversight, and higher capitalization requirements. All of these factors imply that the private MBS market will ultimately generate risky securities. Fannie Mae and Freddie Mac made it easy to evaluate the credit quality of MBS; the government stood behind agency issues as an implicit guarantor. The private MBS market will be both complex and expensive. Securitization has to occur to avoid concentrating risk and fallout from housing market shocks in originating banks. Without securitization there will not be enough capital to support home purchases. But experience with the private MBS market in 2008 leads to the inevitable conclusion that this market will be extremely risky. Fed leadership offered prescriptions for rehabilitation of the private MBS market as the credit crisis was unfolding, mainly an infrastructure

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to provide more loan details for the mortgages that make up securities to be rated by the rating agencies and a template for construction of securities that are comparable across issuers (Kroszner 2008a). There are more robust regulatory alternatives. Following the example of Canada, US regulators could restrict securitization to prime mortgages, foreclosing the production of risky private MBS. After the crisis, securitization has become more burdensome and the private MBS market is small and expensive—with rating agencies demanding more collateral, higher yield spreads, and other credit enhancements (see England 2010 for a summary of industry efforts and setbacks to revive the private MBS market). As the market expands, how will the Fed augment bank supervision to ensure, through capital requirements or liquidity requirements, that banks limit exposure to private MBS risks?

Policy Change and Learning at the Fed

As Fed leaders and other bank supervisors contemplate regulation of the secondary mortgage market, the same incentives that led Fed leadership to encourage private securitization will be at work to discourage strict oversight and regulation as the market for mortgage-backed securities recovers. To supervise the diverse mix of depository institutions that operate in the US financial sector, the Fed relies on a network of expertise cultivated across the various regional Reserve Banks (see Khademian 1996, 69–71). Fed leadership draws on that technical and judgmental expertise to evaluate the impact of innovations in financial instruments and practices. In the case of securitization, regional bank supervisory personnel had few reasons to anticipate that newfound sources of liquidity would jeopardize bank soundness; the ability to tap into new sources of funds and sell risky mortgages typically improves the position of banks. What the bank supervisors did not anticipate was the way that the failure of unregulated or loosely regulated institutions, supervised by other regulators, would conspire to disrupt broader financial markets. Consistent with the dynamics of the normalization of deviance, the Fed—as well as other actors—underestimated the extent to which devaluation of MBS would spill over into other types of assets and trigger widespread financial market disruptions. Precedent existed for this type of disruption. Highly leveraged positions in MBS have undone sophisticated fund managers in the past. In the spring of 1994 a pair of hedge funds with ties to investment bank Kidder Peabody—Granite Capital and Granite Partners—were wiped out with total investor losses totaling over

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$600 million (Hansell 1994a). The losses were spread across a number of major institutional investors, including AIG. The crisis was contained since Kidder’s parent company, GE, elected to absorb a large loss and sell Kidder Peabody to Paine Webber. By leaving oversight of the private MBS market in the hands of the same regulators who failed to learn from the 1994 failure or preempt the 2008 crisis, it seems likely that many of the business practices that led to the recent crisis will be permitted to persist. This is not at all consistent with policy learning or disruption—the “paradigmatic” change described by Hall (1993)—and suggests that more pessimistic theories of policy inertia outlined by Pierson (2004) may better describe the Fed’s response to the crisis. The Fed has historically welcomed innovations that facilitate the flow of credit and capital across sectors and institutions. This is consistent with the Fed’s broader mission (“long run growth of the monetary and credit aggregates”), and it is unlikely that the Fed will or could effectively take on a role that implies stifling the reconstitution of the private MBS market. Since the mid-1970s the Fed has specifically encouraged financial innovation—in lending practices and secondary markets—to diversify the assets and liabilities of retail banks. Undertaken over a series of legislative initiatives, the Fed worked to reduce geographic (branching) restrictions on banks, relax ceilings on interest rates payable on checking accounts, eliminate state usury ceilings, and, in 1999, eliminate the GlassSteagall wall separating the business functions of investment banks and depository institutions. These systematic efforts to deregulate activities of financial institutions produced two distinct benefits for the Fed: satisfying demands for deregulation from member bank constituents and, consistent with the Fed’s mission, permitting movement of capital across sectors and institutions in the financial system. The Fed’s response to the credit crisis underscores the deep-seated reluctance to discourage or slow the proliferation of new financial instruments. When coupled with the gross mismatch in resources and incentives between the innovating private sector and the reacting public regulator, this ambivalence paralyzes rulemaking and reform.

4 Bank Supervision and the Basel Accords

With the benefit of hindsight, it was a fundamental illusion to believe that financial engineering can create complex instruments that are both tailored to the needs of individual investors and, at the same time, tradable in liquid markets. —Herve Hannoun, deputy general manager, Bank for International Settlements, 2008 Although subprime mortgage loans and private MBS are directly impli-

cated in the financial crisis, these financial instruments alone cannot explain the contagion of the crisis—the spread of the crisis across the entire financial sector. In fact, closer oversight of mortgage origination and mortgage securitization does not address one of the fundamental regulatory challenges that the crisis revealed: new risks introduced by new types of securities that are created, sold, and held by regulated and unregulated financial institutions. The creation and sale of new types of securities, specifically cash value and synthetic asset-backed security collateralized debt obligations (or ABS CDO), fueled the financial crisis. Subprime mortgages were originally securitized—pooled and tranched—as subprime MBS. Many of the lower-quality, higher-yield subprime MBS (subordinated, mezzanine, or junior tranche) were then pooled and “resecuritized” as ABS CDO or “two-layer” securities. Just as MBS rely on a stream of principal and interest income from a bundle of mortgages to pay returns to investors, ABS CDO rely on a stream of income from a bundle of MBS to pay returns to investors. ABS CDO may be constructed from MBS, other asset-backed securities, or even other ABS CDO (a product known as “CDO-squared”). Since ABS CDO are typically composed of higher-risk tranches of asset-backed securities, ABS CDO have a relatively high yield, making these securities a very popular product for a variety of investors. 63

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Using the same types of credit enhancements that improved the ratings of subprime MBS, issuing banks could take a pool of lower-quality subprime MBS and convert a large proportion of the value of these risky securities into AAA-rated ABS CDO. The development of ABS CDO is one of several innovations in what is known as structured finance—the creation and sale of investment products that have combinations of risk, maturity, and yield that meet the highly specific needs of particular types of investors. Even with the spectacular increase in subprime lending and equally large increase in subprime MBS, investor demand for ABS CDO outstripped the supply of underlying subprime mortgages. Responding to this demand, innovative bankers relied on the tools of structured finance to create even more exotic securities that packaged the income from a set of derivatives tied to the value of existing ABS CDO. The result was a “synthetic” ABS CDO. These securities permitted banks that did not own subprime mortgages or subprime MBS to create products for investors that had the same risk and yield profile as the popular subprime investments. As subprime borrowers became delinquent on loans originated in 2006 and 2007, the market price of subprime MBS began to plunge and the value of ABS CDO composed of subprime MBS also fell. But since financial institutions and investors also held subprime mortgage market derivatives—synthetic ABS CDO—that far exceeded the value of the underlying mortgages, the collapse of the rather narrow business of subprime mortgage lending triggered a broader shock to financial markets. How much synthetic ABS CDO and in what form was held in the portfolio of individual banks? What banks were responsible for making good on the derivatives contracts associated with these toxic assets? This uncertainty—and the toll of these distressed assets on the balance sheets of leading financial institutions—was at the core of the crisis of confidence that gripped the financial sector in 2008. The path of regulatory reform and adaptation that the United States takes will largely hinge on the way that the 2008 credit crisis is interpreted and understood. Elected officials and Fed leadership will need to make sense of the 2008 crisis by explaining the origins of the crisis and proposing solutions or reforms that demonstrate an effective response. If the major actors with a stake in reform can explain the crisis as largely a failure of the subprime mortgage market, then a combination of consumer protection reform (to prevent fraud and abuse in mortgage origination) and oversight of securitization (ensuring that issuers adequately inform investors of the risks associated with subprime debt) could demonstrate successful learning from and adaptation to the crisis. But if the crisis is understood as largely a function of the proliferation of ABS

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CDO and related structured finance innovations, then regulators are faced with a much more complex and broader public policy challenge: extensive new regulation of financial innovation within and outside of banks. Bank for International Settlements leader Herve Hannoun’s diagnosis of the “fundamental illusion” of structured finance is consistent with an emerging understanding of the crisis as something much broader than the fallout from a housing market bubble. ABS CDO and related subprime mortgage market derivatives are complex financial instruments that create a technical challenge for financial institutions and regulators. In hindsight, financial institutions and the rating agencies were clearly unable to accurately measure and price the risk associated with these instruments, and regulators did not have (and did not seek) a mechanism to validate the risk assessments of financial institutions. After reviewing the technical developments that led to the proliferation of ABS CDO and subprime mortgage market derivatives, I outline the way that the Fed confronted these innovations. The focus is on choices the Fed made in implementing an international supervisory framework for regulation of banks, the Basel Accord. The Fed worked in tandem with other regulators in the United States and abroad to produce a set of international standards for prudential regulation of financial institutions, culminating in a set of capital requirements known as the Basel Accords, or Basel I, first published in 1988. In the implementation of the initial and later versions of the Basel Accord, the Fed adopted rules that encouraged banks to take on additional risk and specifically encouraged the rapid growth of ABS CDO. The establishment and revision of capital requirements in Basel attracted little scrutiny from elected officials, but the implications of the rules have been the focus of scholarship in securities law (e.g., Tarullo 2008) and macroeconomics (e.g., Dewatripont and Tirole 1993). In political science, research on Basel has focused on the mechanisms of global coordination and, to a lesser extent, the domestic politics underpinning the rules (Singer 2004; King and Sinclair 2003). Conflict over changes in capital requirements are examples of what political scientist Jacob Hacker would call a “subterranean” political process. No statute, vote, or public debate accompanied Fed choices about the supervision of risk management or the capital treatment of ABS CDO: “these conditions allow policies to pass that would not survive if subjected to the bright light of political scrutiny” (Hacker 2002, 44). With help from leadership at the New York Fed, actors with a stake in capital treatment of structured finance products—investment banks—won important lowkey victories that encouraged banks and other financial institutions to

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create and hold ABS CDO. One result was the concentrated exposure of key financial institutions to unexpectedly high levels of subprime mortgage risk (mainly large investment banks but also insurance companies, regulated depository institutions, and bank holding companies). Four specific developments—treated in detail below—contributed to this outcome: the original Basel Accords encouraged regulatory arbitrage, the 1999 rules related to resecuritizations encouraged the development of synthetic ABS CDO, a series of updates to capital requirements increased reliance on the rating agencies to evaluate risk, and most importantly, the 2004 implementation of Basel II permitted large institutions to rely on internal evaluation of risk, lowering capital requirements and encouraging risk-taking in these institutions. As the inadequacies of the Basel framework were revealed in the 2008 crisis, the Fed was confronted with a number of new regulatory choices, ranging from oversight of the massive market for credit market derivatives to strengthening of capital requirements applied to bank and nonbank financial institutions. Dodd-Frank specifically mandates that the Fed develop risk-based capital requirements and other enhanced prudential regulation for the bank holding companies it currently supervises as well as large nonbank financial companies (entities that are large enough to cause widespread financial market disruption in the event of failure). The particular challenges posed by these types of nonbank financial institutions and the growth of the derivatives market that links these institutions together are addressed in Chapter 5. This chapter focuses on how the Fed will specifically implement choices related to the new Basel Accords. Why did the Basel framework fail? How will bank supervisors adapt the regulatory framework to contain the crisis and prevent another shock to the financial system? The experience of 2007 and 2008 shows that is extremely difficult for bank supervisors to anticipate risks and, further, that plans to segregate or isolate uncertain risks in unregulated (and uninsured) institutions were unrealistic. The 2008 crisis also highlighted the weaknesses of a regulatory approach that relies on market discipline. Investors, managers, and external rating agencies all failed to recognize and limit risk-taking in financial institutions. The alternative to market discipline is more direct and specific official sector supervision. A shift from market discipline to official sector supervision would require a major reorientation of a variety of actors inside and outside of the Fed and a repudiation of two decades of refinement of the Basel Accord. This will likely prove difficult to accomplish, especially as the sense of urgency or crisis that gripped financial markets in 2008 begins to recede and memories of the crisis fade.

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Reform to address the problems revealed by the crisis implies basic changes in the capital requirements applied to banks—clear limitations or disincentives for regulated banks to issue, sell, or warehouse complex structured finance products. This type of regulatory reform requires a delicate global coordination and is likely to meet widespread resistance from private actors in the financial sector in the United States and abroad. While Fed leadership may now better understand the risks introduced by structured finance products, the politics that drove the choices related to these instruments in 1999 and 2004 are largely unchanged. Large, powerful financial services companies—companies that have found an advocate in Fed leadership in New York—have a very strong incentive to actively resist higher capital requirements and other rules that cut into profits and trading activities. If reform is not carried out, banks and other financial institutions will likely revert to the same business practices and risk-taking that created the conditions for the 2008 financial crisis. Debate over and refinement of capital requirements— which, in practice, means choices about the implementation of the revised Basel Accord in the United States—will indicate the extent of reform and degree of policy learning after the crisis. Fed choices about capital requirements and the application of those requirements to large financial holding companies are particularly important.

Prudential Regulation, Basel, and the Politics of Capital Requirements

The happy talk within the Fed about derivatives and other constructive innovations in the 1990s and 2000s disguised a vigorous, ongoing, and sustained effort to improve risk management through the function of bank supervision—the scrutiny of bank business practices to meet safety and soundness objectives, or what is known as microprudential regulation. The task of bank supervision is shared across several federal and state agencies. The Office of the Comptroller of the Currency (OCC), a federal regulator housed in the Treasury, supervises the largest depository institutions, representing about 60 percent of the total assets held by traditional banks. The Fed’s supervisory role is smaller, supervising less than 15 percent of total assets (Federal Deposit Insurance Corporation 2011a). But the Fed has a second supervisory role that is even more important: the Fed is the “umbrella” supervisor for bank holding companies—large corporations that own or control a traditional bank. Most of the large banks in the United States are affiliated with a bank holding company, so Fed supervi-

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sory choices and preferences impact even those institutions that are officially supervised by the OCC. (The regulatory challenges posed by these bank holding companies are discussed in detail in Chapter 5.) Prudential regulation of banks is implemented by all of the US bank regulators under the provisions of the international Basel Accords. Basel represents a long-term effort to implement a coordinated international regulatory approach to financial institutions. The basic guidelines are produced by the Basel Committee on Bank Supervision, a group of bank supervisory authorities from the largest developed nations organized under the Bank for International Settlements. Basel does not have the force of international law but is instead intended to outline desirable and best practices for domestic bank supervisors. The Basel Accords were largely a response of representatives of globally competitive financial sectors—from the United States and the United Kingdom in particular—to diminishing capital positions of Japanese banks in the late 1980s. The claim was that Japanese banks were moving into markets without the same types of capital requirements required of local financial institutions, placing the local institutions at a competitive disadvantage (see Barth, Caprio, and Levine 2008, 64–65). As a mechanism for international coordination, the Basel framework has been enormously successful, guiding implementation of bank supervision across more than a dozen large industrialized countries. Tarullo (2008) offers a comprehensive assessment of the successes and drawbacks of the various iterations of the Basel guidelines. The Basel Accords were first introduced in 1988. Basel I established simple capital requirements for regulated banks, an approach that relied on three accounting conventions: Tier 1 capital, Tier 2 capital, and total risk-weighted assets. Tier 1 capital is the amount of high-quality capital available to a financial institution. Tier 1 capital includes equity—the total amount of common stock and some forms of preferred stock outstanding—and published retained earnings. These forms of capital are distinctive since they do not have to be repaid. Stock only retains value if the firm has assets after other forms of debt are repaid. Tier 2 capital, a less restrictive form of capital, includes other forms of corporate debt—subordinated term debt instruments and hybrid debt capital instruments—and certain types of reserves (see Bank for International Settlements 1988). These forms of capital have a lower priority for repayment than conventional corporate debt. Total risk-weighted assets are calculated by attaching a risk weight to each asset in the bank’s portfolio. In the 1988 version of the accord, assets were risk-weighted in a way that requires little or no capital for

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cash or investments in government securities (0 percent risk weight) but higher weights for riskier assets such as home mortgages (50 percent risk weight), long-term claims on banks incorporated outside of the major industrialized (OECD) nations (100 percent risk weight), and securities rated below investment grade (100 percent risk weight). The accord specified the treatment of nearly twenty different forms of assets, focusing mainly on what type of entity is a counterparty (government, bank, government-sponsored enterprise, private sector) and the maturity of the debt (under one year or longer than one year). The accord also specified how to calculate exposure to risk from derivatives and off-balance-sheet entities. The accord directed official supervisors (bank regulators) to adopt a common “target standard ratio” of at least 4 percent of total risk-weighted assets in the form of Tier 1 capital and 8 percent in total capital (Tier 1 plus Tier 2). Banks were required to demonstrate that they were adequately capitalized by calculating the total amount of risk-weighted assets and applying the simple two-tier capital standard. Banks that meet the specified target standard ratios are considered adequately capitalized. In the United States, banks are designated as “well capitalized” if Tier 1 capital ratios exceed 6 percent. Banks and other financial institutions thus have an enormous stake in how risk weights are defined—what types of assets are subjected to low or high capital requirements. When banks create new products, such as ABS CDO, regulators must decide how to treat these products under capital requirements. Assets that are assigned a high risk weight require more capital to originate or hold than a security or loan with a low risk weight. Banks have an incentive to transform assets that are risky (subprime home mortgages) into assets that are less risky (highly rated MBS). Banks also have incentives to lobby regulators to assign low risk weights to new products. Refinements to the Basel Accord after 1988 included broader definitions of capital and a broader variety of risk weights, formally linked risk weights to rating agency evaluations of asset quality, and in the negotiation of Basel II in 2004, permitted large financial institutions to substitute internal ratings for the standard risk weights. The Fed and other bank regulators were in the process of implementing Basel II when the US credit crisis intensified; regulators published specific implementation instructions in 2006 and added detailed supervisory guidance in February 2007. The first iteration of the Fed’s guidance on Basel II was distributed in 2006 to banks and other financial institutions, in the form of a Notice of Proposed Rulemaking. The comments from financial institutions and related trade associations—archived and pub-

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lished by the Fed and other regulators during the notice and comment period—give remarkable insight into the financial stakes implicit in revisions to capital requirements. Fairly narrow technical discriminations about the risk weights of particular assets have profound implications for the shape of bank portfolios and the profitability of particular business strategies. For example, the Managed Funds Association, a trade association representing many of the world’s largest hedge funds, objected to “unreasonably high and punitive” capital requirements for equity investments by banks in hedge funds. The proposed capital requirement—equivalent to a risk weight of 1,250 percent—implies that bank investments in hedge funds would be entirely deducted from total capital, a huge disincentive for banks to invest in hedge funds (Gaine 2007). There is little or no public scrutiny of these decisions, little or no attention from elected officials about the form of the rules, very little information about how industry perspectives are integrated in the final rules, and intense pressure from financial institutions for favorable capital treatment and rules. The same conditions—“subterranean” politics— will shape the particular rules adopted under Dodd-Frank and the broader features of the US response to the crisis.

Regulatory Arbitrage, Credit Default Swaps, and the Growth of the CDO Market

As banks adapted to the capital requirements introduced to bring the United States into compliance with Basel I, Fed leadership was sensitive to the incentives created by the rules and recognized the need for the original Basel Accords to be updated and revised. In a 1998 address Fed Chair Greenspan concluded that the original risk-based capital adequacy standards led to “misleading” capital ratios. Greenspan appealed to the increasing complexity of financial products—a function of both technology and advances in pricing theory—to explain the need to restructure the Basel conventions. Basel I capital requirements encouraged banks to securitize mortgages and commercial loans in order to hold rated securities rather than the riskier underlying assets, lowering required capital. This balance-sheet incentive is powerful; using an ABS CDO transaction, a portfolio of loans or securities with an average rating of Baa3 (one of the lowest investment-grade categories) can be securitized and tranched in a way that 85 percent or more is highly rated in a large, marketed, AAA tranche. The remaining 15 percent can be spread across a

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series of small investment-grade tranches that are marketed (the junior tranche) and an equity (below investment grade) tranche typically held by the bank. The bank converts 85 percent of a portfolio of low-quality securities and loans that are subject to a 100 percent risk weight to a senior tranche that is subjected to 20 percent risk weight. The math is compelling. A bank with $100 million in assets that are 100 percent risk-weighted would need to have $4 million in Tier 1 capital to be adequately capitalized. Converting 85 percent of those assets to a AAA security with a 20 percent risk weight lowers required Tier 1 capital to $1.2 million. This securitization frees up $2.8 million in Tier 1 capital and permits the extension of $70 million in new loans. This practice—converting assets from one form to another in order to reduce required capital and generate new loans—is known as regulatory arbitrage. Securitization is motivated by the banks’ need for relief from capital requirements. On top of this balance-sheet incentive for banks to construct or hold ABS CDO, there was tremendous investor demand for the mezzaninegrade ABS CDO—high-yield securities produced with the junior tranches of subprime MBS. Demand for these securities was so high, in fact, that the supply of subprime mortgages and subprime MBS was simply not large enough to permit banks to produce enough ABS CDO to satisfy investors. To meet this demand, investment banks created “synthetic” ABS CDO. Using a bundle of credit default swaps that were linked to the value of traded subprime MBS, banks could structure a new security that had the same risk and return profile as an ABS CDO composed of subprime MBS. In order to construct synthetic ABS CDO there must be an active, robust underlying market for the credit default swaps that are used to construct the securities. (The operation and regulation of the derivatives market and credit default swaps are treated in detail in Chapter 5.) Goodman et al. (2008) describe the rapid growth of the subprime mortgage derivative market after 2004. They trace the origins of the market to the need of subprime MBS issuers to manage risk as they warehoused subprime mortgages prior to securitization. Banks holding subprime mortgages would enter a contract with a hedge fund or other counterparty, and the bank would pay a modest premium to the hedge fund to insure against defaults or other risks in the mortgage pool as securitization took place. As long as house prices increased, the hedge funds faced little risk. On the other side of the transaction, other hedge funds were eager to short subprime MBS, meaning that they would also be willing to pay the same modest premium in exchange for a windfall if there were large-scale defaults on subprime mortgages. The International

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Swaps and Derivatives Association (ISDA) published a template for credit default swaps on MBS in June 2005, permitting a rapid expansion of the market in subprime mortgage market derivatives. In the odd derivatives market, contracts could ultimately be executed across trading partners that did not actually own any of the underlying mortgages or MBS. The development of synthetic ABS CDO tied together banks issuing cash-value ABS CDO, investors in cash and synthetic ABS CDO (life insurance companies, pension funds, banks), and the parties in the credit default swaps (mainly hedge funds). The ABS CDO permitted subprime mortgage market risk to be spread out across financial markets and for this risk to be amplified. The proliferation and riskiness of these transactions attracted scrutiny from economists inside and outside the Fed. Gibson (2004) concluded that the income streams from mezzanine-grade synthetic CDO were particularly vulnerable to fluctuations in macroeconomic performance and that credit ratings attached to the securities failed to communicate to investors the high proportion of principal that is put at risk. Despite these red flags, Fed leadership and Fed bank supervisors took a series of steps, outlined below, that encouraged banks to issue and retain a large volume of synthetic ABS CDO. With the market for subprime mortgage derivatives established (templates for contracts and willing buyers and sellers), the surge in production of synthetic debt instruments was remarkable. Morris (2008) reports that the volume of synthetic CDO issues exceeded the volume of cash CDO by the end of 2007. Outside of the United States, synthetic issues grew much faster—to 75 percent of the global CDO market by 2003 (Tavakoli 2003). The Bank for International Settlements (BIS)—citing Federal Reserve calculations—reports that the total volume of low-quality (BBB) subprime MBS produced in 2006 was $15.7 billion. Exposure of mezzanine-grade CDO to these securities was $30 billion; synthetic securitizations nearly doubled the impact of the subprime MBS write-downs on the balance sheets of investors and financial institutions (Joint Forum 2008). Goodman et al. (2008) conclude that 75 percent of all ABS CDO assets were constructed synthetically, suggesting an even larger impact; synthetic ABS CDO write-downs could be three times the value of the outstanding cash-value ABS CDO. Derivatives amplified the impact of subprime foreclosures and explain why regulators were caught off guard by the scope and intensity of the broader financial market crisis. In the initial stages of the credit crisis, Fed leadership and other regulators were confident that problems related to the securitization of subprime mortgages would be confined to a relatively small group of institutions at the

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periphery of the US financial sector. Instead, nearly all large financial institutions the United States were threatened by the declining value of subprime mortgage market derivatives.

Capital Requirements, Synthetic CDO, and “Super Senior” Risk

What was the role of the Fed in this new and growing market? Tavakoli (2003, 135) describes how a synthetic CDO is particularly attractive for regulatory arbitrage. In a cash CDO, about 85 percent of a bundle of asset-backed securities is packaged in a AAA tranche, with 5 percent in lower-quality tranches and 10 percent in the risky equity tranche. In the synthetic CDO, banks package and sell a bundle of credit market derivatives, rather than a bundle of ABS. Nearly 85 percent of the total volume of the bundle is retained as a “super senior” tranche, 5 percent sold as a AAA tranche, 5 percent as lower-quality tranches, and 5 percent retained in the equity tranche. The synthetic ABS CDO transaction converts 90 percent of a bundle of credit default swaps into the form of AAA or safer “super senior” securities. The Basel Accords didn’t anticipate developments in securitization that would leave banks with novel forms of insured assets such as super senior tranches. As a result, capital requirements for these assets were unclear. Private sector actors were active in their efforts to influence the way that risk weights were constructed for new structured finance products. In Fool’s Gold, Gillian Tett (2008, 60) describes the strategies that Morgan Stanley investment bankers used to get US regulators—the Fed and OCC—to reduce the capital required to be held against the super senior tranches of synthetic ABS CDO. At first, regulators insisted that the bank remove the super senior risk entirely, so Morgan bankers worked with life insurance giant American International Group (AIG) to construct derivatives contracts that would insure the super senior tranches. Regulators relaxed the standards used to evaluate super senior risk, and in November 1999, federal regulators issued a supervisory guidance that outlined a preferential capital standard for super senior tranches. Super senior tranches could be assigned a favorable, 20 percent, risk weight. The November 1999 guidelines concluded, “Banking organizations can utilize [CDOs] and their synthetic variants to manage their balance sheets and, in some instances, transfer credit risk to the capital markets. Such transactions allow economic capital to be more efficiently allocated, resulting in,

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among other things, improved shareholders’ returns” (Federal Reserve System 1999b). Remarkably, the 1999 guidance traced the first synthetic CDO to a 1997 transaction, so experience with synthetic CDOs was very new when the guidance was issued, and still relatively limited less than a decade later, even as the credit crisis unfolded. The guidance in the 1999 supervisory letter created an incentive for banks to create synthetic CDOs. Writing closer to the time of the ruling, industry analysts were uncertain about the effect of the rules on the market: “The jury is out as to whether, on net, the synthetic [CDO] market will be helped or hurt by these new rules” (Mingo and Falkenstein 2000). It turns out that the favorable ruling, combined with the ability to transfer some of this super senior risk to other institutions (notably AIG), cleared the way for the rapid and substantial expansion of the CDO business. The annual global volume of explicitly rated ABS CDO grew at a spectacular rate from less than $2.5 billion in the mid-1990s to nearly $250 billion by in 2002. This growth continued after 2002; a Fed study reported that trading in synthetic ABS CDO tranches exceeded $450 billion in 2006 (Gibson 2007). The related demand for credit ratings for these securities generated enormous profits for the rating agencies. Morris (2008, 77) reports that “between 2002 and 2006, Moody’s doubled its revenue and tripled its stock price.” The feature of the supervisory guidance that made synthetic CDOs attractive was that a bank could retain an uncollateralized senior tranche with a low 20 percent risk weight if particular “stringent” conditions were met. Specifically, the most senior debt sold to investors had to be rated AAA by a nationally recognized rating agency and the institution had to perform “rigorous and robust stress testing” as part of a “credible internal process” for managing risk (Federal Reserve System 1999b, 7). If a bank pursues this type of regulatory compliance, assets that would normally be subjected to a 100 percent risk weight can be trimmed to a 20 percent risk weight. As was the case with subprime MBS, rating agencies played a central and officially sanctioned role in the evaluation of the riskiness of ABS CDO tranches. Tavakoli (2003) describes this type of compliance as “super senior sophistry”: the super senior tranche may make up as much as 85 percent of a synthetic CDO, but tools to price or measure the price or risk of the large super senior tranche are limited and poorly defined. These risks and related questions were raised by Tavakoli years before the emergence of the 2008 crisis, yet regulators expressed surprise at the size of the exposure these tranches created for banks. In a retrospective review of the credit crisis, international regulators and market participants con-

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cluded that the losses from the ABS CDO meltdown were concentrated in three groups of investors: 1. Special-purpose financial institutions that funded investments in the marketed AAA senior tranches with short-term borrowings (see Chapter 5 for details about the transactions and regulation of these structured investment vehicles [SIV]) 2. The insurers that provided financial guaranties for these highquality tranches 3. Originating banks—CDO underwriters—who retained the super senior risk (Joint Forum 2008) The total exposure for major US financial institutions was very large: CITI reported a fourth-quarter 2007 write-down (loss) of $17.4 billion related to subprime assets. Eighty percent of those assets were “ABS CDO super senior” (Citigroup 2008).

Risk Assessment and Rating Agencies Under Basel II

As bankers and other industry participants lobbied US regulators for particular changes in the Basel framework, the BIS also undertook more comprehensive updates to the accord. Major revisions in 1996—the Market Risk Amendments—recognized the increasing complexity of bank balance sheets and the different types of risks that financial institutions faced. A comprehensive set of changes in 2004, Basel II, was an effort to improve the “granularity” of risk weighting—to more finely distinguish and measure the economic costs of risks and to incorporate a measure of market risk (Bank for International Settlements 2004). The various refinements to the Basel Accord institutionalized two ways to monitor the riskiness of bank assets: to permit banks to use the evaluations of rating agencies or for banks to credibly demonstrate that the bank’s internal models and risk assessment procedures were rigorous and reliable. Both of these mechanisms move evaluation of credit risk outside of direct oversight of an official sector supervisor to organizations that focus on evaluating credit quality (delegation to rating agencies) or to institutions that have the capital and technology to develop sophisticated internal controls (self-regulation by large firms). The move toward increasing reliance on rating agencies for risk weighting of capital was gradual but systematic. An expanded role for rating agencies was anticipated in a June 1999 revision to Basel capital

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adequacy standards, incorporated in 2001 US guidelines specific to evaluation of exposures to risks related to securitization, and highlighted as a central feature in the 2004 revisions. Under the 2001 guidelines a security with a safe long-term rating (AAA or AA) has a 20 percent risk weight, while a security with a rating one category below investment grade (BB) carries a 200 percent risk weight (Treasury et al. 2001). The banking regulators confronted problems with external ratings when updated capital requirements for securitizations were published in 2001. The publication of the final rules in the Federal Register included a response to comments on the rule that opposed the use of rating agencies— reservations grounded in perverse incentives of a business model that makes the rating agencies dependent on fee income from institutions seeking ratings. The regulators concluded, Investors rely on ratings to make investment decisions. This reliance exerts market discipline on the rating agencies and gives their ratings market credibility. The market’s reliance on ratings, in turn, gives the agencies confidence that it is appropriate to consider ratings as a major factor in the risk weighting of assets for regulatory capital purposes. (Treasury et al. 2001, 59625)

This confidence in rating agencies seems misplaced given the history of failure associated with the industry. Sinclair (2008) describes a series of “rating crises”: the bankruptcy of Penn Central in 1970; the failure of Franklin National Bank in 1974; the collapse of Orange County municipal debt; sovereign debt crises involving South Korea, Malaysia, and Thailand; and the failure of Enron (which was remarkably close to the time of the Fed’s 2001 guidance quoted above!). Each of these financial market disruptions involved the failure of ratings and rating agencies to communicate the risks associated with particular types of investments—corporate, municipal, or sovereign debt. The historical failure and perverse incentives facing the rating agencies were apparent, yet these agencies became critical elements in the global supervisory framework. King and Sinclair (2003, 346) delivered a prescient early warning about the effects of Basel II, bluntly concluding that “recent efforts to incorporate the outputs of the rating agencies into plans to make global finance less volatile are flawed, and likely to generate unexpected, unwanted outcomes.” Despite these reservations and the long history of “rating crises,” the US implementation of Basel II published in late 2007 specifically relied on rating agencies—most directly in the evaluation of risks associated with securitizations (Treasury et al. 2007, 69421). The 2007 rules distinguish risk weights for twelve sep-

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arate ratings categories—from 7 percent for AAA-rated exposures to 650 percent for BB– (below investment grade). The same factors that conspired to undermine the effectiveness or accuracy of MBS ratings—the volume of securities to be evaluated, the novelty of the securities, and the incentives to accommodate client banks—conspired to undermine the quality of ABS CDO ratings. Because the Basel framework and US regulators linked rating agency determinations to the calculation of risk-based capital, issuing banks were encouraged to structure securities in a way that preserved a marketable AAA tranche. Regulatory arbitrage incentives encouraged banks to retain the highest-quality super senior tranche to remove poorly rated debt or loans from the balance sheet. Because the marketable securities carried the imprimatur of AAA ratings, ABS CDO were attractive for institutional and other investors seeking a relatively high-yield, low-risk investment. Since the marketable securities were rated AAA, when banks sought to hedge or insure the super senior or highly rated tranches, the costs associated with credit market derivatives that hedged this risk were low. The failure of the rating agencies to anticipate the risks associated with ABS CDO led to the concentration of poorly understood risks in regulated institutions that retained the super senior tranche, with investors who purchased the marketed AAA tranche, and in hedge fund and insurance company guarantors who insured those positions. There were efforts before the crisis, in the United States and on the Basel Committee, to complement the use of external ratings with a greater emphasis on the development of risk management capacity within financial institutions. Basel II not only reinforced the role of rating agencies, but the new rules also encouraged large institutions to develop or exploit an internal modeling strategy, moving the pendulum closer to market discipline and away from official sector supervision and oversight. This effort, to substitute the judgment of financial institutions for the judgment of external rating agencies, is one way to mitigate the problems posed by rating agencies, but introduces other risks and uncertainties for bank supervisors.

Basel II, Internal Models, and the Move to Self-Regulation

In the literature on prudential regulation there is a fundamental tension between market discipline and supervisor discipline: the use of market incentives and mechanisms to encourage financial institutions to adopt

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particular types of behavior versus the use of regulatory prescriptions and oversight to coerce particular types of behavior. Proponents of market discipline argue that if private actors—investors, creditors, and depositors— have full, routine, and transparent information about the transactions of financial institutions, then there is little or no need for official (public sector) supervision. Investors—especially sophisticated investors—will compel managers of financial institutions to pursue the appropriate risk-reward balance. Creditors will understand the counterparty risks associated with insurance and other transactions. Writing prior to the crisis, Barth, Caprio, and Levine (2008) offer a compelling empirical case for primary reliance on market discipline. Proponents of a large supervisory role for the official sector point to market failures—typically rooted in asymmetric information that is a function of poor disclosure, opaque instruments, outright fraud, or investor naïveté. These problems of information and openness typically justify close supervisory scrutiny by official regulators. The tension between market discipline and supervisor discipline is inexorable. As supervisors take on a larger role in oversight, creditors and depositors have little incentive to acquire the capacity and information to evaluate the soundness of financial institutions. The same problem complicates simple deposit insurance programs: consumers have little incentive to make sure that the bank they choose is solvent, as long as they know their deposits are insured. The more the official supervisor takes on the role of monitor and regulator, the less that private parties have an incentive to invest in information about particular prices, risks, or practices in particular financial institutions. The supervisory actions of the Fed, consistent with the more global movement ultimately codified in Basel II, increasingly relied on market discipline. At the same time that the rating agencies were becoming more embedded in capital adequacy standards, there was a major push by the Fed to encourage the supervisors of large, complex institutions to rely on and scrutinize their internal models. Fed Chair Greenspan anticipated the general approach in a 1998 address: In recent years, the focus of supervisory efforts in the United States has been on the internal risk measurement and management processes of banks. This emphasis on internal processes has been driven partly by the need to make supervisory policies more risk-focused in light of the increasing complexity of banking activities. In addition, this approach reinforces market incentives that have prompted banks themselves to invest heavily in recent years to improve their management information systems and internal systems for quantifying, pricing, and managing risk. (Greenspan 1998)

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Greenspan’s reasoning was that capital requirements, while critical, are inferior to “first-line” soundness principles that rely on market discipline: “Supervision and regulation can never be a substitute for a bank’s own internal scrutiny of its counterparties and for the market’s scrutiny of the bank” (Greenspan 1998). Under a 1999 supervisory guidance directed to state-chartered banks and Fed-supervised bank holding companies, banks were permitted to use internal ratings technology and models to determine whether assets were above or below investment grade—whether a 100 percent or 200 percent capital requirement should be attached to certain assets. Under the new rules, the focus of bank supervisors shifted from directly conducting stress tests or other static evaluations of the quality of the bank portfolio to evaluating the quality of internal risk management expertise: human capital and technology. Fed staff concluded that “emphasizing oversight of an institution’s internal procedures for identifying and managing risk in contrast with traditional point-in-time examinations, should reduce the cost and burden of regulation” (Federal Reserve System 1999a). The link between bank supervision and internal risk modeling was not a novelty when it appeared in Basel II or in the 1999 guidance. Several specific features of the risk models were stipulated in the Market Risk Amendments to Basel. The 1996 rules required that banks have capital reserve proportional to the maximum loss that the bank could sustain over a ten-day period. This market risk requirement was a supplement to the capital requirements in Basel I. Regulators were encouraged to review the internal risk models that banks used to comply with the new requirement; evaluation was based on an assessment of the resources, expertise, and experience of the risk management team (Holmstrom and Tirole 2000). In a separate action in 1998, the Fed and other bank regulators relaxed constraints on bank investments in mortgage derivatives—deferring to “management’s ability to measure and manage the risk of investment activities” (Federal Reserve Bank of New York 1998). More broadly, Mingo and Falkenstein (2000) describe how evaluation of risk management was integrated into routine supervisory practices in the 1990s. The Fed and other bank supervisors use a common set of ratings categories known as CAMELS—capital, asset quality, management, earnings, liquidity, and sensitivity to market risk. Fed bank examiners were instructed to assess the quality of the bank’s internal capital adequacy determination as one component of the overall supervisory grade. By 2001 bank supervisory guidance specifically stipulated that failure to enhance internal risk management practices related to securitization could negatively impact a bank’s CAMELS ratings (Treasury et al. 2001).

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Reflecting on these refinements to Basel I, Norton (2003) concluded that the changes represented a new private-public partnership between “elite banks” and domestic regulators. The new rules, recognizing the increasing complexity and rapid pace of change in the financial sector, defer to internal management decisions and expertise and permit banks to appeal to this expertise to justify lower capital requirements and lower levels of direct scrutiny. This deference to management is not surprising. At the same time that the Fed was overhauling the supervisory framework, Congress was relaxing major statutory restrictions on bank business and operating practices. The Glass-Steagall wall separating retail and investment banking was repealed in 1999, and legislation designed to limit regulation of derivatives transactions was passed a short time later. The administrative choices of the Fed and the statutory choices made in Congress reflect a similar confidence in the risk management practices within financial institutions. The choices in Congress and the Fed also reflect the power of these elite banks to influence regulatory outcomes. Johnson and Kwak (2010) describe the growing power of large banks in Washington, DC, and the “political influence of Wall Street.” Baker (2010) observes the same outcome in Basel deliberations; a “multi-level regulatory capture” imprinted Basel II with the interests and preferences of large financial institutions. Tarullo (2008, 102–103) specifically discusses how Fed leadership and large international banks organized to influence the final form of Basel II. New York Fed President William McDonough was the chair of the Basel Committee during the period that Basel II was negotiated. He was an advocate for greater reliance on internal models in risk assessment, a position supported by the large US financial institutions that would benefit from the new rules. The second iteration of the Basel rules required large internationally active banks to use internal models to risk-weight assets. Other (smaller) financial institutions could use a “standardized approach” that kept in place the use of rating agency evaluations of asset risks. Smaller US institutions, like community banks, fought the implementation of Basel II as the rules would put large institutions—with the human capital and expertise to adopt the new options—at a competitive advantage (see Garnett 2006). The American Bankers Association concluded that the costs of developing internal models could be “in the hundreds of millions of dollars” for large banks (Strand 2008). In exchange, the banks expected—and the Fed appeared committed to deliver—lower capital requirements. A 2004 Quantitative Impact Study by the Fed demonstrated that new internal modeling approaches reduced the median capital requirement of twenty-six participating banks by over 25 percent, prompt-

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ing US regulators to delay full implementation of Basel II (Board of Governors of the Federal Reserve System et al. 2006). Basel II and the 2007 US implementation laid out three pillars of bank supervision: risk-based capital requirements, supervisory review of capital adequacy, and market discipline. In late 2007 Fed Governor Randall Kroszner described how the pillars of Basel II represented a positive step toward financial market stability. A combination of limited supervisory activity and changes to “sound practices” and “codes of conduct” within the industry would enhance transparency and improve valuation of complex financial instruments. Basel II would encourage investment in technology and expertise that improves information about the prices of assets. Disclosure of this information would enhance market discipline (Kroszner 2007a). Reliance on best practices and codes of conduct, rather than official sector prescriptions and guidance, is a hallmark of Basel II and a second feature of the partnership between elite banks and regulators described by Norton (2003). In 2006 New York Fed President Geithner described the virtues of this partnership: The resiliency we have observed over the past decade or so is not just good luck. It is the consequence of efforts by regulatory, supervisory and private financial institutions to address previous sources of systemic instability. Risk management has improved significantly, and the major firms have made substantial progress toward more sophisticated measurement and control of concentration to specific risk factors. (Geithner 2006)

The credit crisis, unfolding only one year later, revealed that the supervisory framework had a number of flaws and that core, regulated institutions were, in fact, highly vulnerable and undercapitalized. The financial crisis spilled over from unregulated hedge funds and lightly regulated investment banks to the large bank holding companies— CITI, Bank of America, Wells Fargo—supervised by the Fed. Unlike the challenges to the Fed introduced by new or expanded missions in housing finance and consumer protection, the meltdown of regulated bank holding companies implicates core Fed practices, technology, and expertise that was developed or refined under the Basel framework. The specific responses of the Fed and other banking regulators to the failure of rating agencies, internal models, and official supervision will be a critical element of learning from the crisis. The details of this response will reflect updates to the Basel framework, mandates embedded in Dodd-Frank, and complex negotiations across financial sector regulators—most likely coordinated under the new Financial Stability Oversight Council. (For

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details about the FSOC, see Chapter 5.) How did authorities in Basel respond to the crisis? How will the Fed respond and learn from crisis?

Basel and Bank Supervision After the Crisis

The credit crisis revealed to bank supervisors that the capital adequacy standards applied to banks—the first pillar of Basel II—were inadequate to ensure safety and soundness. Policymakers were surprised to learn that major banks had insufficient capital to manage the crisis and that capital requirements actually intensified the credit crisis in ways that were not fully anticipated. As rating agencies downgraded the quality of bank assets, banks were forced to increase the risk weights associated with those assets, increasing the level of required capital, which, in turn, implied fewer funds available to loan. In a review of policy lessons from the crisis, Hannoun (2008) described a similar vulnerability with internal models. During the period of low volatility immediately preceding the crisis, internal metrics of risks (specifically value-at-risk [VaR]) were biased downward, encouraging banks to take on higher and higher levels of risk. As the crisis intensified, banks incorporated new price information that revealed higher levels of risk, suggesting that banks conserve capital and make fewer new loans. The Basel II rules were clearly procyclical, triggering higher and higher levels of lending as economic conditions improved, but prescribing lower and lower levels of lending as economic and financial conditions deteriorated. As the crisis uncovered defects in the Basel framework, the BIS responded in two stages. A set of narrowly targeted reforms that addressed the particular innovations at the heart of the crisis (ABS CDO, for instance) was published in 2009 (Bank for International Settlements 2009). A broader set of long-term changes to strengthen capital requirements were released in September 2010 (Bank for International Settlements 2010). Both sets of reforms met with intense industry opposition, and how US supervisors will implement the new recommendations remains unclear. The 2009 proposals from Basel suggested that regulators were closely scrutinizing resecuritization practices—a specific step to account for the risks associated with ABS CDO. As an initial response, the Basel committee doubled capital requirements for resecuritization exposures. This adjustment reduces (but does not eliminate) the regulatory arbitrage incentive for banks to hold ABS CDO. One of the leading financial industry trade associations, the ISDA, objected to the new treatment of resecuritizations, claiming that the closer scrutiny and lower ratings by the rating

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agencies would combine with higher capital requirements to place extraordinary capital demands on banks (Hills et al. 2009). New proposed US market risk rules similarly differentiate and attach higher capital requirements to resecuritizations. Industry responses to the proposed rules urged US regulators to delay implementation until related Basel Committee recommendations are finalized (Whiting 2011). The new capital requirements under Basel III were formally announced in September 2010. The new requirements increase required Tier 1 capital from 4 percent to 6 percent and also introduce a new capital conservation buffer and new leverage and liquidity requirements. The capital conservation buffer permits national regulators to add a 2.5 percent capital requirement on top of the minimum capital requirement during periods of rapid growth in credit aggregates (a countercyclical adjustment). Under the new liquidity requirement, financial institutions would need to maintain liquid assets equivalent to a thirty-day cash outflow. When the Basel Committee proposed new liquidity requirements as a response to the crisis, banks— European and US—initiated a furious lobbying campaign to highlight the potential costs of new requirements—for both prospective borrowers and bank shareholders (Onaran, Clark, and Heaven 2010). At minimum, the banks sought a long implementation phase for any new requirements. In fact, one remarkable feature of each of the new rules is the lengthy transition period. Phase-in of the new requirements begins on January 1, 2013, and the transition will be completed on January 1, 2018, fully ten years after the crisis. The Basel Accords, including the package of revisions after the crisis published as Basel III, are not binding on any national regulator. The accords set out best practices and prescribe specific requirements, but implementation is dependent on actions by each nation, and it is expected that country-specific choices and factors will result in unique national rules. As a consequence, exactly what form the rules will take in the United States and even when these rules will be implemented remain unclear. The meltdown of two Bear Stearns hedge funds triggered the financial crisis in the spring of 2007. The collapse of Lehman Brothers brought the crisis to the attention of the broader public in the fall of 2008. Three full years after the crisis and four years after the Bear funds imploded, US bank regulators have not yet formalized new capital requirements for banks. Dodd-Frank required that rulemaking related to financial regulatory reform be completed by July 2011. The combination of volume, complexity, and industry opposition has resulted in delays for many of the new rules. By May 2011, only 21 of 387 rules directed by Dodd-Frank were finalized (Eaglesham 2011).

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Risk Management and the Bright Light of Political Scrutiny

The Fed and other Washington regulators failed to put adequate safeguards in place to limit the scope of financial market crises and actually encouraged—in the implementation of the Basel Accord—the proliferation of financial instruments that caused the crisis to spread beyond the narrow subprime mortgage market. There were warning signs about these instruments, from the “super senior sophistry” described by Tavakoli in 2003 to broader concerns among market observers before 2007. A real estate industry trade group—the Council to Shape Change— recognized the growing role of synthetic securities in the financial markets and raised concerns about the lack of transparency in pricing and risk assessment of these instruments, as well as the potential systemic risks introduced by the elaborate counterparty relationships embedded in the securities (Council to Shape Change, 2006). The capital requirements developed as part of the Basel framework gave the Fed leadership the tools to restrict the creation, sale, and purchase of these instruments. The Fed chose to take steps that instead brought about the opposite outcome and contributed to the severity of the financial crisis. Fed leadership and other US regulators accepted industry arguments about the safety of super senior tranches. Fed leadership also accepted industry claims about the sophistication and reliability of internal models of risk. The public scrutiny of the Fed as the crisis unfolded underscored the consequences of these choices for the Fed’s reputation and image, but several factors are at work to obstruct learning from the crisis. As public attention to the crisis wanes, the Fed is confronted with a resilient network of financial sector actors interested in resisting change. In addition, decades of experience with the outsourcing of risk evaluation—to financial institutions and rating agencies—have left the Fed with few tools to independently evaluate the riskiness of securities. The Fed was instrumental in the articulation of rules that were incorporated as Basel II, encouraging increasing reliance on market discipline and internal risk models. Although the crisis underscored the weaknesses of these internal risk management tools, the interests that benefited from and advocated self-regulation are equally active in shaping the rulemaking process that will determine the US response to the crisis. Baker (2010) concluded that one effect of the crisis was to increase, at least temporarily, the salience of financial regulation; the public and elected officials were highly engaged in the process of financial reform and somewhat attentive to the various commissions, congressional reports, and criminal and civil actions that provided information about the causes and consequences of

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the crisis. Birkland (2006) describes how this type of media attention and salience are essential to policy change. As order was restored to US credit markets, attention to financial reform predictably diminished, replaced by attention to symptoms of the broad and sustained economic slowdown triggered by the crisis (job losses, falling government revenue, and the growing federal debt). The massive size and complexity of Dodd-Frank and the nearly 400 rules delegated to agencies suggest that implementation will take years to complete. As the reform process extends into 2012 and 2013, limited public attention turns to other developments, removing the bright light of political scrutiny, reinvigorating industry advocates, and reducing the prospects for learning. US regulators also face difficult choices related to conflicting mandates from Dodd-Frank and the Basel Committee. Dodd-Frank specifically directs US regulators to abandon the use of external ratings as part of the evaluation of bank capital, directly confronting the ratings failures that were at the heart of the crisis. This mandate stands in sharp contrast to Basel III, which retains a central role for rating agencies but sets out new prescriptions for the regulation and oversight of rating agencies. The Clearing House, a New York–based association representing some of the nation’s largest banks, outlined opposition to the proposed changes in the United States. Clearing House comments on the proposed rules highlighted the enormous compliance costs that would be required if banks were to independently evaluate each security in the bank portfolio (“insurmountable internal credit risk analytical burdens”), as well as the potential fragmentation of international standards (Zingale 2010). Fed leadership also directly learned about the costs and complexity of independent evaluations as Fed staff worked to determine the value of securities (MBS and ABS CDO) pledged as collateral for Fed lending programs (Tarullo 2010). Structured finance products are difficult to value and price. The various tools to quantify risks—internal models, external credit ratings, and supervisory judgments—each imply costs and trade-offs. Supervisory judgments also introduce unique political risks: risk weights implicate the Fed in credit allocation. If a particular sector of the economy relies on a particular structured finance innovation to attract capital, then Fed judgments about the riskiness of those innovations can drive more or less credit to that sector of the economy. A high risk weight makes the financial instrument less liquid and less desirable, limiting the inflow of capital from the sale of that instrument. A low risk weight makes the instrument more liquid and more desirable, increasing the flow of capital from potential investors. Fed operating procedures and practices are tailored—constructed—to avoid the judg-

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ment of picking winners and losers in credit markets. The Fed’s operational choices are limited and tricky: continuing reliance on internal models and self-regulation, a nuanced interpretation of Dodd-Frank that incorporates some external evaluations, or the costly and politically risky development of more in-house modeling and analytic tools to independently evaluate risk. New structured finance products introduced new forms of risk to bank balance sheets, but these instruments also increased the risk of financial contagion. The Fed’s response to crisis—before and after the market for asset-backed securities collapsed in the summer of 2007— suggests that the Fed severely underestimated the extent to which new, complex instruments undermined the stability of the entire financial sector. The crisis revealed that not only were banks undercapitalized but banks were also vulnerable to the failure or distress of nonbanks. Fully addressing this problem of contagion implies extending some form of oversight to the broad range of financial institutions involved in the crisis: investment banks, hedge funds, money market mutual funds, and narrower special-purpose vehicles—the legal entities that hold securities or credit default swaps that make up a cash-value and synthetic ABS CDO. Many of these institutions have either deliberately (hedge funds) or indirectly (special-purpose vehicles) escaped scrutiny from the major regulators. Even if Fed decisionmakers successfully update bank supervisory practices and rules to reduce the risk exposure of regulated depository institutions, risks outside of the banking system could still undermine the stability and performance of the financial sector.

5 The Fed and the Shadow Banking System

Innovations in finance and financial markets generated links among

a host of financial institutions—some regulated by federal agencies, some regulated by state bank and insurance supervisors, and others only loosely monitored (if at all) by the Securities and Exchange Commission (SEC). The credit crisis revealed how these links across firms could amplify a shock to the financial system. The failure of one firm (particularly a large or “systemically important” firm) could jeopardize a number of related firms, placing the entire financial system at risk. This problem—systemic risk or financial contagion—has been the focus of work by regulators and private sector actors, particularly after the collapse and failure of the large hedge fund Long Term Capital Management in 1998. The failure of Lehman Brothers in 2008 and the impact of that failure on credit markets threatened the supply of capital that fueled the US and global economies. The credit crisis brought the problem of systemic risk to the attention of the broader public, and the federal government worked to construct immediate and long-term solutions to the problem. First, the government infused huge amounts of capital into the financial system via the Troubled Asset Relief Program (TARP) and a host of Fed-funded lending facilities. Bank regulators introduced innovations in prudential regulation in 2009, most visibly in the form of highly publicized “stress tests” for the largest financial institutions and with the vague expectation that many types of financial institutions—depository institutions, hedge funds, and investment banks—would face greater regulatory scrutiny in the future. The longterm solution, spelled out in Dodd-Frank, includes two initiatives to specifically address systemic risk: a new Financial Stability Oversight Council (FSOC) and a set of comprehensive recommendations for the regulation of derivatives. Rules creating the new FSOC give the Fed the authority to 87

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designate nonbank firms as systemically important and to subject these firms to scrutiny and oversight. This chapter focuses on how the expansion of Fed authority to supervise nonbank financial institutions presents both technical and political challenges. The technical challenges are a function of the differences between the small banks and bank holding companies that have been the traditional focus of Fed supervision and the variety of firms—investment banks, hedge funds, money market mutual funds, and even insurance companies—that could be the object of broader supervision. These challenges impact both the monetary policy and bank supervisory functions of the Fed. How will capital requirements or other prudential regulations be adapted to monitor hedge funds or investment banks? How will the Fed coordinate these activities with other agencies under the new FSOC? The FSOC institutionalizes Fed responsibility for the extension of prudential regulation beyond depository institutions to other types of financial institutions, but the authority is shared across a number of agencies with distinctly different missions, constituents, and expertise. The politics of Fed actions are also complicated by the wide variety of interests with a stake in these diverse financial services firms. These interests will attempt to influence the scope and type of regulation or supervision that the Fed adopts. How will the expansion of the network of actors and interests with a stake in prudential regulation alter choices about the pace and extent of regulatory reform? How will the Fed respond to increased scrutiny by Congress—especially as the Fed adopts new and poorly understood tools, endures increasing skepticism about its capacity to manage the economy, and, in general, exercises expanded power and authority to resolve financial market disruptions? How will the Fed reconcile objectives of systemic risk mitigation with the mandate to pursue stable prices? The answers to these questions are the subject of intense speculation among financial market journalists and economists. Preliminary reactions range from benign to alarmist. Fed Chair Bernanke, commenting on the Fed adoption of new authority to manage systemic risk, concluded that the new role would “be an incremental and natural extension of the Federal Reserve’s existing supervisory and regulatory responsibilities, reflecting the important relationship between financial stability and the roles of a central bank” (Bernanke 2009a). Other observers are more pessimistic. Economist Allan Meltzer, for instance, suggested that political pressures, presumably to prop up the economy and the housing market, will conspire to extend monetary policy accommodation after the short-term crisis eases. The result will be a 1970s-style “great inflation” (Miller 2009).

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The Fed has already taken on new supervisory authority for large investment banks—a function of the choice by these firms to adopt the legal status of bank holding companies in the fall of 2008. The Fed also confronts choices about the regulation of other firms that could pose systemic risks—hedge funds, insurance companies, money market mutual funds, and various special-purpose vehicles that make up what is commonly referred to as the “shadow banking system.” The crisis revealed that core, regulated institutions were placed in jeopardy by links to these unregulated institutions. After reviewing the ways that financial innovation created unanticipated systemic risks, I turn to particular problems and choices associated with the various bank and nonbank financial institutions that make up the contemporary financial sector. The conclusion maps out the implications of the new systemic risk mission for the contemporary Fed.

Credit Market Derivatives and the Problem of Systemic Risk

Credit default swaps are a class of loosely regulated derivatives that have facilitated a revolution in the way that risk is distributed across (and concentrated in) financial institutions. The simple logic of the credit default swap is compelling. Credit default swaps permit a bank or other firm to reduce the amount of risk associated with a loan, bond, or other credit line. If the borrower defaults—constituting what is known as a “credit event”—then the counterparty to the derivatives transaction (the insurer) steps in to meet the obligation. Counterparties receive a fee or premium to insure the bond or loan. In a lively account of the origins of this instrument, Tett (2008) claims that the first credit default swap involved JP Morgan seeking insurance from the European Bank for Reconstruction and Development for a $4.8 billion Exxon credit line in 1993. If Exxon entered bankruptcy, the counterparty—the European Bank—would pay off the credit line to JP Morgan. The new risk posed by the transaction is what is known as counterparty credit risk. In the event of a credit event, what if the counterparty— the insurer—cannot pay? Further, if one firm is a counterparty in hundreds or thousands of derivatives transactions, what happens if that firm becomes insolvent—unable to meet the commitments implied by its outstanding derivatives contracts? In addition to counterparty credit risk, derivatives introduce other types of risk management challenges. Gibson (2007) describes model risk (reflecting the fact that institutions rely on internal models, rather than market prices, to determine the

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value of derivatives) and rating agency risk (dependence on rating agencies to determine the risks associated with a derivative). The International Swaps and Derivatives Association (ISDA) reports the total amount of outstanding derivatives contracts grew from $51 trillion in 1998 to $454 trillion in 2007, an annual growth rate of nearly 25 percent. Outstanding credit default swaps were first reported separately in 2001—at less than $1 trillion—and grew twice as fast as the total derivatives market, to a peak of $62 trillion by the end of 2007 (International Swaps and Derivatives Association 2010). The explosive growth of hedge funds and the 1998 Long Term Capital Management recapitalization highlighted the problems associated with counterparty credit risk and the market for derivatives. Derivative contracts are treated differently than other claims in bankruptcy proceedings; “safe harbor” provisions permit derivatives contracts to be settled, and collateral assets attached to the transaction can be sold without waiting for a decision from or intervention by a bankruptcy court (Vasser 2005). If a large firm fails and many counterparties exercise such a right, then prices of the collateral assets may fall dramatically, affecting the balance sheets of financial institutions that are not parties to the original transaction (Haubrich 2007). The bankruptcy or liquidation of a firm with a large number of derivatives counterparties can amplify a financial crisis. Edwards (1999) identified this indirect contagion as the core public policy lesson from the failure of Long Term Capital Management. Risky transactions by one firm can affect the material performance of firms that are not a party to the original transaction. This issue is particularly problematic if the risky transactions of an unregulated, unsupervised financial institution can erode the performance of a regulated, insured financial institution. A wide variety of firms buy and sell derivatives: regulated banks and securities dealers, insurance companies, special-purpose vehicles, hedge funds, and nonfinancial firms (Bank for International Settlements 2011). Rapid growth in the number of hedge funds, especially highly leveraged hedge funds with substantial dealings in derivatives, generated financial relationships between regulated banks and unregulated institutions—a pernicious problem if bank supervisors are to police and manage risk in the regulated banks. The risks of the growing market for derivatives drew the attention of regulators and elected officials well before the 2008 financial crisis, but Fed leadership played a critical role in resisting regulation and oversight of the market. In a far-reaching and remarkably prescient report (Financial Derivatives: Actions Needed to Protect the Financial System),

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analysts at the Government Accountability Office (GAO) concluded— in 1994!—that the derivatives market introduced serious risks for the financial system. These risks were poorly measured and monitored by regulators and firms. The GAO report specifically cautioned about the risk of a taxpayer-funded bailout: This combination of global involvement, concentration, and linkages means that the sudden failure or abrupt withdrawal from trading of any of these large dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole. . . . While federal regulators have often been able to keep financial disruptions from becoming crises, in some cases intervention has and could result in industry loans or a financial bailout paid for by taxpayers. (Government Accountability Office 1994)

Industry assessments and Fed leadership have typically downplayed these risks and instead emphasized the benefits of derivative transactions. Risks that were previously concentrated in regulated institutions could be distributed across a wide variety of firms, promoting both financial stability and the flow of funds from investors to borrowers. Fed Chair Alan Greenspan appealed to precisely this logic when derivatives came under congressional scrutiny after the GAO report. In testimony before Congress, Chairman Greenspan largely dismissed the concerns of the GAO. He reported that the risk of a taxpayer-funded bailout of major dealers in the derivatives market was “negligible.” He concluded that the market discipline imposed by investors, rating agencies, and counterparties suggested government regulation would be unnecessary. In short, Greenspan asserted, “As far as the Federal Reserve Board is concerned, we feel we are ahead of the curve on this issue” (Hansell 1994c). Tett (2008) describes the nimble lobbying efforts by the ISDA to head off moves to regulate derivatives in 1994. Fed Chair Greenspan was joined by former New York Fed president E. Gerald Corrigan in support of loose or little regulation of credit market derivatives. In testimony before Congress, Corrigan, by then an executive at Goldman Sachs, assured lawmakers that he was “hard pressed to think of sensible things that might be done through legislation that would better equip the Fed or other bodies to cope with a financial disruption of consequence” (Hansell 1994b). His testimony was echoed by executives from the major investment banks and accounting firms. Congress did not act on the 1994 GAO report. This optimistic assessment of firms’ ability to assess and manage risk is characteristic of both the financial services industry and the Fed

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response to continuing innovation in credit markets. The rapid collapse of the Long Term Capital Management (LTCM) hedge fund in 1998 highlighted the urgency of a regulatory response to the proliferation of derivatives a full ten years before the financial crisis. The Commodity Futures Trading Commission (CFTC) asserted some regulatory authority over credit market derivatives after the LTCM collapse, but Secretary of the Treasury Robert Rubin, Deputy Secretary Lawrence Summers, and Greenspan successfully opposed these initiatives (Schwartz and Dash 2008). Under the Commodities Futures Modernization Act of 2000, Congress specifically defined credit default swaps as something different from futures or securities, which placed these particular derivatives outside of the jurisdiction of the CFTC or the SEC. Industry responses to the risk management challenges implied by derivatives focus on voluntary compliance with best practices and improved internal risk management: the self-regulation characteristic of the elite bank regulator partnership that Norton (2003) described. The broader features of this self-regulation were spelled out in a series of documents produced by the Counterparty Risk Management Policy Group led by E. Gerald Corrigan (the “Corrigan Group”). The 2008 iteration of the group’s recommendations suggested, for instance, that management of financial institutions “engage in a periodic process of systemic ‘brainstorming’ aimed at identifying potential contagion ‘hot spots’” (Counterparty Risk Management Policy Group 2008). The report concedes a limited role for official sector supervision, recommending that a single principal actor associated with the official regulator meet annually with the management and board of directors of large financial firms. But the report stipulates that “these high level exchanges of views should minimize the use of quantitative metrics and maximize the use of discussion and informed judgment.” Remarkably, Fed officials joined with other government regulators to applaud these limited efforts. Summarizing a number of developments in 2006, including the Corrigan initiatives, Assistant Treasury Secretary Emil Henry concluded, “These are all very heartening developments and proof of self-correcting free market capitalism at its best” (Treasury 2006). In a June 2008 speech, New York Fed President Tim Geithner remarked how “we are fortunate to have Jerry Corrigan engaged“ with the counterparty credit risk problem (Geithner 2008). In early 2007, months before the credit crisis unfolded, Fed Chair Bernanke remained optimistic about the ability of regulated institutions to manage risks associated with derivatives: “We can use our supervisory authority to ensure that the large institutions that form the core of the

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financial system—which happen to be the leading dealers in the credit derivatives markets and the principal counterparties and creditors of hedge funds—manage the risks that they face in a safe and sound manner” (Bernanke 2007a). Only ten months later, the Fed engaged in an unprecedented intervention, facilitating the rapid sale of Bear Stearns to avoid a financial market meltdown. Fed decisionmakers concluded that the “deep involvement” of Bear Stearns in the derivatives and short-term funding market could have jeopardized the financial stability of other firms or paralyzed credit markets (Bernanke 2008a). Because the market for derivatives is not transparent, it was not clear who was exposed to risks from a Bear bankruptcy or even the number and total amount of derivatives contracts that Bear had on its books. Derivatives had a unique role in the contagion of the crisis, and regulation of the derivatives market is a key component of the government’s response to the crisis. Rep. Edward Markey (D-MA), the sponsor of the 1994 legislation that inspired the Corrigan and Greenspan testimony, reintroduced proposals for derivative market reform in the fall of 2008. Congress took no action on his proposal. As part of a broader financial regulatory reform blueprint, the Treasury Department released a set of proposals for regulating derivatives in 2009, envisioning joint regulation of the derivatives market by the CFTC and SEC (Treasury 2009). Dodd-Frank outlines a framework for regulating derivatives markets, but there was no concrete progress on specific rules in 2009 or 2010. As with components of DoddFrank that impose new capital and other requirements on banks, rulemaking related to oversight of derivatives has missed key deadlines. The New York Fed vice president in charge of evaluating rules for managing the derivative market, Theo Lubke, resigned to accept a position at banking giant Goldman Sachs in late 2010, fueling speculation about industry efforts to undermine regulation of the market (Leising and Harrington 2010). Further clouding the prospects for reform, the chairman of the House Financial Services Committee, Rep. Spencer Bachus (R-AL), cosponsored proposals to “restore order” to the rulemaking process by extending Dodd-Frank deadlines from July 2011 to December 2012 (Bachus 2011). Regardless of the ultimate form of the rules, derivatives regulation is likely to implicate the Fed in two important ways. First, as systemic risk regulator in the FSOC, Fed supervision or oversight authority will extend to the largest participants in the derivatives markets: hedge funds and investment banks. Second, many regulators and market participants are advocating the creation of mechanisms to improve transparency and operation of the derivatives market, principally through establishing a

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central clearinghouse to record and manage derivative transactions. This effort, while endorsed by Fed leadership, is largely taking place outside of the Fed in the SEC and CFTC (see Bernanke 2011). Nevertheless, if clearinghouses are in fact created, the Fed could ultimately engage in supervision of these clearinghouses as too-big-too-fail “financial market utilities” (Committee on Capital Markets Regulation 2011). These extensions of the scope of the Fed’s authority cap a decades-long shift in the supervisory focus of the Federal Reserve System, from an initial focus on small and state-chartered banks to the current focus on the largest and most powerful firms in the financial sector.

Large Banks, Small Banks, and Bank Supervision at the Fed

The function of bank regulation and supervision was fragmented throughout the twentieth century—across state regulators and a number of federal regulators (the Fed, the Office of Thrift Supervision [OTS], the OCC, and the FDIC). Historically the Fed’s primary constituents were member commercial banks (typically smaller, state-chartered banks). As consolidation reduced the number of small banks and as large bank holding companies began to dominate the financial sector, Fed attention shifted from small state-chartered banks to large, complex financial institutions. Commenting on recent proposals to completely eliminate Fed oversight of small banks, Kansas City Fed President Thomas Hoenig described the drawbacks of this shift: Congress established the Federal Reserve System in 1913 with 12 banks in a federated structure, like our political system, so that it would include regional perspectives to counterbalance the influence of Wall Street and Washington. To now narrow the Fed’s supervision to just the largest banks would be to devalue those broader perspectives. The Federal Reserve would no longer be the central bank of the United States, but only the central bank of Wall Street. (Hoenig 2010)

The 2008 credit crisis placed the Fed at the heart of the financial regulatory environment and amplified the influence and voice of large institutions. A number of financial services corporations sought the legal status of a bank holding company—a nonbank company that has ties to a depository institution. The Fed is the primary regulator for bank holding companies, so some of the world’s largest and most powerful financial services firms came under the Fed’s jurisdiction in the fall of 2008. Most of these firms technically assumed the legal form of a particular type of bank hold-

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ing company—a “financial holding company.” This type of entity was first constructed by the Financial Services Modernization Act (GrammLeach-Bliley) in 1999; financial holding company status permits firms to engage in a wide range of financial transactions, including securities underwriting and merchant banking. The legislation specifically designated the Fed as the “umbrella supervisor” for these entities, and specified that particular regulatory functions would fall to other regulators: securities activity to the SEC and insurance activities to the state insurance commissioners (Federal Reserve Bank of San Francisco 2000). These statutory changes anticipated coordination of financial holding company regulation across a number of different government agencies. The Fed faced increasingly complex decisions about the treatment and oversight of bank holding companies. Bank holding companies are simply corporations that own a retail bank (depository institution). Bank holding companies are scrutinized for both capital adequacy (is the holding company adequately capitalized to support the bank?) and to protect insured deposits (will the holding company raid the bank for capital?). Regulations governing lending and investment activities of bank holding companies are designed to ensure that the benefits of federal insurance and protection conferred on the bank are not used to lower borrowing costs for the affiliated nonbank enterprises and that the lending terms for affiliates are similar to those available to other third parties. Creation of the Troubled Asset Relief Program (TARP) and lending facilities at the Fed led a number of firms to register as bank holding companies: credit card and financial services conglomerate American Express, investment bank Goldman Sachs, and auto lending giant GMAC. As bank holding companies, these firms could access Treasury and Fed credit, at the cost of complying with Fed supervision. These changes in legal status effectively ended the business of standalone investment banking. All of the investment banks at one time supervised under a voluntary SEC program were either bankrupted or placed under oversight of the Fed. The net effect of these changes and ongoing consolidation in the banking industry implies a critical role for the Fed: the nineteen largest US bank holding companies held twothirds of all assets and half of all loans in the US banking system in 2009 (Federal Reserve System 2009b). The Fed has the exclusive regulatory authority to supervise bank holding companies, and Dodd-Frank extended this regulatory authority to include thrift holding companies previously supervised by the OTS. The Fed’s central role was also revealed as the government developed and publicized “stress tests” for the largest banks operating in the United

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States. Fed examiners conducted stress tests on nineteen large financial institutions—all bank holding companies with assets exceeding $100 billion—as part of a broader federal effort to identity institutions in need of capital and restore confidence in US financial institutions (Torres and O’Leary 2009). The results of the stress tests—formally the Supervisory Capital Assessment Program (SCAP)—were published in May 2009. The Fed was highly engaged before the financial crisis with supervision of the large complex institutions. After Gramm-Leach-Bliley opened the door for consolidation of investment and retail banking functions in 1999, the Fed recognized “substantial conceptual and technical challenges to be overcome in the development of risk management systems” that treat the unique risks associated with the diverse lines of business in financial holding companies (Cumming and Hirtle 2001). The Fed used the Basel framework to define risk-based capital requirements for bank holding companies, refined comprehensive reporting requirements for large bank holding companies, and developed a common evaluation metric to evaluate bank holdings. The ratings are similar and link to the CAMELS guidelines applied to commercial banks: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk. The Fed evaluates bank holding company performance in three areas (risk management, financial condition, potential impact), reports a composite rating for the holding company, and integrates ratings of the depository institutions owned by the company; the result is an RFI/C(D) rating. Specific Fed experience with bank holding companies suggests the complex challenges these firms pose for regulators. Regulation Y implements the Bank Holding Company Act of 1956, permitting the Fed to place specific restrictions on the permitted lines of business, impose capital requirements, and require other supervisory disclosures from bank holding companies. The Fed will rely on this authority to enforce the “Volcker Rule,” Dodd-Frank language that limits the ability of banking entities—that is, depository institutions and bank holding companies—to engage in proprietary trading. Proprietary trading is simply when firms invest their own capital, rather than limiting transactions to investing the capital of clients or depositors. Proprietary trading in financial assets— securities, equities, hedge funds, currency—accounts for an important revenue stream for investment banks. The rule would compel Goldman Sachs, for instance, to abandon lucrative core business functions or renounce bank holding company status. Goldman retained bank holding company status and closed several proprietary trading units in 2010 to comply with the Volcker Rule (Moore 2011). The Federal Reserve Act

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specifies limits on bank holding company extensions of credit and other transactions between the holding company and bank affiliates, known as 23A and 23B restrictions. Gramm-Leach-Bliley complicated these rules as bank supervisors needed to exercise particular caution to protect insured deposits from risks associated with affiliated investment banking activities. Responding to these concerns, the Fed implemented Regulation W in 2003. The rules specifically addressed credit exposures for derivatives and links between banks and financial subsidiaries (Federal Reserve System 2002). The rules were refined in a series of legal interpretations that clarified how the Fed would enforce the new restrictions. Merrill Lynch, for example, was granted a 2006 exemption to section 23A regulations in order to consolidate hedge fund and other operations from a London affiliate into a US depository institution (Board of Governors of the Federal Reserve System 2006). GMAC requested exemption from several Fed restrictions on consumer lending. Michigan-based GMAC, now known as Ally Financial, is the bank holding company for Ally Bank, a Utah-based bank. In a May 2009 supervisory letter, the Board of Governors spelled out the conditions under which Ally Bank could finance consumer loans and dealer purchases of inventory. Both transactions could be used to support GM sales, benefitting the holding company. The letter draws the Fed into specific decisions about the characteristics of permissible consumer loans—minimum borrower FICO scores and required down payments (Board of Governors of the Federal Reserve System 2009b). As the Fed’s supervisory focus shifts to the larger bank holding companies, the Fed faces more and more of these complex judgments about permissible lines of business and the scope and management of risks in individual banks and across a remarkably diverse set of affiliated businesses.

The Shadow Banking System and Prudential Regulation

What types of financial institutions should be subject to regulation? Under what conditions and with what goals? The Fed has traditionally integrated bank supervision with broader monetary policy functions. The idea was simply that monetary policy operated principally via banks. During the period leading up to the financial crisis, innovations in structured finance and the proliferation of hedge funds led to the emergence of a large “shadow banking” system, a network of nonbank financial institutions that accounted for a large proportion of capital flows and credit movements in the US and global economies. Academic

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work on the transmission of monetary policy recognized how the traditional “bank lending” channel operated in tandem with a broader “credit” channel (Bernanke and Gertler 1995). These changes in the financial sector led to connections between a bewildering array of financial institutions: hedge funds, investment banks, and a variety of special-purpose vehicles—notably structured investment vehicles (SIVs). Some of these institutions—hedge funds—are deliberately left unregulated. Others, such as SIVs, were created and structured in a way that skirted existing regulations. Yet others were supervised in relatively unobtrusive ways (investment banks). In retrospect the Fed clearly could have policed more aggressively the risk management practices of the depository institutions that were the traditional focus of Fed supervisory efforts. Prior to the collapse of Bear Stearns, the Fed could have led banks to adopt more robust counterparty credit risk management practices, averting the prospect of a systemic financial crisis with the bankruptcy of a large nonbank firm. The Fed underestimated the risks posed by bank ties to elements of the shadow banking system, and one result has been a renewed focus on how the traditionally lightly regulated firms might be brought under some form of supervision. The structure of each of these types of financial institutions— the legal status, permitted lines of business, objectives, and portfolios—are very different. The structural distinctions imply different types of risks for investors, different types of supervisory challenges, and different rationales for regulation and oversight. In the sections below, I review specific regulatory challenges posed by four distinct entities: structured investment vehicles, hedge funds, investment banks, and money market mutual funds. Most reform proposals that address the credit crisis envision some role for closer Fed scrutiny of each of these elements of the shadow banking system, particularly the links between large, complex bank holding companies and the broader network of financial institutions. As the Fed incorporates its new role of systemic risk regulator, Fed leadership will need to develop new technology and expertise to monitor a wide variety of financial institutions that are not traditional banking entities. Structured Investment Vehicles

One arcane creation brought to light by the financial crisis is the specialpurpose vehicle (SPV), a legal entity that collects and distributes the principal and interest income from a bundle of securities or mortgages that backs MBS or ABS CDO. During the frenzy of securitization in 2005 and 2006, investment banks and bank holding companies routinely

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created and gained experience with the function of these entities. This experience led banks to develop an even more highly specialized type of financial entity: the structured investment vehicle (SIV). SIVs are created to sell short-term debt to finance the purchase of asset-backed securities (including ABS CDO)—exploiting the difference between the low cost of high-quality short-term debt and the high returns on low-quality long-term debt. By creating an SIV, large financial institutions can remove lower-quality long-term obligations from their balance sheet, freeing up capital to make new loans. In contrast to the SPVs created to facilitate a garden-variety securitization, SIVs are intended to persist over time, continuously refinancing short-term debt and refreshing the portfolio of ABS CDO as assets mature, creating a permanent and large shadow banking system. SIVs are legally distinct from banks or bank holding companies and are often incorporated or registered in offshore tax havens so that they are not regulated by bank supervisors or subject to capital requirements. Citigroup is credited with the creation of the first SIV in 1988, and ultimately Citigroup was linked with seven distinct SIVs holding over $100 billion in assets (Tett 2008). In the narrowest technical sense, SIVs are legally distinct and bankruptcy-remote financial entities, meaning that the bank that created the SIV is not responsible for the liabilities or losses associated with SIV activity. SIVs are simply conduits for the transfer of money from mortgage servicers or other parties to a network of investors. SIVs do not represent explicit liabilities for sponsoring banks. Fed leadership recognized, however, that sponsoring bank reputations were linked to the performance of related SIVs; the bank assumed a form of implicit guarantee for SIV shareholders. If the SIV was failing, the regulated bank would be expected to stop the failure (see Krozner 2008b). This implicit guarantee links the funds of regulated, insured depository institutions to the risks taken on by unregulated, uninsured novel financial entities. As publicity about the 2007 collapse of the Bear subprime hedge funds soured investors on subprime MBS and ABS CDO, rating agencies systematically downgraded the credit quality of all SIVs and investors stopped purchasing the short-term debt that SIVs were using to fund portfolios of MBS and ABS CDO (Standard and Poor’s 2007). The SIVs could not sell the securities in the portfolio since investor demand for those assets had evaporated. In order to refinance short-term debt, the SIVs required immediate and substantial capital infusions to stay solvent. Bank holding companies were unprepared for the capital requirements that SIV distress would imply, a contingency that Fed supervisors could have highlighted. Spanish bank supervisors, for

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instance, placed high capital requirements on SIVs, making them unattractive to Spanish banks (Hannoun 2008, 11). US regulators made choices that permitted or encouraged SIVs and opened the channel for financial market disruption to seep from unregulated hedge funds to unregulated SIVs to regulated depository institutions and bank holding companies. The pace and scope of the distress for regulated institutions came as a complete and utter surprise to Fed leadership. Like credit default swaps and the super senior positions in ABS CDO, these links generated uncertainty about the solvency of particular institutions. These largely unmeasured risks are hallmarks of the 2008 crisis. Market discipline has an ostensible role in encouraging prudent risktaking in SIVs. SIVs are dependent upon rating agencies to secure favorable ratings for senior debt and dependent upon investors for short-term cash. If either rating agencies or investors reveal information about excessive risk-taking, then markets can discipline or restrain the growth of SIVs. In one sense, market discipline was ultimately effective. Investors fled SIVs as the credit crisis intensified and the last remaining SIV, Sigma Finance, ceased trading and began winding down early in the crisis (Unmack and Shenn 2008). Fed Governor Randall Kroszner placed blame for the failure of market discipline before the crisis squarely at the feet of investors: “If certain market participants had done more verification, they might not have invested in these vehicles, or might have demanded higher returns in line with the actual risks” (Kroszner 2008b). But as with MBS and ABS CDO, the rating agencies were implicated in the SIV failure since much of the SIV-issued debt was rated AAA. The California Public Employees’ Retirement System sued the major rating agencies specifically for “wildly inaccurate and unreasonably high” ratings of SIV securities. The trading strategies and composition of the SIV portfolios were regarded as proprietary, so investors were entirely dependent on the rating agencies to evaluate the quality of the SIV debt (Wayne 2009). Outside of the framework of banking regulation, there have been legal changes that respond to the risks highlighted by the crisis. The Financial Accounting Standards Board (FASB) now requires that loans and securities held by broad classes of SPVs be directly included in the bank balance sheet. FDIC analysts concluded that these changes would immediately impact banks, increasing levels of required capital for many institutions that relied on these vehicles (Thompson 2009). The banking regulators anticipate a phase-in period to permit banks to adjust to the new requirement, but in many ways the FASB action preempts the need for related changes in capital requirements. This is notable since

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FASB is a private organization, not a public agency. The SEC relies on FASB to articulate financial accounting and reporting standards, rather than attempting to craft these standards internally. The implication is that the most direct and immediate technical response to the accounting and financial problems implicated in the credit crisis came from outside of the public sector. Bank supervisors will ultimately determine how the new FASB standards translate into capital requirements for banks. The American Bankers Association responded to the proposed FASB modifications by suggesting—among other things—that securities or loans housed in an SPV receive a lower risk weighting than loans held directly by a bank, reflecting the lower risk that the legal status of the SPV confers (American Bankers Association 2009). If the bank supervisors adopt that recommendation, then the impact of the FASB standards will be diminished and banks will retain the incentive to securitize loans in order to reduce capital requirements. SIVs offer a powerful lesson about the challenges facing regulators of financial institutions. Managers of financial institutions face strong incentives to use accounting and regulatory loopholes to reduce capital requirements. Regulators—operating with limited budgets and staff and subject to political pressure to be permissive—struggle to adapt or contain these risks. Investment Banks

One straightforward step to contain financial market crises could be prudential regulation of investment banks. Investment banks are financial institutions that link together major industrial and commercial borrowers with institutional and other large-scale investors through the issue of securities and equities. The ability to issue securities and equities (stocks) makes investment banks distinctly different from retail or Main Street banks; before 1999 the two businesses were not permitted to exist under the same commercial charter. This restriction, known as the GlassSteagall wall, dates to the 1930s, a response to the financial crisis that precipitated the Great Depression. Deregulation of financial services in the 1990s did away with the Glass-Steagall wall, and some of the largest bank holding companies, like Citigroup, engage in both retail and investment banking. Until 2008, the largest and most powerful investment banks— Goldman Sachs, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley—remained separate from retail banking, as stand-alone firms outside of Fed oversight. The early casualties of the crisis were not bank

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holding companies but stand-alone investment banks Bear Stearns and Lehman Brothers. Only after these firms failed did the rest of the financial sector unravel. These failures, coupled with the creation of lending facilities that provided investment banks with access to Fed credit, led Fed leadership to endorse a “more robust framework” for prudential regulation of investment banks (Bernanke 2008b). Reflecting on the failure of Lehman Brothers, former SEC chairman Christopher Cox noted that Lehman conducted business across a network of more than 200 subsidiary businesses, including off-shore companies, mortgage companies, and reinsurance companies. SEC regulatory authority extended to only seven of these subsidiaries, leaving most to operate without meaningful oversight (Cox 2010). Prior to the fall of 2008, four of the largest investment banks were regulated by the SEC under the voluntary Consolidated Supervised Entities (CES) program, a program that clearly failed to adequately monitor or assess the evolving and growing risks associated with the business. Investment banks regarded the Fed’s risk management approach under Basel II as too conservative, prescribing capital requirements that were “excessive relative to risk and loss experience” (Ad Hoc Working Group of US Investment Banks 2004). Cox nevertheless defended the voluntary program as more rigorous than Fed prudential regulation, going “beyond the Fed’s requirements in several respects,” including the frequency of compliance reporting and the specification of a liquidity requirement on top of conventional capital requirements. As the crisis intensified in 2008, the Fed placed examiners at the major investment banks to work with SEC supervisors, but only the change in legal status permitted the Fed to press investment banks to raise more capital. After taking on the status of bank holding company, Goldman Sachs requested Fed approval to continue to apply SEC-approved risk models to avoid higher capital requirements under Fed supervision. The Board of Governors permitted Goldman to use the more permissive rules related to the computation of market risks in 2009 but mandated immediate compliance with Fed credit risk rules (Board of Governors of the Federal Reserve System 2009a). In 2008 the Fed and the SEC argued for legal authority to directly supervise investment banks. The SEC appealed to the unique business lines and trading activities of investment banks to justify locating supervisory authority in the SEC. Fed leadership argued that the information acquired in the context of supervision was vital to make good judgments about the extension of loans and credit during periods of financial crisis (Geithner 2008). Because the largest investment banks are now bank holding compa-

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nies, the Fed is the de facto regulator for the business of investment banking. If the large investment banks renounced bank holding company status by selling stakes in depository institutions, Fed supervision would likely still remain in place as a part of the new FSOC regime to identify and oversee large, systemically important firms. Further, if investment banks renounced bank holding company status, they may no longer have access to Fed credit facilities and, instead, would be subject to an FDIC-style wind-down or other intervention—the resolution authority developed under Dodd-Frank (see Chapter 6 for details about this authority). Hedge Funds

Hedge funds present perhaps the most complex regulatory challenges. The 1998 LTCM collapse, discussed above, highlighted the need for enhanced oversight of hedge funds. Before the 2008 crisis, the Fed and other federal regulators embraced approaches that focused on market discipline, rather than government supervision. Hedge funds are specifically intended as vehicles to permit sophisticated investors to engage in risky financial transactions (see Edwards 1999). Hedge funds are designed to serve only the needs of wealthy and (presumably) sophisticated investors; these funds are open only to accredited investors, who must have, under rules established in 1982, income exceeding $200,000 per year for two consecutive years or net worth in excess of $1 million. The expectation of regulators is that market discipline brought to bear by these affluent consumers would rein in hedge fund practices. The academic and practitioner literature on risk management practices before the crisis was optimistic about the effectiveness of market discipline. While urging greater attention to risks associated with hedge funds, a report authored by three Fed officials concluded, The evidence suggests that the indirect approach has been sufficient. In the ten years since hedge funds emerged as major market participants, markets have demonstrated surprising resilience in the face of significant disturbances, including the bursting of the technology bubble, the 2001–2002 recession, the events of 9/11, two wars, and a wave of corporate scandals. (Cole, Feldberg, and Lynch 2007)

The same study describes positive industry responses to the 1998 LTCM meltdown—investments in information technology and more rigorous scrutiny of hedge fund risks by individual banks. In the spring of 2007, leadership at the New York Fed identified counterparty credit risk

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management as the key tool to insulate the real economy from the collapse of hedge funds (Kambhu, Schuermann, and Stiroh 2007). Writing prior to the spillover of the Bear funds collapse into the broader financial markets, Kambhu et al. also note positive industry developments since the 1998 collapse of LTCM: “improved risk management techniques by counterparties, improved supervision, more effective disclosure and transparency, and more effective hedging and risk distribution techniques” (2007, 14). Also reflecting on these risks in early 2007, about four months before the meltdown of the Bear Stearns funds, Fed Governor Randall Kroszner offered a generally positive assessment of the status of risk management and added that “unregulated or less regulated entities should in principle be subject to more effective market discipline than banks because, without a safety net supporting them, their creditors have stronger incentives to monitor and limit their risk-taking” (Kroszner 2007b). This perspective was reinforced in the Bush administration’s 2008 Treasury Blueprint even after the Bear Stearns failure. The reform proposal described an optimal regulatory structure that separates market stability functions (to be held by the Fed) from the prudential regulator functions, which would be applied only to institutions backed by some form of explicit government guarantee. Only a limited oversight of business practices would be applied to hedge funds or investment banks, presumably enhancing market discipline (Treasury 2008). Before the crisis, Fed decisionmakers focused on improving supervision of “core” institutions, rather than directly monitoring hedge funds (Geithner 2006). Even in this context, the financial services industry actively worked to protect the ability of hedge funds to borrow from banks. During the notice and comment period on Basel II in mid-2007, Citigroup, the Managed Funds Association, and other industry voices urged the banking regulators to relax a proposed 100 percent risk weight for bank investments in hedge funds. Citigroup argued that equity investments in hedge funds should be treated in the same way as equity investments in other firms (Citigroup 2007). The Managed Funds Association concluded that the proposed capital requirement would “place US institutions at a competitive disadvantage” and “interfere with the efficient operation of the US hedge fund industry” (Gaine 2007). The final rule published by the banking regulators relaxed the capital requirement, permitting supervisors some discretion over the treatment of these hedge fund investments. Apparently, to the dissatisfaction of the American Bankers Association, Fed supervisors chose to use this discretion after the crisis to restrict regulated bank investments in hedge funds (American Bankers Association 2011). With the

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Fed’s new role in the Financial Stability Oversight Council, Fed leadership will revisit these regulatory questions, directly evaluating the riskiness and monitoring the performance of the largest hedge funds. Money Market Mutual Funds

As the bankruptcy of Lehman Brothers rippled across the financial sector, Fed actors were surprised to learn of vast investments by one of the largest and oldest money market mutual funds, the Reserve Fund, in Lehman Brothers securities. SEC disclosures indicate that the Reserve Primary Fund held over $785 million in short-term Lehman debt. The Lehman bankruptcy pushed the value of the Reserve Primary Fund below $1 (“breaking the buck”), and managers were forced to suspend redemption privileges for investors. This failure—only the second in the forty-year history of the money market mutual fund industry—led to a huge volume of redemptions from other money market mutual funds. The cascade of redemptions led managers of funds to attempt to liquidate short-term assets, and these sales dramatically reduced the volume of commercial paper that could be financed by fund purchases. The overall effect was a severe and widespread disruption in the short-term credit market, triggered by investor anxiety and fears of broader failures among the money funds. Money market mutual funds originated as investment alternatives to retail deposits. Before 1980 the Fed prohibited the payment of interest on bank deposits under Regulation Q. Operating outside of traditional depository institutions, money market mutual funds offer a modest interest rate and protection of principal (a share value of $1). Unlike traditional bank deposits, money market mutual funds are not backed by the insurance fund of the FDIC, the funds are not supervised by the Fed, and they are subject to very little oversight from the SEC (see Cargill and Garcia 1985). The Reserve Fund requested and received authority from the SEC to suspend redemptions from two of its large funds in midSeptember 2008 (Securities and Exchange Commission 2008b). As the Reserve Fund struggled, the Fed took several discrete steps to stabilize short-term credit markets, including a lending facility for banks that in turn lend to money market mutual funds, and an extraordinary lending facility that provided direct loans to money market mutual funds (Bernanke 2008c). Not surprisingly the American Bankers Association bridled at the proposed intervention; banks accept regulation in exchange for insurance, and money market mutual funds are excluded from close supervision but ultimately benefit from insurance—a form of bailout—in periods of dis-

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ruption (Henriques 2008). The implicit guarantee of large money market mutual funds creates a competitive advantage for these funds compared to traditional regulated banks. The rescue of the money market mutual fund industry, through a combination of Fed loans and Treasury guarantees, highlights an acute dilemma for the Fed. If the Fed cedes regulatory authority to agencies that have enforcement or supervisory responsibilities (like the SEC), but which lack resolution authority or access to capital to perform lender-of-last-resort functions, the Fed is dependent on the capacity and vigor of these other agencies to safeguard Fed assets and reputation. Edward Kane described similar incentives in his work on the government response to the US savings and loan crisis, when bank management, regulators, and members of Congress had incentives to minimize the scope and costs of potential losses in the thrift industry. Critical warning signs were ignored. There was no incentive for regulators to resolve failing firms, but powerful incentives to leave management in place with the remote hope that failures would come to light only in some future administration or under new leadership—a “regulatory gamble” (Kane 1989). The president of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota, appealed to a similar logic, defending an ongoing role for the Fed in bank supervision in 2010. If the Fed is to serve as lender of last resort, then the Fed needs reliable information to determine if an institution seeking capital is viable or risky. If supervisory authority is located outside of the Fed—in another agency— then the Fed operates without this critical information: What exactly are this other agency’s incentives to provide the Federal Reserve with the best possible information? . . . One can readily imagine that in the politically charged circumstances of a financial panic, this other agency’s objective might be to keep as many banks alive as possible. In these circumstances, the Federal Reserve would have no way to obtain reliable information from this other regulatory body and would have no way to make appropriately targeted loans. (Kocherlakota 2010)

This scenario describes the aftermath of the Lehman Brothers failure and the Reserve Fund collapse. The Fed scrambled to respond to the financial shocks created by redemptions from money market mutual funds despite the absence of Fed authority to regulate or supervise these funds. New York Fed leadership advocated closer scrutiny of money market mutual funds as one of several steps to recognize and reduce risks associated with the shadow banking system (Krieger 2011). As part of the Fed’s new authority under the FSOC, the largest money market mutual funds are likely to face closer supervision and higher capital requirements.

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The Systemic Risk Mission and the Contemporary Fed

The FSOC implies broad new regulatory authority for the Federal Reserve System. The new authority would permit the Fed to identify firms as systemic risks (firms that are “too big too fail”) and apply capital and other regulatory requirements to these firms. The supervisory authority could extend across the financial sector—to hedge funds, investment banks, insurance companies, mutual funds, and even financial market utilities structuring the market for derivatives. The FSOC is designed to give the Fed information on the performance and riskiness of any financial institution that could pose a systemic risk and establishes legal authority for the federal government to suspend the firm’s operations in an orderly fashion. Rather than relying on ad hoc negotiations and choices like those that led to the Bear Stearns sale, the Lehman Brothers bankruptcy, and the AIG bailout, the FSOC institutionalizes agency collaboration and permits the development of rules regarding the resolution of distressed firms that pose systemic risks. The Fed is one member of the FSOC, with a particular focus on supervision and oversight. Decisions about how to resolve distressed firms will be shared with several agencies, including the SEC, the FDIC, the CFTC, and Treasury. The Fed’s new supervisory and oversight authority largely complements Fed expansion to include oversight of bank holding companies and institutionalizes a role that has roots in Fed emergency lending powers established in the 1930s (Shiller 2008a). Although the Fed shares decisionmaking authority in the FSOC with nine other regulators, the Fed retains ultimate control over the instruments that permit dramatic intervention in financial markets. Details about the operation of the FSOC—the criteria to be used to designate firms as systemic risks, the metrics to be used to measure and manage risk, and the operation of the resolution authority—remain unclear. For instance, the FSOC must first determine the scope of oversight. How many firms are risky enough to warrant special scrutiny? FDIC Chair Sheila Bair advocated a more inclusive, larger set of firms, while Fed Chair Bernanke indicated support for a smaller group (see Katz and Christie 2011). Using Bair’s more inclusive approach minimizes incentives for larger firms to reorganize under a different charter or business in order to escape close scrutiny, but increases the workload associated with and complexity of the Fed’s supervisory activity. Even three years after the crisis, the details of the framework designed to preempt and address the next large failure remain elusive. The network of actors with a stake and voice in proposed solutions to the problem of systemic financial risk is large and complex, ranging

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from international consortiums of official sector actors (organized under the Bank for International Settlements, for instance) to a variety of private sector actors in the traditional and shadow banking systems and the trade associations and groups that represent those private actors. The Financial Stability Forum (FSF) illustrates the range of international actors with a stake; the Basel Committee, the International Organization of Securities Commissions, the International Association of Insurance Supervisors, the International Accounting Standards Board, the International Monetary Fund, the Bank for International Settlements, and the “national authorities” for a dozen countries all formally collaborate on the problem of financial stability (Financial Stability Forum 2008). A variety of financial institutions—hedge funds, investment banks, rating agencies, retail banks—and the agencies that closely or loosely supervise these entities have a preference over the way that the government manages systemic risk. The FSOC reflects many of these diverse domestic interests. SEC Commissioner Luis Aguilar justified the creation of a multiagency council for systemic risk by appealing to the idea that the Fed’s understanding of the financial sector was rooted in experience with and advocacy for banks. He suggested that if the power to manage systemic risk was concentrated in one agency—the Fed, for instance— that agency might give preferential treatment to the firms it regulates (Aguilar 2010). Advocates of the FSOC structure specifically intended to expose Fed oversight choices to a wider variety of interests (firms, consumers, and investors) than the network that influences traditional monetary policy and bank supervision. Fed leaders have confronted this prospect in the context of previous efforts to overhaul bank regulation—and identified clear threats to the Fed’s core mission. In the mid-1970s, several members of Congress proposed the rationalization of bank regulation—the consolidation of regulatory authority for all banks inside the Federal Reserve System. The Fed actively resisted this effort. Its reservations were grounded in the understanding of how the expanded network of institutions and actors would threaten monetary policy functions (Corder 1998). Staff at the Federal Reserve Bank of San Francisco specifically warned that “interests of various industries and financial institutions would divert attention from monetary policy” (Federal Reserve Bank of San Francisco 1974). Reflecting insights from the recent crisis, Fed Chairman Bernanke and Governor Daniel Tarullo argued that the new Fed authority would in fact improve monetary policy. Recognizing the substantial changes in the financial sector implied by the shadow banking system, they concluded,

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Indeed, there are some important synergies between systemic risk regulation and monetary policy, as insights garnered from each of those functions informs the performance of the other. Close familiarity with private credit relationships, particularly among the largest financial institutions and through critical payment and settlement systems, makes monetary policy makers better able to anticipate how their actions will affect the economy. (Bernanke 2009a)

This contemporary perspective reflects the gradual and systematic shift from small bank supervision to the oversight of large financial institutions and, further, suggests that Fed leadership has used its experience with large bank holding companies to improve performance of the core monetary policy functions. But in hearings related to financial regulatory reform proposals in March 2009, the American Bankers Association cautioned members of Congress that the coupling of the systemic risk regulator and monetary policy functions could jeopardize the independence of the central bank. These concerns were echoed at the same hearing by Rep. Scott Garrett (R-NJ). He cautioned that the Fed might be reluctant to raise interest rates during periods of financial distress, responding to increasing systemic risks but jeopardizing price stability (US House of Representatives 2009, 5). If increasing interest rates destabilize the financial system, then the role of systemic risk regulator will come into conflict with the mission to pursue stable prices. This conflicting mandate is not new for the Fed. The Fed is already asked to prioritize growth, stability, and the long-run growth of the monetary aggregates. The new mission of systemic risk regulator simply adds another objective to balance against the specific goal of price stability. On top of the changes to mission and exposure to new interests and preferences, expanded prudential supervision confronts the Fed with a technical challenge. Bank regulators, in general, face conflicting goals of encouraging innovation, competitiveness, consumer protection, and safety and soundness of individual institutions (see Khademian 1996). Recent work, like Brunnermeier et al. (2009), has highlighted the potential conflict between promoting the safety and soundness of individual financial institutions (the microprudential regulation described in Chapter 4) and the stability of the financial system as a whole (macroprudential regulation). Large global firms—like the large investment banks—face extraordinary international competitive pressures. Hedge funds are legally structured to encourage and permit high levels of risk and innovation. The implication is that the Fed’s lessons, principles, and decades of experience refining microprudential oversight of banks might not translate into the

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capacity to engage in macroprudential regulation or to regulate institutions that are not banks. To engage successfully in broader prudential oversight, the Fed would require substantial new staff and, further, staff with expertise beyond that of existing commercial bank supervisors. Even in the early stages of the crisis, the Fed did make important staffing changes to reflect these new responsibilities. In 2010 former SEC chairman Christopher Cox described extensive collaboration between Fed and SEC leadership and successful Fed efforts to recruit SEC personnel to Fed supervisory positions in New York and Washington. The recruiting effort was so successful that the SEC had to negotiate a temporary “nopoaching” agreement to retain staff (see Cox 2010). The New York Fed also reorganized to reflect the new and broader authority, anticipating a higher investment of resources in supervision. One specific change in response to the crisis was to transfer risk analysts from the New York Fed building to on-site supervisory teams (Salas and Keoun 2011). The Wall Street Journal reported that the New York Fed plans to double the number of full-time, on-site regulators from 150 to 300, including additional staff to directly oversee the activities of the largest financial institutions (Lucchetti 2011). These adaptations reflect the number of large institutions specifically under the geographic jurisdiction of the New York Fed, including JPMorgan Chase, Goldman Sachs, and nonbank financial giant GE Capital. The literature on crisis, innovation, and government performance suggests that the agencies are vulnerable to failure as they adapt to new constituencies and new functions. Congress has been tempted in the past to adapt the human and technical resources of a high-performance agency to a new and expansive task—to treat agencies as “infinitely pliable” (Derthick 1990). The results have not always been positive. The experience of FEMA after 9/11 and the Social Security Administration’s struggles to implement the SSI program each reveal the unanticipated consequences of new and different authority. Taken alone, the new Fed role on the FSOC signals an important shift in federal approaches to market stability. The new council formalizes agency cooperation, and the new authority for the Fed has already triggered changes in organization of staff supporting the Board of Governors of the Federal Reserve System and changes in the levels and responsibilities of supervisory staff in the Federal Reserve Bank of New York. This single reform formally adds a new mission, places the Fed on a collision course with industry segments that have escaped close scrutiny and regulation (mutual funds and hedge funds), and implies a need for new human capital—expertise in risk management rooted in economics, accounting, and law. This expertise—already reflected in Obama board

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appointments Daniel Tarullo and Sarah Bloom Raskin—contrasts with the traditional areas of expertise valued in the Fed: macroeconomics and monetary economics. Combined with the variety of other changes to mission and function implied by Dodd-Frank and other elements of the government response in 2008, Fed leadership confronts a disruptive and costly transition that muddles the Fed’s mission, complicates the Fed’s political environment, and taxes the agency’s intellectual and technical resources.

6 The $2 Trillion Balance Sheet

The government’s response to the credit crisis in the fall of 2008

was, for the most part, the Fed’s response to the credit crisis. There was intense public debate over the creation of the Treasury’s Troubled Asset Relief Program (TARP), but Fed lending facilities that were established with little public or media attention actually provided more capital more rapidly than the TARP program. In an August 2009 summary of the federal response to the financial crisis, the TARP Congressional Oversight Panel reported that more than half of the federal outlays, loans, and guarantees ($1.6 of $3.1 trillion) could be attributed to Fed programs— compared to less than $700 billion from TARP (Troubled Asset Relief Program Congressional Oversight Panel 2009, 109). The Fed programs are largely credited with preventing a catastrophic collapse of the financial markets and explain in part why the Fed’s reputation for competence persists despite notable failures to anticipate the spillover and scope of the subprime crisis. Remarkably, the Fed and financial market actors had little or no experience with many of the new tools, and what limited experience they did have was drawn from other countries—especially Japan. Japan carried out a program of aggressive monetary easing from 2001 to 2006. The central bank set a target of 0 percent for overnight interbank lending rates and dramatically expanded the bank’s balance sheet (assets held by the central bank). This set of policies was designed to counteract a sustained decline in prices experienced in Japan and was implemented by broadening the range of securities and other financial instruments that the central bank could purchase. The program was not a stellar success—overnight interest rates remained at 0 percent for five years—but the experience was instructive for US policymakers. Well before the 2008 crisis, Bernanke 113

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(2002) drew on the Japanese experience as he outlined the types of programs that the US central bank would adopt to confront deflation, anticipating both the securities purchases and term lending facilities implemented in 2008 and 2009. Fed staff prepared an extensive review of the efficacy of these alternative measures in a 2004 working report. The staff concluded that understanding of the effects of the alternative measures remained fairly limited, and evidence of the effectiveness of the Bank of Japan strategies was mixed (see Bernanke, Reinhart, and Sack 2004). Under these conditions of uncertainty and limited experience, the Fed experimented with several different strategies to inject capital in the fall of 2008. The Fed initiated new programs to expand Fed lending and broadened the range of securities directly purchased by the Fed to include agency MBS and long-term Treasury securities. All of the approaches grew out of programs that the Fed has used in the past. The Fed has at times purchased agency MBS and long-term securities to pursue specific policy objectives. The Fed also has a long history of using discountwindow loans to provide assistance to banks that need access to capital to meet overnight reserve requirements. But the scale of the 2008 purchases and loans was unprecedented. The response designed by the Fed had three distinct elements: maintenance of a zero or near-zero target for overnight interbank lending rates (the federal funds rate), the expansion of the Fed’s balance sheet with purchases of government securities including agency MBS, and the expansion of lending facilities to directly support distressed financial institutions. The last function—known as lender of last resort—has been part of the Fed’s policy repertoire for decades, but has typically been used fairly narrowly. Discount-window loans usually carry a high interest rate relative to the interbank market (which would deter banks from relying on the Fed), and the loans are associated with a negative stigma. Only banks unable to obtain funds from the interbank market are expected to rely on the discount window. The new lending programs expanded the lender-of-last-resort function by relaxing collateral requirements for loans from the Reserve Banks, extending the terms of loans provided to banks, and providing capital to firms other than traditional depository institutions. In a particularly innovative step, the Fed created off-balance-sheet entities to hold assets of failing institutions—notably Bear Stearns and AIG. All of these tools imply a new and broader role for the Fed—especially the Federal Reserve Bank of New York—in providing liquidity to particular sectors of the economy. The new Fed lending facilities and securities purchase programs are the truly novel aspects of the Fed’s response to the credit crisis. The

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standard operating procedures and routines that the Fed has used to stabilize the economy were not sufficient. Prior to the crisis, Fed monetary policy actions centered on the purchase and sale of short-term Treasury securities—open market operations—to meet a targeted federal funds rate. This tactic alone could not address the problems of market disruption and deflation that emerged in 2007 and 2008. The Fed anticipated the use of extraordinary measures to address these problems, but the actual implementation, refinement, and eventual termination of these programs introduces a great deal of uncertainty for Fed leadership. The contagion of the credit crisis tested the ability of the Fed leaders to create and expand new lending facilities; the resolution of the crisis will test the ability of Fed leaders to revert to standard operating procedures. The literature on crisis management indicates this problem is pervasive. Policymakers want to declare an end to the crisis—to demonstrate that the crisis response was effective and return to a routine (see Boin et al. 2005). To make this transition credible—from crisis to a normal state of affairs—the extraordinary tools and powers designed to stem the crisis need to be replaced with familiar instruments and operations. The challenge is technical (How quickly should the new lending facilities be closed?) as well as political (Will elected officials and the public expect Fed lending to address particular credit market goals to continue or expand?). The enormous portfolio of agency MBS the Fed is acquiring illustrates both challenges: At what point will the Fed begin to sell agency MBS? How will these sales affect the cost of credit for homeowners? Increasing interest rates on mortgages would inevitably place the Fed at odds with efforts to improve the volume of home sales and construction—a key component of recovery from the crisis. After reviewing the scope of the Fed’s response—the size and type of commitments that expanded the Fed’s balance sheet—I outline the specific implications of these new commitments for the Fed’s independence and the Fed’s pursuit of price stability. One primary lesson of the credit crisis is that the Fed can rapidly and effectively intervene to stabilize financial markets. This insight, knowing that the Fed will step in if conditions deteriorate, gives firms incentives to take risks that could disrupt the broader financial sector. This is the problem of moral hazard: as the Fed demonstrates it can intervene, firms will adopt risky behavior that eventually forces the Fed to intervene. The new Financial Stability Oversight Council (FSOC) confronts this problem by making credible the government’s threat to break up or wind down large, risky financial institutions. The use of new tools to stabilize financial markets in 2008 and the creation of the FSOC imply new roles for the Fed that may be difficult to

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shed, even after credit market conditions and the real economy show signs of improvement. These new roles can conflict with the traditional Fed mission of price stability, aggravate the problem of moral hazard that Fed intervention creates, and attract close scrutiny from elected officials and other observers (see Torres 2009b). As the Fed has weathered lawsuits, congressional inquiries, and internal disputes about the scope and terms of intervention, the political challenges of the Fed’s role as lender of last resort are already becoming clear, even if the lessons of the crisis are not.

The Fed’s Balance Sheet After 2007

The repertoire of new Fed programs introduced in 2008 was remarkable. Table 6.1 describes the growth of the Fed’s total assets from 2007 to 2011 and reveals the introduction of a number of new lending and credit programs. The size of the Fed’s balance sheet—the amount of assets that the regional Reserve Banks hold and acquire during the crisis—is an indicator of the intensity of the Fed’s response to the crisis. The aggregate growth of the Fed’s assets is by itself surprising—expanding by over $1 trillion in one year and continuing to expand more than three years after the crisis. The variety of programs that the Fed set up to manage the crisis is equally revealing. The Fed set up specialized programs to respond to particular problems associated with depository institutions, the mortgage

Table 6.1 Federal Reserve System Assets, 2007–2011 (billions)

Total assets Short-term Treasury securities Long-term Treasury securities Federal agency securities Mortgage-backed securities Term auction credit (TAF) Other loans LLC holdings Other assets

2007

2009

857.3 277.0 513.5 0.0 0.0 0.0 0.2 0.0 66.6

1,997.5 18.4 650.0 97.8 462.5 273.7 116.3 175.5 203.3

2011 2,854.3 18.4 1,605.4 115.3 908.8 0.0 12.7 61.1 132.6

Source: Federal Reserve Statistical Release H.4.1 “Factors Affecting Reserve Balances . . . ,” average holdings, first week of July each calendar year (Federal Reserve System 2009c, 2011)

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market, money market mutual funds, and the commercial paper market, and to manage bailouts or failures of particular firms (particularly AIG and Bear Stearns). Most of these programs took the form of term auction credit—a particular type of loan from the Fed to financial institutions. The details of various lending programs are outlined later in the chapter. Before the crisis, the Fed’s balance sheet was nearly entirely composed of US Treasury securities, but by July 2009, other types of debt made up over 70 percent of the balance sheet. Treasury securities were and continue to be the largest single class of assets held by the Reserve Banks, but account for a rapidly shrinking proportion of total assets. The Fed’s balance sheet reveals the fundamental importance of three steps taken to address the credit crisis: 1. Purchase of $1 trillion of agency MBS 2. Extension of $300 billion of term auction credit (loans to banks) 3. Lending of $100 billion under the Commercial Paper Funding Facility (included under LLC holdings in Table 6.1) These three programs alone accounted for over 40 percent of the Fed’s assets in July 2009. The 2011 numbers indicate that, even as the immediate crisis has subsided, the Fed continued to engage in large-scale asset purchases. The Fed extended purchases of long-term Treasury securities (designated as Quantitative Easing Two [QE2]) well into 2011 as the term auction and other lending facilities were terminated. This step is one move in the direction of a return to normal, with purchases of Treasury securities as the mainstay of continued intervention. The largest component of the Fed’s response—the purchase of agency MBS—was part of a broader financial stability program that the Obama administration initiated. In the spring of 2009 the Fed committed to purchasing more than $1.25 trillion in agency MBS specifically to stimulate mortgage lending and home sales (Federal Reserve System 2009f). This decision—to divert credit to a particular sector of the economy—was not without controversy within and outside the Fed. Richmond Fed President Jeffrey Lacker dissented from the January 2009 Federal Open Market Committee (FOMC) statement. He suggested that Fed purchases of agency debt and mortgage-backed securities distorted credit markets and proposed that the Fed focus on more neutral purchases of Treasury securities (Federal Reserve System 2009d). The balance sheet reveals a second major response: changes in the types of Treasury securities that the Fed purchased. In the spring of 2009 the Fed reinforced commitments to purchase Treasury securities with a

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maturity of ten years or longer. This purchase program was redolent of Operation Twist, a Fed program designed to manipulate the yield curve to address the balance-of-payments deficit in the 1960s (Corder 1998). Fed statistical releases—summarized in Table 6.2—indicate that holdings of long-term Treasury securities grew nearly fivefold between July 2007 and July 2011, an annual level of purchases that exceeds $150 billion. Before 2009, recent Fed experience with purchases in the long end of the securities market was limited. Between July 1997 and July 2007 the Fed added less than $100 billion in securities with a maturity of more than five years (increasing total holdings from $83 billion to $156 billion in ten years). Purchases in the long end of the market are generally intended to lower borrowing costs for consumers and business, reducing interest rates on mortgages and business loans that are tied to yields on longer-term Treasury securities. The purchase of longer-term government securities was a large component of the Bank of Japan’s quantitative easing program. But in a thorough review of the empirical literature on the Japanese program, Ugai (2006) claims that the purchases of longer-term securities had at most modest effects on yields of related financial instruments. A retrospective study of the impact of 2009 Fed purchases—about $300 billion—revealed a sustained “economically important” reduction of long-term interest rates on Treasury securities—about one-quarter percentage point (twenty-five basis points) over the course of the quantitative easing program (Amico and King 2011). This finding likely contributed to FOMC choices to extend quantitative easing in the form of long-term Treasury purchases into the summer of 2011.

Fed Lending Programs: From AMLF to TSLF

In addition to the purchases of Treasury and agency securities, the Fed created over a dozen new auction and lending facilities to remedy the liquidity and market problems that the crisis created. A variety of assetbacked securities (private and agency) and short-term commercial paper serve as collateral for these extensions of credit, permitting banks to obtain cash from the Fed rather than sell new or liquidate existing assets in the market. In addition to the new programs, the Fed relaxed the terms for traditional borrowing facilities—the discount window—to include longer-term loans (from overnight to ninety days) and decreased the penalty rate associated with this form of borrowing. The two largest new programs used by the Fed were the Term Auction Facility (TAF) and the Commercial Paper Funding Facility

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Table 6.2 Maturity Distribution of Treasury Securities Held by the Fed, 2007–2011 (millions of dollars)

Total Less than one year One to five years Over five years

2007

2009

2011

$790,553 398,697 234,953 156,903

673,470 101,976 261,730 299,765

1,624,515 134,258 708,800 781,457

Source: Federal Reserve Statistical Release H.4.1 “Factors Affecting Reserve Balances . . . ,” Wednesday, first week of July each calendar year (Federal Reserve System 2009c, 2011)

(CPFF). Advances under the TAF are available strictly to depository institutions (banks) and are only short term (a maximum of eighty-four days). Institutions must pledge collateral for any TAF advances; eligible collateral is restricted to the types of collateral required for discountwindow lending, but the form of that collateral is fairly liberal. Banks can receive advances of 90 percent or more of the amount of collateral provided in the form of US Treasury securities, foreign government bonds, municipal bonds, asset-backed securities, MBS, and collateralized debt obligations. Collateral in the form of home mortgages, auto loans, or credit card receivables is more heavily discounted. The programs provide a way for banks to meet short-term funding needs without borrowing from other banks or relying on short-term borrowing from the broader capital markets. The Fed had outstanding TAF advances totaling $280 billion in July 2009. The other large credit program—the Commercial Paper Funding Facility—was designed to ensure that US issuers of commercial paper (short-term financing instruments) could continue to raise capital to make loans. Financial institutions sell short-term commercial paper to investors. Using the cash raised from the sale of these instruments, financial institutions then make longer-term loans to businesses and households. Disruptions in the commercial paper market threaten this supply of critical capital to financial institutions and the flow of loans to consumers and firms. The CPFF is one of several new Fed programs that involve the creation of new financial entities—in this case a limited liability company, CPFF LLC. The company purchases new commercial paper using loans or advances from the New York Fed. This approach guarantees that even if private investor demand for commercial paper is low, institutions dependent on commercial paper can find buyers for new

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issues. Each of the new LLCs is consolidated on the balance sheet of the New York Fed; the CPFF LLC alone added $120 billion to the New York Fed balance sheet in July 2009. The Fed also took direct steps to revitalize the market for the financial instruments at the core of the crisis: asset-backed securities. The Fed created and then expanded a Term Asset-Backed Securities Loan Facility (TALF), committing to purchases of as much as $1 trillion of a wide range of newly issued AAA-rated asset-backed securities (including private MBS and other asset-backed securities). The TALF is a joint Fed-Treasury program. The New York Fed loans funds to support the securities purchases, but TARP funds provide credit protection for the Fed loans. As the plan was implemented in 2009, the Fed expanded the TALF to include five-year loan maturities and included commercial MBS as eligible collateral (see Federal Reserve System 2009e). Loans outstanding under the TALF program expanded from $20 billion in July 2009 to over $40 billion two months later. Fed leadership identified TALF as one of the more effective remedies for the 2008 market disruption; the Fed observed lower interest rates and higher volume in asset-backed security markets after the initiation of TALF lending (Kohn 2010). A pair of programs was designed to provide capital to firms that underpin the market for government, corporate, and asset-backed securities. Like the discount window, the Primary Dealer Credit Facility (PDCF) provides overnight loans. The novelty of the PDCF is that the target borrowers are primary dealers rather than traditional depository institutions. Primary dealers are roughly twenty of the largest securities trading firms in the world, including Citigroup, Goldman Sachs, and other large investment banking firms. The PDCF advanced nearly $50 billion in the early months of the credit crisis, but had no outstanding advances in July 2009. Also targeting primary dealers, the Term Securities Lending Facility (TSLF) is an auction facility that permits primary dealers to exchange—for a one-month term—a variety of investment-grade collateral for Treasury securities held in the System Open Market Account. The Treasury securities can then be used as collateral for overnight advances or in repurchase agreements with other financial institutions, enhancing broader financial market stability. This program was an extension of an existing overnight securities lending facility that the Fed traditionally provided for primary dealers, and the program was an important short-term source of substantial liquidity for financial markets in 2008. Since the program effectively permitted large financial institutions to convert illiquid asset-backed securities into collateral for low-rate short-term loans, the program was a particularly important source

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of funding for firms like Goldman Sachs and Morgan Stanley (Financial Crisis Inquiry Commission 2011, 391). The Fed also created a pair of programs to specifically address the problems for money market mutual funds created by the Lehman Brothers failure. Investors concerned about the safety of money market mutual funds withdrew huge amounts of capital after a large money market mutual fund—Reserve Fund—reported losses associated with substantial positions in Lehman Brothers’ short-term debt. Money market mutual funds are not eligible for discount-window borrowing, so the Fed designed a set of tools to permit these funds to gain access to capital. Using a set of privately created and publicly funded special-purpose vehicles, the Fed created a market for money market securities by indirectly purchasing outstanding securities. The Fed’s weekly statistical release does not reveal any financing activity under this Money Market Investor Funding Facility (MMIFF), but the program provided assurances to investors—on top of the explicit Treasury guarantee of money market mutual fund investments— that the government would support money market funds. The more successful Fed response to the money market mutual fund problem was the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF). The AMLF provides loans to banks to purchase commercial paper from money market mutual funds. The terms of the loans are substantially longer than conventional Fed loans—up to 270 days. Money market funds held roughly 40 percent of outstanding asset-backed commercial paper, so money market mutual funds could use the Fed lending facility to raise cash in the event of withdrawals without resorting to the sale of asset-backed commercial paper at a steep market discount. The program was initiated within one week of the failure of Lehman and perceived by observers as the “first thawing” after the credit market freeze (Torres and Condon 2008). In addition to the broader lending programs, the Fed’s balance sheet contains line items that reflect loans to particular firms: the extension of credit to AIG and the Maiden Lane LLCs. Maiden Lane identifies entities that hold distressed assets from Bear Stearns (Maiden Lane I), MBS from AIG (Maiden Lane II), and CDO from AIG (Maiden Lane III). The resolution of AIG has proven to be particularly complex and expensive. On top of the $40 billion in outstanding credit extended to AIG by July 2009 and $35 billion in assets acquired by Maiden Lane II and III, the New York Fed provided $8.5 billion in credit to facilitate the securitization of life insurance premiums by two AIG subsidiaries (Federal Reserve System 2009g).

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The menu of programs drives home two inescapable features of the 2008 crisis and the government response. First, the Fed is implicated in the banking and business activities of a wide range of financial institutions— well beyond the banks and bank holding companies that are at the core of the Fed’s supervisory authority. (Fed responsibilities under the new Financial Stability Oversight Council formally recognizes these supervisory functions.) Second, regardless of formal divisions of authority and regulatory jurisdictions, the Fed is the lender of last resort. The Fed’s injection of capital—immediate and substantial—prevented an even broader financial disruption. What are the implications of this role for the Fed? I review three particular policy challenges: the balance between bailouts and risk-taking, the political implications of loans to particular firms, and the conflict between being lender of last resort and pursuing price stability. The Fed has confronted each of these problems in the administration of traditional discount-window lending, but the scale of the challenge is larger given the expansion of the Fed balance sheet to over $2 trillion.

Too Big to Fail and the Problem of Moral Hazard

The array of lending programs sponsored by the Fed reflects the wide variety and types of institutions that were at risk in the fall of 2008. Fed lending facilities were used to support not just banks but money market mutual funds, securities dealers, insurance companies, and investment banks. This extension of the lender-of-last-resort function is novel in scale, but not entirely unanticipated. The Fed was formally designated by Congress as a lender of last resort for nonbank financial institutions in 1991, and Fed emergency lending power to these firms dates back to 1932 (see Shiller 2008a). The statutory change in 1991 reflected two decades of liberalization of uses of the discount window, beginning with the opening of the discount window to banks with client firms placed in financial jeopardy by the bankruptcy of Penn Central in 1970. Walker Todd of the Cleveland Fed presciently warned that the implicit taxpayer guarantee of nonbank losses implied by the 1991 statute would erode market discipline (Todd 1993). The fear was that firms outside of the Fed’s regulatory or supervisory control would take on greater risks knowing that Fed credit was available. The Fed is acutely sensitive to this problem of moral hazard. Financial institutions can exploit the existence of a safety net by taking excessive risks— realizing large gains privately but passing large losses on to taxpayers. This

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behavior—if occurring on a large scale—increases the chance of a widespread financial crisis. Richmond Fed President Jeffrey Lacker recognized these challenges in a 2009 FOMC meeting, arguing that targeted lending programs “channel credit away from other worthy borrowers, amount to fiscal policy, would exacerbate moral hazard, and might be hard to unwind” (Federal Reserve System 2009d). Schwartz (1992) argued that the Fed should confront the problem of moral hazard by responding to financial crises exclusively via open market operations—providing liquidity broadly— rather than discount-window lending to selected firms, most likely troubled or failing firms. Her assessment of the policy of discount-window lending was unambiguous: “Discount window accommodation to insolvent institutions, whether banks or nonbanks, misallocates resources. Political decisions substitute for market decisions. Institutions that have failed the test of market viability should not be supported by the Fed’s money issues” (Schwartz 1992, 65). The crisis management strategy of the Fed ignored these prescriptions and instead provided loans and credit to a wide variety of firms. In some cases, Fed loans managed to prolong the existence of banks that ultimately failed, saddling the FDIC with the costs of the failure (Appelbaum and McGinty 2011). Despite attention to and understanding of the problem, Fed choices before and during the 2008 crisis ratified the expectation that large systemically important firms would receive assistance from the Fed in some form; some complex financial institutions are simply “too big too fail.” For instance, the recapitalization of Long Term Capital Management in 1998 reinforced the sentiment that the Fed would not permit the outright failure of large hedge funds or investment banks (see Haubrich 2007). The Financial Economists Roundtable (1999) concluded that the LTCM transaction raised questions about “whether in the future [the Fed] intends to extend the Federal safety net that underpins financial markets to all financial institutions deemed ‘too large too fail.’” In a critical assessment of the Fed’s first steps in the subprime crisis, Reinhart (2008) claims that the Fed’s choice to extend credit to facilitate the Bear Stearns sale created an expectation that government contributions would play a part in the resolution of large failing financial institutions. The failure of Lehman Brothers four months later makes the extent of the Fed’s policies or criteria for lending somewhat uncertain, but the problem facing the Fed is clear. There is ample precedent for direct Fed intervention targeted to a number of types of firms, and future financial crises will trigger demands for the same type of Fed intervention. The more successful that

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Fed actions are now in propping up distressed firms, the more acute the problem of moral hazard will be in the future. Dodd-Frank established new authority for the FDIC to resolve failing large institutions, suggesting a sharp break from past practices and a new tool to confront moral hazard. The new rules permit the FSOC to identify large bank and nonbank firms as systemically important, triggering supervision by the Fed and potentially requiring higher capital and liquidity requirements. Dodd-Frank also establishes an “Orderly Liquidation Authority” for these firms, permitting the secretary of the treasury to bring in the FDIC to wind down large distressed firms and avoid disruptive bankruptcy proceedings (see Bair 2011). Because the resolution authority is implemented under the FSOC, decisions about intervention and liquidation will involve cross-agency negotiations that draw in, at minimum, the secretary of the treasury, the Fed, the SEC, the FDIC, and the OCC. In a 2011 report the FDIC described how the Lehman Brothers resolution would have progressed in 2008 if Dodd-Frank rules had been in place. The general conclusion is that the new rules would have permitted the FDIC to intervene, find a potential buyer as Lehman failed, and prevent substantial disruption and instability in commercial paper and derivative markets (Federal Deposit Insurance Corporation 2011b). But, like the Fed’s new supervisory responsibilities outlined in Chapter 5, details about the resolution authority and criteria to determine which firms will be designated by the FSOC as systemic risks are not finalized, so the scope and implications of the changes are unclear.

Specialized Lending Facilities and Fed Independence

In a technical sense, the new lending facilities and other elements of the crisis pose a challenge as the Fed will need to carefully unwind the facilities—extracting capital by selling securities slowly as the credit markets recover. Since the Fed has no experience with the new lending programs or large-scale purchases of MBS, the quantitative effects—the timing and magnitude of the effects of Fed actions on capital markets and the real economy—are poorly understood. On the other hand, the maturity of most of the loans the Fed makes is fairly short, so in one sense the technical approach is simple. Most of the programs will gradually diminish in size as soon as the Fed stops initiating new loans. Many of the programs did begin to shrink in 2009, and most of the term auction credit, other loans, and LLC holdings were diminished substantially

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by July 2011. There are signs that the broader exit may take some time. In the spring of 2011 the Fed auctioned billions of MBS acquired in the Maiden Lane transactions, but suspended the sales after complaints that the Fed sales depressed prices and undermined recovery in the credit markets (Gage 2011). The expansion of the Fed’s balance sheet has more nuanced implications related to the Fed’s role in credit allocation. Fed choices about which securities to purchase influence the allocation of capital across the economy. The Fed has historically struggled with the political implications of expanded authority to direct credit selectively to particular sectors of the economy. In the late 1960s Fed Chair William Martin resisted congressional authority to purchase agency MBS in the conduct of open market operations as a violation of a “fundamental principle of sound monetary policy“ (Martin 1968). Martin feared that purchase of agency issues would result in broader and more expansive demands from the Congress to purchase other types of agency securities and to channel credit to other vulnerable sectors of the economy. Fed leadership suggested that Congress should subsidize the flow of capital into the housing markets directly—on the budget—rather than attempting to use the Fed to purchase agency issues to influence the flow indirectly (US Senate 1970, 69). The Fed did not support the agency market with outright purchases until late 1971, after Arthur Burns took over as chairman of the Board of Governors. In a brief memo outlining the implications of the prospective policy change for Burns, a Fed staff member described the basis for the Board’s reservations: “this would represent a foot in the door for the various agencies and would then expose the System to undesirable political pressures from individual agencies to support their own operations” (Axilrod 1970). Any extension of Fed purchases beyond Treasury securities jeopardizes Fed independence and introduces distortions in credit markets. In a more contemporary work, Broadus and Goodfriend (2001) highlight two distinct implications of extending Fed purchases beyond Treasuries. First, Fed purchases of private securities would invite congressional oversight of how credit is allocated. Second, congressional pressure to retain assets could disrupt monetary policy choices. The Fed will confront these pressures as it reaches the turning point from monetary easing to monetary restraint in the near future. The Fed’s portfolio includes large amounts of Treasury securities and large amounts of MBS. If the Fed sells MBS first, then the costs of capital, for homebuyers in particular, will increase. If the Fed holds MBS and sells Treasury securities, the costs of capital for a wide range of borrowers, including corpo-

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rations and the US government, will increase at a faster pace than the cost of capital for homebuyers. Navigating this trade-off is new for the Fed and is likely to be treacherous. Using the discount window or other credit facilities to channel credit to firms raises similar challenges. Should the Fed extend credit—via open market purchases or credit facilities—to transportation authorities, student loan authorities, municipal governments, or agricultural cooperatives? Or strictly to banks? The 2008 crisis revealed these pressures. Congress specifically looked to the Fed to provide loans to automakers (Torres 2009b), and advocates for the student loan industry pressed the Fed to include student-loan-backed securities as eligible collateral for Fed loans (American Securitization Forum 2008). What will be the Fed’s new role in determining which sectors of the economy get special borrowing privileges? Answers to these questions invite (appropriately) oversight from elected officials in the Congress and the White House— scrutiny that the Fed has sought to avoid by relying on general changes in the level of interest rates, rather than aid directed to specific sectors. The particular recipients of Fed loans and credit in 2008 and 2009 have invited more rigorous and intense scrutiny of Fed monetary policy choices. In a 2008 lawsuit (Bloomberg LP v. Board of Governors of the Federal Reserve System), financial market journalists attempted to force the Fed to disclose the names of firms that borrowed from auction and lending facilities. Bloomberg won the lawsuit, and the Fed’s resistance to disclosure was behind steps taken by members of Congress to require more extensive audits of Fed operations. Court-mandated Fed disclosures in 2011 revealed that the specialized lending programs provided cash to US and foreign financial institutions, permitting banks to pledge asset-backed securities, commercial loans, and mortgages as collateral for a huge volume of discount-window lending (Morgenson 2011). The favorable terms of the lending and the identity of borrowers—particularly foreign firms and large investment banks—attracted scrutiny and contempt from elected officials (see, for instance, Paul [2011] for a blistering criticism). Fed revenues and expenditures will also draw the attention of lawmakers as the balance sheet expands. One implication of the growth of the Fed balance sheet is a windfall of revenue for the Reserve Banks. The Fed typically generates substantial interest income from its portfolio of Treasury securities—and rebates more than 90 percent of this income back to the Treasury. The remainder of the interest income funds Fed operating expenses. If the balance sheet is expanded, and this expansion is largely accomplished with the purchase of agency MBS, then the Fed will experience an increase in interest income. Agency

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MBS typically carry a higher yield than Treasury securities, and the Fed’s target of $1.25 trillion in purchases implies a large stream of interest income. At an annual yield of 4 to 5 percent, the Fed could expect to see $50 billion in interest income from new additions to the balance sheet. This increase in revenue would more than cover the costs associated with declines in the portfolio of ABS CDO holdings in the Maiden Lane entities or losses associated with the AIG bailout, disguising the true costs of the bailout and the magnitude of federal assistance to large financial institutions. Disposition of the Fed’s income will attract attention from members of Congress and from the same journalists who pushed for Fed disclosure of details about the lending programs. Before the financial crisis, the financial market press and many political actors afforded the Fed a distinct deference. Fed Chair Alan Greenspan was given particularly wide latitude to react and respond to changing financial market and macroeconomic conditions. As talk of the Great Moderation gave way to talk of the second Great Depression, scrutiny of and attention to monetary policy increased. The form of the 2008–2009 intervention—an extraordinary and distinct departure from the general and politically innocuous strategy of purchasing short-term Treasury securities—places the Fed in a new and uncomfortable spotlight in Washington, DC.

The Expanding Balance Sheet and the Pursuit of Price Stability

In addition to the prospect of increased oversight and scrutiny of Fed operations, the provision of short-term liquidity can undermine the mission of the Fed to pursue price stability. The collision between the two missions comes in several forms. The expanded volume of lending to individual firms—even though backed by collateral—can create incentives for the Fed to keep interest rates low. If interest rate increases contract the supply of credit and financial institutions fail, then the Fed absorbs a high level of assets—collateral—that are declining in value. Given the small number of firms likely to fail, this risk is small. But more important, the large scale of purchases required to expand the balance sheet can alter expectations about the future ability (and willingness) of the Fed to restrain inflation. During 1979–1984 the Fed initiated a campaign of interest rate hikes designed to reverse and stabilize inflation, suggesting that the Fed can endure withering political pressure in the pursuit of low inflation. During the period of declining inflation and high interest rates, the annual number

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of bank and thrift failures rose dramatically, ultimately peaking at over 500 in 1989. Fed choices about monetary policy did have implications for the survival of these financial institutions, but the Fed had no direct financial stake in these firms. Much of the cost of the failure of these institutions was ultimately absorbed by the FDIC (and individual investors). If the Fed takes on broad lender-of-last-resort functions for banks (especially longer-term loans or advances backed by collateral other than Treasury securities), then monetary policy choices become entangled with the Fed balance sheet. The provision of credit to nonbanks also introduces a new complication to monetary policy deliberations since the Fed becomes the lender of last resort—the major potential creditor—to these institutions. Increases in the federal funds rate to contain inflation could impact the Fed’s bottom line in a negative way if firms that hold outstanding Fed lines or loans are financially vulnerable or if increasing interest rates undermine the value of the Fed’s portfolio of agency MBS or ABS CDO reflected on the balance sheet. This tension has always been implicit in monetary policy choices: safety and soundness goals of bank supervision can clash with monetary policies to combat inflation. The Fed’s desire to sustain individual firms may collide with the need to restrain the growth of money and credit aggregates. The financial crisis simply aggravates this tension. A more fundamental problem is the sheer scale of Fed purchases of securities. Fed purchases of huge volumes of Treasury securities and agency MBS pose an indirect threat to the pursuit of price stability by shaping expectations about the Fed’s willingness to limit inflation. The Fed purchases ratify popular concerns that the Fed stands ready to absorb the massive borrowing needs of the US government—borrowing that reflects the need for short-term stimulus spending and long-run pressures from Medicare and Social Security. Large purchases of Treasury securities imply a rapid monetization of federal debt. By purchasing new debt issues, the central bank can facilitate borrowing to finance government spending, with the potential long-run consequence of higher inflation. In remarks preceding testimony by Chairman Bernanke in the summer of 2009, Rep. Paul Ryan (R-WI), the ranking member of the House Budget Committee, warned, This can be a dangerous policy mix. The Treasury is issuing debt. And the central bank is buying it. It gives the alarming impression that the U.S. one day might begin to meet its financial obligations by simply printing money. And we all know what happens to a country that chooses to monetize its debt. It gets runaway inflation, a gradual erosion of workers’ paychecks and family savings. (Ryan 2009)

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Although Chairman Bernanke was quick to dismiss the idea that the Fed was monetizing debt, decisions later in 2009 and 2010 to expand purchases of Treasury securities generated an unusual amount of discord within the Fed. At issue was whether and how to sustain the Fed’s purchases of assets to stimulate the economy. The eventual decision to extend the purchases of Treasury securities was accompanied by an unusually public and contentious disagreement among Fed leadership. Although broadly supportive of Fed purchases of long-term securities, Dallas Fed President Richard Fisher addressed the Fed’s dilemma in a February 2009 speech. He noted that excessive purchases of long-term Treasury securities, in particular, “would undermine confidence in our independence and raise serious doubts about our commitment to longterm price stability” (Fisher 2009). In the spring of 2010, leadership at the Federal Reserve Banks of St. Louis (James Bullard), Dallas (Fisher), Philadelphia (Charles Plosser), Richmond (Jeffrey Lacker), and most visibly, Kansas City (Thomas Hoenig) made statements that suggested growing dissatisfaction with Chairman Bernanke and the Board in Washington, DC. While the other Reserve Bank presidents formally supported the decisions to expand the Fed’s balance sheet, Hoenig dissented from the FOMC statement at every meeting in 2010. The formal dissents and public disagreements—which spilled over into FOMC deliberations in 2011—highlight the pressure that the expanding balance sheet places on the pursuit of price stability.

Crisis Termination and Policy Learning

In the stages of crisis outlined by Boin et al. (2005), one critical period is the termination of the crisis: the decision to revert to standard operating procedures, settle on an account of causes and consequences of the crisis, and begin efforts to learn from the failures that the crisis revealed. By some measures, the financial crisis is over: nearly all of the extraordinary lending programs have been terminated, and indicators of credit market volatility and equity prices have nearly returned to precrisis levels. By other measures—foreclosures and home prices, unemployment, and the size of the Fed’s balance sheet—the economic disruption persists more than three years after the credit market meltdown. Until the Fed transitions from monetary accommodation to monetary restraint, reducing the size of the balance sheet and returning to conventional targeting of the federal funds rate, it is hard to make the case that the crisis is over. Despite the publication of several exhaustive accounts of the crisis—

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final reports from the Financial Crisis Inquiry Commission and the Senate Committee on Homeland Security and Governmental Affairs, a number of best-selling books (13 Bankers, Too Big to Fail, The Big Short), an Academy Award–winning documentary (Inside Job), and even an HBO movie—the lessons of the crisis remain unsettled. Deep skepticism persists about the willingness and capacity of government’s ability to learn from the crisis (see, for example, Chan 2011). The termination of crisis and the transition to learning is not simply symbolic. Crisis management expends the resources of an agency. When the crisis ends, agency resources can be directed to institutionalize lessons of the crisis and improve information about new potential risks. As long as the Fed total assets remain in excess of $2 trillion and continue to expand, Fed resources are deployed in the management of technical and political risks associated with the growing balance sheet—juggling pressures to maintain credit for the housing sector, support fragile credit markets, and strike the right balance between monetary accommodation and the risks of inflation. Boin et al. (2005, 97–98) distinguish between the operational and political dimensions of crisis termination. The extraordinary public attention to and appetite for information about the crisis has diminished (indicating “political closure”), but the Occupy Wall Street protest has revived popular interest in the problem of Wall Street power. The Fed and other financial services regulators are still writing the rules and managing the operational elements designed to cope with the crisis (suggesting no “operational closure”). The discrepancy between diminishing political attention to the crisis and continuing operational uncertainty—the absence of new rules, the growing balance sheet—concentrates the influence of financial services firms. As the attention of the public, the media, and of Washington is diverted to other issues, financial services firms continue to lobby and press regulators for concessions and relief. This combination of intense pressure from affected interests and resource constraints imposed by ongoing crisis management operations makes the process of learning at the Fed cumbersome and reversible.

7 Learning from the Crisis

Organizational learning implies three distinct types of adaptations:

recognizing new problems and tasks (refining the mission), introducing new technology and human capital (acquiring expertise), and adjusting to constituents or actors with a stake in the new mission (accommodating new interests). At the same time, agencies must preserve core functions nurtured and improved over time. In the case of the Fed, the crisis and the response by Congress in the form of Dodd-Frank complicates the Fed’s mission, demands new expertise in risk assessment and monitoring, and broadens the network of actors with a stake in Fed choices, potentially integrating a variety of interests that drove the shadow banking system. Each of these changes—in mission, expertise, and interests— implies some tension with the core monetary policy function of the Board of Governors of the Federal Reserve System. Fed leadership, both on the Board and at the regional Reserve Banks, has openly anticipated some of the implications of the new scrutiny of Fed actions and choices. Fed leadership, for instance, directly confronted uncertainty about the coordination of Fed actions with the Department of the Treasury in a rare joint public statement. Issued weeks after Jeffrey Lacker’s dissent at the January 2009 FOMC meeting, the statement articulated the Fed’s primary mandate to pursue monetary policy with the twin objectives of stable prices and maximum employment. The statement also specified a series of steps that would guide Fed and Treasury actions after the crisis and communicated the specific pledge by Treasury to remove the Maiden Lane entities from the Fed’s balance sheet “in the longer term” (Federal Reserve System 2009h). After reviewing the challenges posed by the accommodation of new actors, a broader Fed mission, and the gaps in expertise revealed by the 131

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crisis, I revisit the problem of learning and policy change. What types of agencies learn from failure? How do we prevent the next financial crisis?

Interests: The Face of Power—Wall Street and Large Banks After five short years, we may now need to be reminded what Wall Street was like before Uncle Sam stationed a policeman at the corner, lest, in time to come, some attempt be made to abolish the post. (Pecora, 1939)

Like the stock market crash of 1929 and the Great Depression, the problem of Wall Street power is in many ways at the heart of the current financial crisis. One best-selling account of the origins of the crisis—13 Bankers—spells out the ways that Wall Street influenced decisions by the Fed and other regulators (Johnson and Kwak 2010). This influence was a combination of hard power and soft power. Hard power took the form of campaign contributions, intense lobbying, and infiltration of key bureaucratic leadership positions (the “Wall Street–Washington corridor”). Soft power was reflected in a combination of ideas that dominated policy deliberations: laissez-faire regulatory orthodoxy, the drive to broader homeownership, and the idea that economic prosperity hinged on a large and rapidly growing financial sector. Under Alan Greenspan, the Fed was a vocal proponent of financial innovation and the idea that complex financial instruments are essential for managing and distributing risk in the financial sector. This sentiment was echoed in the speeches and actions of Washington and New York leaders before the crisis, during the crisis, and during the deliberations over financial reform. The impact of these ideas was observed in decisions about how to respond to subprime lending, private-label securitization, structured finance, and the market for derivatives. At each turn, the interests of financial services companies were served by an intellectual framework in the Fed, and the broader profession of economics, that valued efficiency over risk mitigation, market discipline over official sector supervision, and Wall Street discretion over Washington oversight. The ideas that animated the variety of administrative and statutory changes that implemented this vision place fundamental public concerns— like financial stability, consumer protection, and stable housing finance— at the periphery of policy deliberations. Bachrach and Baratz (1962, 949) explain this form of power in plain language: “To the extent that a person or group—consciously or unconsciously—creates or reinforces barriers to

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the public airing of policy conflicts, that person or group has power.” The complex administrative rules that define financial regulatory policy have never been the subject of intense public scrutiny, and when confronted with crises and demands for reform, the financial sector has effectively delayed or weakened new regulation. By further placing large, complex firms at the center of the Fed’s regulatory attention, this form of influence by Wall Street on Fed decisionmaking and ideas is likely to be amplified— not diminished—after the financial crisis. The Fed will add a variety of large firms—by design, the largest and riskiest financial institutions—to the network of firms under direct supervision of the Reserve Banks. The Fed’s experience with consumer protection (detailed in Chapter 2) illustrates how Fed decisionmakers implemented regulations in ways that minimize costs for regulated banks. The expanded and powerful network of actors with a stake in Fed choices will make similar attempts to soften new capital and liquidity requirements, limit new restrictions on permitted lines of business, and weaken new disclosure and reporting requirements. The geographic concentration of many of these financial sector actors in or near New York City suggests that the New York Fed will be a critical arbiter of these conflicts. Controversial decisions by New York Fed leadership in the context of the AIG bailout contributed to speculation that Wall Street banks might benefit from this discretion. In December 2008 the New York Fed decided to settle outstanding AIG derivatives contracts with large bank counterparties at face value, rather than negotiating a lower settlement price and reducing taxpayer exposure to the AIG losses. Goldman Sachs, for instance, was paid the $14 billion face value for securities that had a market value of $8 billion, a “back door bailout” of $6 billion (Wayne 2009). Powerful financial institutions will bring the tools of hard and soft power to bear on the Fed in New York and Washington. It should not be surprising to see supervisory and other choices after the crisis that reflect the interests and preferences of these actors, replicating the conditions that led to the 2008 meltdown. Cures are elusive when, as Keynes famously noted in his 1926 essay “The End of Laissez Faire,” “It may even be to the interest of individuals to aggravate the disease.” One characteristic feature of a crisis is intense public and media attention to a particular policy problem. Birkland (2006) treats crises as distinctive “focusing” events that highlight the need for government response and action. Financial crises undermine the power—as Bachrach and Baratz describe it—of financial institutions. The public demands reform and investigation to determine the root causes of actions and choices that generated the crisis. Elected officials and regulators are

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under pressure to manage and terminate the crisis, but the crisis simultaneously permits regulators to use public pressure to change business practices and standards. As that public attention fades, the power of the financial sector is reasserted—influencing rulemaking and other adaptations that follow the crisis. The federal response to the 2008 financial crisis, Dodd-Frank, accelerates this accumulation of power by requiring a vast amount of rulemaking in a short time, concentrating the authority for oversight of the most powerful firms in the Fed, and closing the door—at least temporarily—on congressional efforts to respond to the crisis.

Mission: Making Sense of the Fed’s Role in the Economy

The crisis has altered the Fed’s mission in several ways. The new Consumer Financial Protection Bureau (CFPB) segregates and finances the mission of consumer protection within the Federal Reserve System, but independent of the Board of Governors. Dodd-Frank institutionalizes the Fed’s role as market stability regulator. Fed lending programs set an important precedent for how the United States will respond to future crises. Housing finance reform suggests an important implicit role for the Fed in stabilizing the flow of capital to the mortgage market. Finally, the trauma of the crisis brings new attention to the role of monetary policy as a potential response to asset bubbles. This broadening mission reflects the recognition—inside and outside the Fed—that monetary policy narrowly conceived was insufficient to prevent a serious financial crisis and real economic disruption. The transformation of the Fed’s mission carries distinct and well-understood political risks. In the 1970s, as a variety of new functions were considered for the Fed—consumer protection, housing, and expanded supervision—Philadelphia Fed President David Eastburn warned, “The main rationale for the Fed’s independence is because of the special nature of monetary policy. The more the Fed’s authority is expanded beyond ‘pure’ monetary policy, the more diluted becomes the argument for independence” (Eastburn 1974). The multiple and competing missions anticipated for the Fed under Dodd-Frank revive these arguments. Is there a compelling reason, for instance, for a market stability regulator or a consumer protection bureau or a housing finance guarantor to share the Fed’s broad independence from appropriations and other mechanisms of oversight? The new missions for the Fed also complicate questions of accountability. For what exactly is the Fed responsible? How is the objective of price stability—low inflation— reconciled with these other functions? Three of the new missions—market

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stability, consumer protection, and asset price stability—imply a significant reorientation of Fed ideas, technology, and priorities. Consumer Protection

The crisis leaves the Fed with a broader consumer protection mission, but this mission is to be performed independent of other Fed functions, with an explicit separation from the authority of the Board of Governors. Carpenter (2010b) suggests that the new regulator will perpetuate the legacy of Fed resistance or antipathy to consumer protection. The segregation of consumer protection functions in the new bureau may also work to undermine learning from the 2008 crisis. Mahler and Casamayou (2009) describe how, following the 1986 Challenger disaster, safety officers were given new and visible authority within NASA. There was nevertheless a persistent bias in the organization that placed more weight on “high status” science and technology considerations and less weight on “low status” safety concerns. “The weaknesses of the safety organization reduced the likelihood that safety officers would challenge higherstatus colleagues to insist that problems . . . be considered urgent” (Mahler and Casamayou 2009, 168). This organizational bias limited learning from the Challenger accident and set the stage for the Columbia accident in 2003. In a similar way, decisions by Congress to segregate consumer protection functions outside the Board of Governors make it less likely that the Board will institutionalize key lessons about the financial costs of consumer protection failures. Market Stability Regulation

Financial reforms put in place after the crisis also give the Fed new responsibilities as a market stability regulator. Although Fed leadership adopted this role before the crisis, Dodd-Frank formalizes the Fed’s authority as lead supervisor for the FSOC. The early stages of the crisis made it clear that the Fed would need new tools and new powers to fully respond to the problems in the financial market, and many observers recognized that these steps would substantially broaden the Fed’s power and influence (Shiller 2008a). Further, the new role would require a more fundamental reappraisal of the way that central banks have been reformed and structured to specifically manage inflation. Roberts (2010) describes the transformation of central banking in the largest industrialized countries after 1980. Across a number of nations, central banks were made progressively more independent and autonomous in an effort

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to control inflation. The idea of central bank independence was rooted in the search for solutions to the problem of persistent and growing inflation. One consequence of this transformation was that central banks developed a singular focus on controlling the problem of inflation; the institutions, ideas, and monitoring capacity of the bank were directed to manage inflation. The regime was not equipped to identify or respond to threats to financial stability as they emerged. Roberts identifies a “doctrinal blindness” that discounted the possibility of price bubbles and discouraged investment of resources in solving the problem of instability. Reaching a similar conclusion, Goodhart (2005) describes dramatic advances in economic understanding of the mechanics of monetary policy, but sees little concrete progress on the measurement and management of financial instability. This blind spot left regulators vulnerable to what Shiller (2008b, 41–46) describes as the “social contagion of boom thinking.” Regulators, like market participants, were seduced by “new era” stories that promised ongoing and riskless gains. The insights of Roberts, Shiller, and Goodhart suggest that the mission of a market stability regulator requires a major reorientation at the Fed. Fed leaders will need to tackle the problem of systemic risk with the same enterprise, zeal, and focus that they brought to bear on the problem of inflation in the 1980s. How much attention the problem of systemic risk will receive and what influence the systemic risk regulators will ultimately have is unclear. Will questions of market stability or systemic risk, like the consumer protection function, be isolated and segregated from high-attention, high-status macroeconomic policy choices? Monetary Policy and Asset Bubbles

Some Fed critics point to basic failures of monetary policy to explain the crisis. Posner (2009), for instance, describes monetary policy as “profoundly flawed,” arguing that the Fed’s response to the 2000 dotcom collapse—a prolonged period of money supply growth—triggered extreme inflation in asset prices (housing and stocks). As Fed leadership reflected on the 2008 crisis, several key actors indicated that future monetary policy choices would attend more closely to these “asset bubbles.” Janet Yellen, San Francisco Fed president during the crisis and member of the Board of Governors from 2010, described the need for preemptive monetary policy restraint in the face of rising asset bubbles (Yellen 2009). Minneapolis Fed President Gary Stern endorsed a similar reassessment of monetary policy choices during the crisis (McKee and

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Chen 2009). Acting on these impulses would involve a fundamental change in Fed approaches to financial markets, shifting from a Chicago school laissez-faire view of market efficiency to what Minsky (1969) labeled “unreconstructed Keynesianism.” The Chicago school maintains that markets are efficient, implying that asset prices are accurate reflections of economic value. Keynes, especially as understood by Minsky, emphasized the role of psychology of expectations: euphoric sentiment leads investors to seek out higher and higher levels of risk and to seek leverage to realize what, over the course of the business cycle, are lower and lower returns on this risk seeking. This dynamic makes financial markets inherently unstable. If the Fed adapts monetary policy to respond to asset bubbles, Fed leadership faces two new political considerations. First, addressing asset bubbles implies lowering asset prices or at least preventing their rapid inflation. Fed leadership concluded that these actions, which imply the destruction of wealth in the form of lower housing or stock prices, leave the central bank in a “politically untenable position” (Stevenson 2002). The Fed also confronts the problem of credit allocation. If a housing bubble prompts Fed action, capital would be diverted from housing to other sectors of the economy—to slow the increase in housing prices relative to other prices. The structural and procedural choices that the Fed honed to fight and contain inflation prescribe the opposite type of actions—to apply monetary policy restraint generally, through higher interest rates across the entire economy. Fed easing in response to declines in asset prices raises similar political questions. Dallas Fed President Richard Fisher, one of three dissenting votes at the August 2011 FOMC meeting, warned against linking monetary policy choices to asset prices: “My longstanding belief is that the Federal Reserve should never enact such asymmetric policies to protect stock market traders and investors” (Matthews 2011). Actions to respond to asset price bubbles draw the Fed into specific choices about how much capital should be going to one sector of the economy versus another, the type of credit allocation that (appropriately) invites scrutiny from members of Congress with a stake in the performance of particular sectors of the economy.

Expertise: What Went Wrong?

The 2008 crisis revealed significant gaps in the Fed’s expertise. Fed choices about capital requirements and about the regulation of banks and bank holding companies set up the conditions that fueled the spread

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of the credit crisis. Relationships with hedge funds and SIVs implied liquidity and capital needs for regulated banks that were unexpected. The core institutions of the financial sector were much more vulnerable and undercapitalized than Fed leadership understood. The Fed’s failure to anticipate the 2008 crisis does not inspire much confidence in the Fed as the lead supervisor at the FSOC. In the congressional debates over financial regulatory reform, many members of Congress recognized the Fed’s failures and opposed efforts to broaden Fed powers. Sen. Richard Shelby (R-AL), for instance, concluded that proposals to concentrate regulatory authority in the Fed represented “a grossly inflated view of the Fed’s expertise” (Schmidt 2009). The failure to anticipate the meltdown underscores a more general problem confronting agencies trying to manage uncertain future risks. Research on crisis management and crisis response indicates that a variety of psychological mechanisms and administrative routines conspire to limit the ability of public sector managers to anticipate imminent threats. Boin et al. (2005, 24–25) describe a number of ways that crises may come as a surprise—from the basic intuition that routine measures of performance may leave an organization without the data necessary to observe early signs of the crisis, to more nuanced and particular claims that public sector regulators may accept “commercially expedient, reassuring myths concerning the state of risk prevention and mitigation in particular systems.” At every turn in the development and growth of new financial markets— for ABS CDO, derivatives, and private MBS—private actors assured regulators about the stability, safety, and desirability of the new instruments. Rather than skeptically evaluate these claims, regulators increasingly outsourced the evaluation of risk to rating agencies or relied on self-regulation (internal models) to manage risk. The normalization or domestication of risk is a particular hallmark of the financial sector. Confident, even euphoric, about the prospect of future gains, investors accept higher and higher levels of risk over the course of the business cycle. This confidence inflates asset prices, ratifies the evaluations of credit rating agencies, and vindicates internal risk models. Until investor confidence is shaken, the regulator has no tool to anticipate risks or failure. Consistent with the observations of Minsky (1980), it is not clear that this is a technical problem with an easy solution. Financial sector entrepreneurs have a huge and particular financial incentive to innovate— to generate new and unfamiliar investment and lending opportunities that fill specific consumer and investor needs. The regulator reacts to these innovations, typically with fewer resources than the financial sector entrepreneur. If there are few opportunities to profit in originating or packaging

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home mortgage debt, then investors and entrepreneurs will turn to other segments of the capital markets. The source of the next financial contagion may be related not to MBS but to derivatives developed to package and exploit risky investments in energy, commercial property, commodities, sovereign debt, or currency. As Henry Simons observed in 1936, we experience “the reappearance of prohibited practices in new and un-prohibited forms” (quoted in Minsky 1980). The creation of the FSOC is an explicit sign that elected officials and policymakers now recognize financial instability as a problem to be solved. The ability of Fed leadership and other agency leaders on the FSOC to overcome the fundamental problem—normalization of deviance—is less clear.

Warnings, Minority Views, and Learning from Diverse Perspectives

Given the gaps in expertise revealed by the crisis and the actions taken by Fed leadership to respond to the crisis, what particular steps might the Fed take to avoid the next financial crisis? Experience drawn from federal agencies managing high-risk technology suggests some solutions. In an effort to uncover organizational or administrative practices that led to the destruction of the space shuttle Columbia in 2003, the Columbia Accident Investigation Board (CAIB) identified several federal agencies with strong safety track records. Two common features of these highly reliable organizations were procedures that carried warning signals to agency leadership (“the concise and timely communication of problems using redundant paths”) and organizational cultures that encouraged dissenting viewpoints. Describing the US Navy experience with nuclear propulsion, the CAIB described this culture: “The Naval Reactor Program encourages minority opinions and ‘bad news.’ Leaders continually emphasize that when no minority opinions are present, the responsibility for a thorough and critical examination falls to management. Alternate perspectives and critical questions are always encouraged” (Columbia Accident Investigation Board 2003, 183). A range of choices leading up to the financial crisis, in areas as diverse as mortgage lending, securitization, structured finance, and the derivatives markets, indicated missed opportunities within the Fed to recognize risks and avoid the 2008 meltdown. Warning signals from a number of sources could have triggered a response from Fed leadership before 2008: direct and clear warnings from the GAO about housing finance and risks associated with derivatives, warnings from trade associa-

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tions and industry insiders about uncertain risks from structured finance products (the Council to Shape Change, Janet Tavakoli), warnings from other regulators (OCC Counsel Julie Williams) and Fed insiders (Edward Gramlich) about mortgage lending irregularities, warnings in public comments on proposed rules to implement Basel II, and occasional (if isolated) warning signals from the economics profession (for example, Raghuram Rajan’s 2005 address as described in Krugman 2009). Why would the Fed miss these signals? The experience of the navy reactor programs suggests an important difference between the Fed’s practices and those of high-reliability organizations. The most visible forum for deliberation and decisionmaking in the Fed, the FOMC, operates with a bias against dissent. The power of the norm of unanimity is apparent to Fed observers and insiders: former Fed governor Alan Blinder noted that in thirty-five FOMC meetings spanning 1998 to 2001, there were only eleven dissenting votes (Blinder 2004). The frequency of dissents fell to even lower levels in the latter part of Alan Greenspan’s term (thru 2006). Describing the safety culture at NASA, Mahler and Casamayou (2009, 181) specifically suggest that a “strong internal pressure for orthodoxy” limits opportunities for learning. If FOMC practices discourage dissent and minority views, dissonant warnings or unorthodox approaches would not likely inform FOMC choices. The absence of these alternative views increases the probability of error and failure. Choices made after the crisis provide mixed evidence about the prospects for disruption or change in the Fed’s decisionmaking process. Jones (2003), drawing on the work of Herbert Simon, highlights how the choppy or disjointed response of agencies to new or emerging problems is rooted in the persistence of attention to existing problems and identification with particular organizational routines and practices. Casamayou (1993) describes the challenge of evaluating the concern for safety and risk to a “sense of mission” in complex technological work environments. Although identifying exactly what this sense of mission looks like in practice is difficult, the allocation of resources to new constituencies may demonstrate attention to a new problem, and restructuring can indicate efforts to disrupt organizational routines. Hopeful organizational changes at the Fed indicate a shift in attention and practice: the Board of Governors established a new Office of Financial Stability Policy and Research in November 2010. The new office integrates FSOC functions and oversight of large nonbank institutions with other Board functions. As with the CFPB, it is too early to evaluate the success of the new office, but the change is a clear indicator of efforts to bring expert attention to new

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problems. Observing the process of financial regulatory reform in 2009, Carpenter (2010a) is less optimistic. He describes how established agencies, notably the Fed, worked aggressively to maintain power and authority by shaping the legislative debate and process. This “bureaucratic politics of turf and reputation” explains the ultimate result of the 2009 reform effort: a division of new power and authority among existing regulators rather than the creation of new, independent entities to challenge and disrupt the regulatory environment. Decisions to locate the CPFB within the Fed and to construct the stability regulator (the FSOC) as an interagency working group are both products of this effort.

Obstacles to Learning

Given the high levels of risk embedded in the financial sector, the prudent step may be for the Fed to focus on mitigation of damage rather than the identification and prohibition of risky practices. Johnson and Kwak (2010) have a straightforward prescription grounded in this view: reduce the permissible size of financial institutions. Specifically, Johnson and Kwak propose a limit on the size of banks; total assets would be capped at 4 percent of gross domestic product. Thomas Hoenig, the former president of the Kansas City Fed recently appointed to the FDIC board of directors, endorses this approach. In a 2011 interview, Hoenig concluded, “Extremely powerful institutions, both financially and politically, undermine the long-term strength of our system and make us look like a financial oligarchy.” Modifications to the Basel Accords include a similar objective: Basel III proposes a higher capital requirement for large firms, an economic penalty that would discourage consolidation and create an advantage for smaller firms. If the Johnson and Kwak prescription were implemented or if the Basel reforms have the intended consequence, then few or no institutions would be too big to fail. The problem of moral hazard would be minimized, and the probability of the failure of one firm triggering a financial crisis would be reduced. This step also makes the political problems facing regulators more manageable, reducing the concentration of economic and political power in a few financial services firms. There a number of reasons to be skeptical about the implementation of this straightforward remedy. First, the expansion of Fed authority under Dodd-Frank is a form of congressional reward for management and leadership during the crisis. The successful crisis response by Fed leadership in late 2008 and 2009 helped the Fed recover lost prestige

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and credibility. The controversial, uncertain, and awkward rollout and implementation of the TARP program in the Treasury contrasted with the Fed’s massive and relatively smooth extension of credit. Recent empirical work on natural disaster responses concludes that voters are more likely to reward politicians who manage crises by extending particular and direct relief, rather than rewarding politicians who invest resources to prevent or prepare for a disaster (Healy and Malhotra 2011). The Board of Governors and New York Fed leadership—once they were motivated to address the crisis—adopted an impressive and ultimately successful array of tools to repair confidence in and performance of US credit markets. The reappointment of Fed Chair Bernanke and the appointment of Timothy Geithner as secretary of the treasury might indicate that elected officials rely on the same calculations as voters, rewarding agency leaders who manage crisis by providing particular and direct relief, rather than agency leaders who prevent crisis in the first place. While Dodd-Frank formally makes the problem of systemic risk an object of attention for Fed regulators, the incentives for Fed leadership are to develop or refine existing tools to offer particular and immediate relief to financial markets—in the form of credit and lending facilities—rather than take new and politically costly steps to mitigate or minimize the risks of financial market disruption. On top of the incentives facing Fed leadership, the managers of the largest financial services institutions have strong incentives—and ample power—to obstruct initiatives to break up or limit the size of large financial holding companies or hedge funds.

Public Scrutiny and Private Power

The introductory chapter sketched out two perspectives on learning after crisis. The disruption associated with crisis may widen the scope of interested actors, permit new ideas and perspectives to inform policy, draw public attention to new problems, and encourage the search for new technology and expertise. On the other hand, powerful actors may crowd out reform ideas, agencies may be overwhelmed by new functions or tasks, and familiar problems of attention may conspire to undermine learning in the long run. Both perspectives point to the fact that even if elected officials and agency leaders recognize a problem and craft a response, learning is not automatic. Carpenter and Sin (2007) and Birkland (2006) similarly emphasize that events—even a disaster—do not automatically become “focusing events.” Instrumental actors need to

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use the power of narrative and attention of the media to mobilize support and advance particular policy choices. If or when this action is successful, organizations require investment of resources and time in order to learn. The agency’s mission must embrace the new problem, the agency must have the technology or expertise to implement the solution, and the agency must have a constituency—in the form of groups or actors who support the new mission. If these conditions are not met, then the crisis response does not translate into crisis learning. The discussion of mission and interest above implies two very different changes in the Fed’s political environment. First, the crisis brings Fed choices to the attention of the broader public, the media, and members of Congress—a new and uncomfortable scrutiny of Fed monetary policy choices, lending programs, and bank supervisory actions. Second, Dodd-Frank places the largest financial services firms under Fed supervision and requires a huge volume of rulemaking, creating the potential for intense lobbying and other direct pressure on Fed decisionmakers from these large firms. The danger or challenge is that, as the crisis fades, private power replaces public attention. The most direct analogy to the 2008 crisis is certainly the stock market crash of 1929 and the Great Depression that extended through the 1930s. The lessons drawn from that crisis spanned a number of policy areas: fiscal policy, monetary policy, securities regulation, government lending programs, and housing finance. The learning process that culminated in these lessons took decades. The thorough investigation of financial market practices that were the immediate cause of the 1929 crash—the Senate Banking Committee hearings on Stock Exchange Practices initiated in 1932 (also known as the Pecora Commission)—did not conclude until 1934. Chernow (1990) gives a riveting account of the testimony and questioning of the partners of the nation’s largest private bank, JP Morgan, by committee counsel Ferdinand Pecora. The committee investigations revealed, for instance, that none of Morgan’s twenty partners had any income tax liabilities—a consequence of capital losses—in 1931 and 1932. This public disclosure, while completely unrelated to business practices and conduct at the exchange, generated public pressure to introduce bank reform. Seligman (1995) ties fundamental changes in securities law during the Depression directly to the Pecora hearings. The hearings exposed corrupt trading practices in Wall Street firms and major banks—information that led to public demands for tighter regulation and scrutiny of financial services. Pecora (1939, 283) later described these revelations as a “spectacle of cynical disregard of fiduciary duty.” The Banking Act of 1933 prohibited private banks from simultaneously providing invest-

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ment services and collecting deposits (the Glass-Steagall wall), realizing an idea that Hoover had advocated as early as 1929. The Securities Act of 1933 (Truth in Securities Act) introduced new disclosure requirements for sellers. The Securities Exchange Act of 1934 provided for the creation of the SEC. In an upbeat assessment of agency performance, Seligman, for instance, credits the SEC with moving “beyond laws formed in crisis” to the “systematic study” of capital markets and institutions (1995, 621). The lengthy public hearings, extending five years beyond the stock market crash, sustained public attention on the financial crisis and permitted learning and innovation to occur over a long period. Unlike the Depression-era response to financial crisis, public policy problems generated by this financial shock—unemployment, foreclosures, and dwindling state and federal tax revenue—have pushed financial regulation off the political agenda. With the polemic debate over the financial regulatory reform bill largely over, Fed actions and choices take place in the “subterranean” space of capital requirements, financial market utilities, and accounting treatment of structured investment vehicles, minimizing public scrutiny and maximizing private power. The new tools adopted to manage the crisis open up Fed choices to higher levels of scrutiny and raise questions about the organization of monetary policy choices. In the 1990s the Fed embraced calls for transparency in monetary policy. The FOMC, for instance, began issuing more explicit statements of forecasts and goals and provided access to minutes of FOMC deliberations. These actions were part of a broader and ultimately successful campaign to “depoliticize” monetary policy (Krippner 2007). These choices about monetary policy were undertaken at the same time that the Fed was taking steps to encourage innovation in structured finance and reduce the scope of governmental regulation of the growing market for derivatives. The financial crisis not only brought these basic Fed choices and goals into question but reinvigorated debates about Fed governance structure, audits, and secrecy. For instance, reversing course on questions of transparency and openness during the crisis, the Fed refused to name the financial institutions that participated in the extraordinary lending and term credit programs. When the Fed did release documents that detailed the terms for and recipients of loans from the various programs, there was a backlash in Congress and the press—about the favorable, low interest rates for large institutions; about the number of foreign institutions borrowing from the Fed; and about continued Fed efforts to obscure key details related to the program. The US Senate passed a resolution urging review of the appropriate role of regional Reserve Banks in Fed monetary policy choices, and there was support in

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both houses of Congress to expand GAO auditing of Fed functions, particularly transactions related to the conduct of monetary policy. These measures met with vigorous opposition from Fed leadership (Torres and Schmidt 2009). The Obama Treasury Department urged a comprehensive review of the Fed’s governance structure, and Dodd-Frank puts into action many administration and congressional proposals. Dodd-Frank specifically requires the Fed to release detailed information about the lending facilities set up to manage the crisis, mandates a GAO audit of Fed actions, and anticipates more comprehensive study of Fed governance. The broad scope of the GAO audit of Fed lending programs includes scrutiny of the use of third-party contractors, the ways that loan programs might benefit particular firms, and the potential for conflicts of interest. Resisting these measures in 2009, Fed Governor Donald Kohn spelled out the risks of GAO audit: audits would stifle candor in policy deliberations, interfere with the communication of monetary policy goals and objectives, and even be used as leverage to influence monetary policy choices (Kohn 2009). From the Fed’s perspective, this scrutiny, oversight, and lack of confidence in Fed practices are problematic, jeopardizing the central bank’s independence. Reflecting on threats to Fed independence, the 2009 annual report of the St. Louis Fed described the increasing level of congressional attention to the Fed and monetary policy. From 1990 to 2005 the number of appearances and testimony of Fed officials before Congress declined from forty to fifty per year to fewer than twenty. In 2009 that number spiked to nearly sixty appearances (Federal Reserve Bank of St. Louis 2009). As a consequence of effective, accommodating monetary policy choices and the Great Moderation in inflation and output, the Fed enjoyed a period of extraordinary deference from elected officials. But while members of Congress gave the Fed this broad-ranging discretion over monetary policy, the Fed made the series of regulatory and supervisory choices that set the stage for the crisis—in regulation of mortgage lending, specification of capital requirements, regulation of derivative markets, and oversight of large bank holding companies. As David Eastburn suggested in 1974, the special role of monetary policy—the core mission of the Fed—justifies a unique political arrangement that insulates the Fed from political pressure. There is no similar justification for removing or protecting other Fed functions from congressional oversight, public scrutiny, or presidential influence. In fact, these other functions require much more public input and attention. Away from the bright light of political scrutiny, the interests of financial institutions dominated broader con-

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cerns about consumer protection, bank safety and soundness, and financial market stability. Scrutiny from Congress might, appropriately, be the catalyst for reassessments of these choices. Congressional attention is not a symptom of policy dysfunction or a signal of eroding Fed status; the persistence of congressional and media attention is a healthy indicator of a broader public airing of policy conflict. In the wide range of Fed functions outside of the domain of traditional monetary policy, this public scrutiny could strengthen the hand of Fed leadership or other actors with an interest in pursuing new approaches to financial sector regulation or oversight. In fact, opening up Fed choices to more public deliberation and review is probably the single best indicator of meaningful change. Studying the Corps of Engineers in the 1970s, Mazmanian and Nienaber (1979, 193) highlighted the link between changes in mission and changes in openness: “the price the agency may have to pay to . . . execute its new missions effectively is a basic reformulation of its decision-making processes,” specifically a “more open decision-making process.” The corps was an unlikely success story for organizational change, an engineering and construction agency charged to incorporate and respond to a broad mandate of environmental stewardship and responsibility. The Fed is similarly charged with a broad mandate to protect consumers, bank customers, and homeowners from financial disruption. By more directly integrating these interests into Fed decisionmaking procedures, the Fed is more likely to successfully perform this new and broader mission. Successfully learning to recognize the risk of financial market disruption and take its mitigation seriously requires confronting the technical as well as the political challenges at the core of the crisis. Fed leaders can learn from the experience of other agencies managing highly risky technology to better identify and manage the risk of financial crisis by attending to minority views and reducing the internal pressure for orthodoxy. The Fed can also learn from the experience of other agencies to better balance private interests and public power by exploiting changes in its mission to bring in administrative constituencies that support new ideas and policy change. The 2008 financial crisis led to a remarkably high level of public attention to financial regulation and the debate over reform alternatives. A few of those reforms have been implemented, but delays in rulemaking and implementation have been widespread. The delays—in changes to the regulation of derivatives, resolution of large firms, and even consumer protection—contribute to perceptions that the opportunity to learn from the crisis may have been squandered. As the shape of the government’s long-term response to the crisis unfolds, choices within the

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Fed—about the scope of the new missions, the organization and training of staff, and strength of ties between the Fed and Wall Street—will determine how we learn from the crisis. The process of learning is lengthy, contingent, and contested. Without the urgency of crisis, the attention of media, or persistent congressional oversight—the public airing of policy conflicts—the lessons may remain unlearned.

Acronyms and Abbreviations

ABA ABS ABS CDO AIG alt-A AMLF Basel BIS CAMELS

CDO CFPB CFTC CPFF CPFF LLC CRA CRMPG Dodd-Frank

American Bankers Association Asset-backed security Asset-backed security collateralized debt obligations American International Group Inc. Low- or no-documentation residential loan Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility Basel Accords Bank for International Settlements Bank ratings system: capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk Collateralized debt obligations Consumer Financial Protection Bureau Commodity Futures Trading Commission Commercial Paper Funding Facility Commercial Paper Funding Facility Limited Liability Company Community Reinvestment Act Counterparty Risk Management Policy Group (Corrigan Group) Dodd-Frank Wall Street Reform and Consumer Protection Act 149

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Fannie Mae FASB FDIC Fed FEMA FHA FHLB FOMC Freddie Mac FSF FSOC FTC GAO Ginnie Mae GMAC Gramm-LeachBliley GSE HMDA HOEPA HUD ISDA LTCM Maiden Lane MBS MMIFF NASA NCUA New York Fed NPR OCC OTS PDCF

Federal National Mortgage Association Financial Accounting Standards Board Federal Deposit Insurance Corporation Federal Reserve System Federal Emergency Management Agency Federal Housing Administration Federal Home Loan Bank system Federal Open Market Committee Federal Home Loan Mortgage Corporation Financial Stability Forum Financial Stability Oversight Council Federal Trade Commission Government Accountability Office Government National Mortgage Association General Motors Acceptance Corporation Financial Services Modernization Act of 1999 Government-sponsored enterprise Home Mortgage Disclosure Act Home Ownership and Equity Protection Act Department of Housing and Urban Development International Swaps and Derivatives Association Long Term Capital Management Maiden Lane LLC Mortgage-backed security Money Market Investor Funding Facility National Aeronautics and Space Administration National Credit Union Administration Federal Reserve Bank of New York Notice of Proposed Rulemaking Office of the Comptroller of the Currency Office of Thrift Supervision Primary Dealer Credit Facility

List of Acronyms and Abbreviations

RFI/C(D) SEC SIV SPV TAF TALF TARP TILA TSLF VA VaR

Bank holding company ratings system Securities and Exchange Commission Structured investment vehicle Special-purpose vehicle Term Auction Facility Term Asset-Backed Securities Loan Facility Troubled Asset Relief Program Truth in Lending Act Term Securities Lending Facility Veterans Administration Value-at-risk

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Glossary of Key Financial Terms

Asset-backed security collateralized debt obligation (ABS CDO). A financial instrument that bundles or packages a large group of asset-backed securities, including mortgage-backed securities, other asset-backed securities, and even other ABS CDO. The principal and interest income from the underlying assets is distributed to investors starting with the senior (least risky) tranche and continuing down to junior (subordinate) and equity tranches. These securities can be constructed to generate yields (returns) and risks that attract specific types of investors. Some banks created structured finance products that did not contain any underlying MBS, but were instead composed of a bundle of credit default swaps that reference the underlying MBS. This product is known as a synthetic ABS CDO, distinct from the more conventional cash-value ABS CDO. Basel Accords. An international supervisory framework that guides the

regulation of banks, specifically defining the types and amount of capital that a bank must have in order to be designated as safe or well-capitalized. The accords date from 1988 and have undergone a series of revisions to coordinate regulator response to innovation and change in finance and financial markets. Bank holding company. A nonbank company that has ties to a depository institution. The Fed is the primary regulator for bank holding companies. In the fall of 2008 a number of large firms assumed the legal form of a particular type of bank holding company, a financial holding company. First constructed in Gramm-Leach-Bliley in 1999, financial holding status permits firms to engage in a wide range of financial transactions, including

153

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securities underwriting and merchant banking. The legislation specifically designated the Fed as the “umbrella supervisor” for these entities. Credit default swap (CDS). A derivative tied to the credit risk of a company, sovereign, or security. If a company, country, or financial instrument defaults on obligations to creditors or borrowers, this event will trigger a payment from the seller of credit protection to the buyer of credit protection. Banks issuing subprime MBS often used credit default swaps to manage risk as they moved mortgages from their own portfolios to a special-purpose vehicle. Depository institution. A financial institution that takes deposits.

Depository institutions are insured by the FDIC and regulated by one of several state and federal bank regulators. Housing GSEs. Congressionally chartered, privately owned financial insti-

tutions that provide capital to the mortgage market: the Federal Home Loan Banks, Fannie Mae, and Freddie Mac. Fannie and Freddie issue residential mortgage-backed securities. (A third federal agency that is not a GSE, Ginnie Mae, also issues MBS.) Investment bank. A financial institution that secures capital for corpo-

rate and government borrowers. Investment banks create, issue, trade, and sell debt securities and equities (stock). Mortgage-backed security (MBS). A financial instrument that bundles

or packages a large number of mortgages together in a single pool. The principal and interest income from the mortgages creates an income stream for investors in the securities. These securities can be engineered (tranched) so that some investors (the senior tranche) have priority over other investors (the mezzanine or junior tranche). Agency MBS are created and sold by federal agencies or government-sponsored enterprises. Private-label MBS are created and sold by private firms (investment banks or mortgage lenders). Primary dealer. One of about twenty financial institutions—typically

investment banks—that buy and sell government securities in transactions with the Federal Reserve System. Special-purpose vehicle (SPV). A financial entity created in the process

of securitizing loans and other debt. The vehicle is legally distinct and

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bankruptcy remote from the firm that issues the securities. The sole purpose of the vehicle is to act as a conduit for principal and interest income from the securitized loans to the investors in the security. Structured investment vehicle (SIV). A financial entity that raises

short-term funds to purchase a portfolio of MBS, ABS CDO, or other securities. Principal and interest income from the portfolio are distributed, after paying short-term funding costs, to investors. Like the SPV, the SIV is legally distinct and bankruptcy remote from the financial institution responsible for its creation. Subprime loan. A residential mortgage loan given to a borrower with

characteristics that fail to meet prime lending standards: a poor credit score, low or no down payment, or little or no documentation for income and work history. Super senior tranche. The safest and largest tranche created in the construction of a synthetic ABS CDO. A smaller subordinate marketable tranche is typically rated as AAA, so the super senior tranche, often held on the books of the issuing bank, was treated as very low risk.

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Index

13 Bankers, 16, 80, 130–132, 141 2/28 loans, 28, 30 Abt Associates, 34 Agency mortgage-backed securities (or Agency issues): defined, 41, 154; exposure to subprime risk, 49; Fed purchases of 56, 114–117, 125–126; monetary policy and, 52, 128; origins and growth of, 43–46; and long-term housing finance reform, 59 Ally Bank, 97 American International Group (AIG): extensions of credit to 8–9, 17, 37, 117; failure of, 1, 20, 115; Maiden Lane holdings and, 56, 114, 121, 127; mortgage-backed securities losses (c.1994), 61; subprime derivative exposure and counterparties, 73–74. 107, 133 American Bankers Association, 80, 101, 104–105, 109 Ameriquest, 28, 34, 53 Asset-backed securities: failure of markets for, 1, 52, 86; Fed purchases of, 9, 57, 119–121, 126; resecuritization of, 63, 73; structured investment vehicles and, 99. See also Mortgage-backed securities Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, 118, 121 Asset-backed security collateralized debt obligations: defined, 6–7, 153; role in the crisis, 10, 63–66, 82, 138; capital requirements for, 69–74; regulatory arbitrage and, 71; failure of market for

74–75; credit rating agencies and, 77, 85–86; structured investment vehicles and, 98–100; Maiden Lane holdings of, 121, 127–128, 138 Audits, of the Federal Reserve System, 3, 145 Bachus, Spencer, 94 Bair, Sheila, 107, 124 Bank for International Settlements: Basel Accords, 68, 75; responding to the 2008 crisis, 75, 82; coordination with other international actors, 108. See also Hannoun, Herve Bank holding company: defined, 153; Fed supervision of, 15–16, 67–68, 81, 88, 107–109, 122, 145; internal risk models and, 79; investment bank designation as, 17, 21, 89, 102–103; in the private mortgage–backed securities market, 59, 66; prudential regulation of, 94–98; structured investment vehicles and, 98–101 Bank Holding Company Act of 1956, 96 Banking Act of 1933, 143. See also GlassSteagall Wall Bank of America, 54, 81 Bank of Japan, 113–114 Basel Accords: application to bank holding companies, 96; Basel I, 65–70; Basel II, 75–83, 102, 104; defined, 153; internal risk management and, 70; reform after 2008 or Basel III, 10, 63, 82–85, 140–141; regulatory arbitrage under, 66, 71; synthetic securities and, 73

173

174

Index

Basel Committee on Bank Supervision, 68, 77, 80, 82–83, 85, 108 Bear Stearns: derivatives positions, 93; hedge funds linked to, 7–8, 83; Maiden Lane assets related to, 114, 117, 121; oversight of, 98, 101–102, 104, 107; participation in the private mortgagebacked securities market, 48, 53; purchase by JPMorgan Chase, 9, 17, 37, 56, 93, 123 Bernanke, Ben: failure to anticipate the crisis, 8, 20, 92–93; on expanded regulation of mortgage lending, 35; on Fed responses to the crisis, 3, 88, 94, 105, 142; on housing and monetary policy, 52, 92–94; on Japanese monetary policy, 113–114; on large scale purchases of Treasury securities, 128–129; on prudential regulation, 98, 102; on subprime lending and causes of the crisis, 11; on systemic risk regulation, 107–109 Blinder, Alan, 19, 140 Bloomberg LP v. Board of Governors of the Federal Reserve System, 126 Board of Governors of the Federal Reserve System: crisis response, 8–9, 43, 49, 100, 115, 120, 131, 142; Consumer Financial Protection Bureau and, 26–27, 38, 134–135; disclosure of details related to extraordinary lending programs, 129; Financial Stability Oversight Council and, 110, 140; monetary policy mission (or core mission), 17, 22–23, 27, 45, 108–109, 131, 136, 145; regulation of bank holding companies, 97; regulation of derivatives, 91; regulation of investment banks, 102; statutory mission of, 51 Bubbles, asset or price, 134, 136–137 Bullard, James, 129 Burns, Arthur, 19, 21, 125 Bush, George W. (Bush administration), 21, 30, 48, 104 California Public Employees’ Retirement System, 100 CAMELS ratings, 79, 96 Chernow, Ron, 143 Citigroup: exposure to subprime mortgagebacked securities, 75, 81; investment banking business, 101; investments in hedge funds, 104; primary dealer designation, 120; structured investment

vehicles, 99; subprime mortgage market and, 34 Clearing House, The, 85 Commercial Paper Funding Facility, 118–120, 149 Commodities Futures Modernization Act of 2000, 92 Commodity Futures Trading Commission, 92–94, 107 Community Reinvestment Act, 32 Comptroller of the Currency, Office of: bank supervision by, 14–15, 67–68, 94; Basel Accords and, 73; Consumer Financial Protection Bureau and, 38; Financial Stability Oversight Council and, 124; preemption of state regulation, 33; secondary mortgage market, 42, 46; warning signs from, 36, 140 Consolidated Supervised Entities program, 102 Consumer and Community Affairs, Division of, 26 Consumer Financial Protection Bureau, 26–27, 32, 38–40, 134, 140 Consumer protection: Consumer Financial Protection Bureau and, 26–27, 38, 134–136; Fed experience with, 14, 22, 26, 32–35, 81, 109, 132–133; opposition to 27, 31–33, 59, 135; regulation of high-priced mortgages and, 37–38, 56, 64; reinvigoration of, 2–3, 135, 146 Corps of Engineers, 15, 146 Corrigan, E. Gerald, 91–93 Council to Shape Change, 6, 84, 140 Counterparty credit risk, 74, 89–90, 92, 98, 103 Counterparty risk management policy group (Corrigan group), 92 Countrywide, 28, 48, 53–54 Cox, Christopher, 102, 110 Credit allocation: asset bubbles and 137; capital requirements and, 85; consumer protection and, 33; lending facilities and, 125; selective credit controls as, 19 Credit default swap: defined, 154; growth and regulation of, 89, 92, 100; regulatory arbitrage, 70–73; secondary mortgage market, 41; synthetic debt instruments and, 73; systemic risk 86, 100 Credit enhancement, 55, 60, 64 Credit rating agencies: after the crisis, 59–60, 80–82, 74–75; Basel Accords and, 65–66, 69; derivatives and, 90–91; Financial Stability Oversight Council

Index

and, 108; ratings of collateralized debt obligations, 74–78; ratings of subprime mortgage-backed securities, 54–56, 58; role in the crisis, 10, 42, 52, 138; structured investment vehicles and, 99–100 Crisis: accountability for, 141–142; learning from, 1–4, 13–15, 61, 142–143; management of, 115, 120; stages of, 13, 129; termination of, 129–130 Depository institutions: bank holding companies and, 96, 103; defined, 154; deregulation of, 31, 61; Fed lending to, 114, 117–120; housing finance and, 46; money market mutual funds and, 105; mortgage-backed securities and 42, 44, 59–60, 66; prudential regulation of, 12, 15–17, 21–22, 42, 67, 79–81, 86–89, 94; subprime lending and, 27, 32, 53; structured investment vehicles and, 98–100 Depository Institutions Deregulation and Monetary Control Act of 1980, 31 Derivatives: capital requirements for, 69, 97; clearinghouses for, 94, 107; counterparty credit risk and, 89; DoddFrank rules about, 87. 93, 146; internal risk management and, 79–80; Long Term Capital Management failure and, 90; regulation of 87, 90–93, 132–133, 138–139, 144; regulatory arbitrage and, 71–73; role in the crisis, 1, 7, 52, 64–67, 77, 133; systemic risk and 6–7, 10, 12; warning signs about, 91, 139. See also Credit default swaps Discount window lending, 114, 118, 120–123, 126 Dissents within the Federal Open Market Committee, 11, 117, 129, 131, 137; norms against, 139–140 Dodd, Christopher, 35 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank): consumer protection measures or Consumer Financial Protection Bureau, 32, 38, 40; credit rating agency provisions, 55, 59, 85–86; derivatives regulation under, 87, 93, 95; disclosure and audit requirements for the Board of Governors, 145; expansion of Fed supervisory authority under, 12, 20, 59, 66, 95, 111, 131–134, 142–143; Financial Stability Oversight Council,

175

87, 124, 134–135; limits on proprietary trading or Volcker rule, 96; prudential regulation under, 81; resolving large firms under, 103, 124; rulemaking and implementation, 70, 83, 85, 93, 134, 141–142 Eastburn, David, 134 Elite bank regulator partnership, 80–81, 92 European Union, 38 Expertise: acquiring and preserving, 12–13, 17–19, 26, 44, 60, 131, 142–143; evaluation of, as part of bank supervision, 79–81; Fed staffing and, 58–59, 98, 110–111; gaps in or loss of, 3, 18, 39, 42, 58, 131, 137–139; organizational learning and, 15, 18, 139–140 Fair Housing Act of 1968, 32 Fannie Mae: Fed financial support of, 56–59; Fed opposition to, 46, 50; mortgage delinquency rate, 29; origins and function, 6, 41, 44–45; purchases of private and subprime mortgage-backed securities, 48 Federal Bureau of Investigation, 54 Federal Deposit Insurance Corporation: bank insurance fund, 14, 105; bank supervisory role, 94; board of directors, 141; Consumer Financial Protection Bureau and, 39; Fed impact on, 123, 126; Financial Stability Oversight Council role, 107, 123; on accounting treatment of special-purpose vehicles, 100; savings and loan crisis response, 14, 18. See also Bair, Sheila Federal Emergency Management Administration, 14–15, 17, 110 Federal funds rate: housing bubble and, 5, 11; impact on national housing goals, 26, 51; impact on Reserve Bank assets, 128, 129; normal operating procedure, 21, 129; zero or near-zero target for, 114–115 Federal Home Loan Bank system, 15, 29, 44, 46 Federal Home Loan Mortgage Corporation. See Freddie Mac Federal Housing Administration, 29–34, 44–45 Federal Housing Enterprises Financial Safety and Soundness Act of 1992, 48 Federal National Mortgage Association. See Fannie Mae

176

Index

Federal Open Market Committee: communication by, 144; coordination with US Treasury, 131; dissents on, 140; on extraordinary lending programs, 123; on large-scale asset purchases, 117–118, 129; responding to asset bubbles, 137; and subprime exposure of housing GSEs, 49; Federal Reserve Act, 51, 96 Federal Reserve Bank of New York: Basel II and, 65, 80; counterparty credit risk assessment and, 103–104; derivatives regulation and, 92–93, 103; failure to anticipate the crisis, 8, 81, 92; Limited Liability Companies created by, 9, 56–57, 119, 121, 124, 127, 131; power and authority after the crisis, 17, 110, 114, 133; resolution of AIG derivatives contracts, 133; responding to the crisis, 8–9, 21, 54, 106, 110, 119–121, 144 Federal Reserve Banks: tension with Board of Governors over purchases of longterm Treasury securities, 129; Dallas, 129, 137; expenditures, 26, 38; Kansas City, 11, 94, 129, 141; Minneapolis, 106, 136; Philadelphia, 129, 134; Richmond, 117, 123, 129; San Francisco, 108, 136; St. Louis, 129, 145. See also Federal Reserve Bank of New York Federal Trade Commission, 34–35, 38, 53 Financial Accounting Standards Board, 100–101 Financial contagion. See Systemic risk Financial Crisis Inquiry Commission, 49, 55, 121, 130 Financial holding company, 67, 95–96, 142, 153 Financial market utility, 94, 107, 144 Financial Services Modernization Act of 1999. See Gramm-Leach-Bliley Financial Stability Oversight Council: broader Fed power under, 88, 93, 103, 115; money market mutual funds and, 106; origin and role, 82, 87–88, 139–141; resolution authority, 103, 124; systemic risk and, 107–110, 135–136, 138 Financial Stability Policy, Office of, 140 First Alliance, 53–54 Fisher, Richard, 129, 137 Fitch Ratings, 54 Fraud: at Bear Stearns hedge funds, 7–8; in the mortgage lending industry, 10, 33–34, 36, 39, 64; in the private

mortgage-backed securities market, 42, 46, 52–54, 78 Freddie Mac: Fed support of, 56–59; limiting growth of, 50; mortgage delinquency rate, 29; origins and function, 6, 41, 44–45; purchases of private and subprime MBS, 48–49; Friedman, Milton, 19 Garrett, Scott, 109 Geithner, Timothy: appointment to Treasury, 142; assessments of private sector risk management practices, 8, 81; on counterparty credit risk, 92; on supervision of hedge funds and investment banks, 102, 104 General Electric (or GE Capital), 61, 110 General Motors Acceptance Corporation (GMAC), 21, 95, 97 Ginnie Mae, 5, 31, 41, 44–46, 50 Glass-Steagall wall, 47, 61, 80, 101, 144 Goldman Sachs: as a bank holding company, 21, 95, 102, 110; as a standalone investment bank, 101; former Fed officials working for, 91, 93; impact of Volcker rule on, 96; investigations and fines of, 54; loans and other credit from the Fed to, 120, 121, 133 Goodhart, Charles, 136 Government Accountability Office: audits of the Fed, 145, warnings about derivatives, 91, 139; warnings about subprime lending, 5, 24 Government National Mortgage Association. See Ginnie Mae Government Performance and Results Act, 37 Government-sponsored enterprise. See Fannie Mae, Freddie Mac, and Federal Home Loan Bank system Gramlich, Edward, 5, 28, 31, 33, 140 Gramm-Leach-Bliley, 47, 95–97, 153 Great Moderation, 20, 127, 145 Greenspan, Alan: discretion over policy, 2, 19–21, 127; easy money under, 11; on Fannie Mae and Freddie Mac, 50–51; Federal Open Market Committee dissents under, 140; on fraud in banks, 36; on internal risk management, 78–79; on regulation of derivatives, 91–93, 132; on regulatory arbitrage, 70; on subprime lending as a constructive innovation, 30 Greider, William, 19

Index

Hacker, Jacob, 13, 65 Hannoun, Herve, 63 Heclo, Hugh, 1 Hedge funds: capital requirements for bank investments in, 70, 104; failure of, 1, 7–10, 60, 83, 90, 99, 104; Financial Stability Oversight Council and, 17, 105, 107–108, 138; moral hazard and, 123; proliferation of, 21, 90, 96; prudential regulation of, 2, 10, 61, 86–89, 103–105, 109–110; subprime mortgage-backed securities exposure of, 7, 71–72; systemic risks introduced by, 93, 98, 100, 138 Hoenig, Thomas, 11, 95, 129, 141 Home Mortgage Disclosure Act, 32 Home Ownership and Equity Protection Act, 33 Home prices, 4–5, 25, 45, 129, 137 House of Representatives, United States, 109 Housing and Urban Development, Department of, consumer protection functions, 38, housing finance reform proposals, 43, 57–58; housing GSEs and, 48; innovations in housing finance, 44; policy and research on subprime lending, 30, 34 Housing finance: Fed role in 21, 51, 56–57, 136; government programs to expand, 43–46; innovations in, 41; reform of, 12, 43, 58–59; Wall Street and, 46–49 Housing goals: Federal Reserve System accountability for, 31,46, 51, 57, in lowand moderate-income neighborhoods, 48; subprime mortgage market and, 27–30 Housing GSEs, 50–51, 56–57, 154. See also Fannie Mae, Freddie Mac, and Federal Home Loan Bank system Inflation rate (or Price stability): Fed balance sheet and, 115, 127–129; Fed independence and, 19, 22, 31, 88, 137, 145; as focus of Fed attention, 3, 17, 22, 57, 134–136; long-term prospects for, 12, 88, 127, 115–116, 130; systemic risks and, 109, 122, 135–136 Inside Job, 130 Interests. See Networks Internal risk management: Basel II and, 73, 75–81; derivatives and, 79–80, 90–92; procyclical features of, 82; reliability of 84–86, 138; Value-at-Risk, 82

177

International Swaps and Derivatives Association, 71, 82, 90–91 Investment banks: bank holding company status of, 16–17, 21, 89, 95, 103; Basel Accords and 65–66, 73; credit rating agencies and, 55; defined, 154; depository institutions and, 9, 61, 80–81, 97; derivatives regulation and, 91; failure of, 1, 6, 8–9, 11, 87, 102; Fed lending to, 120–122, 126; Financial Stability Oversight Council and, 107–109; hedge funds and, 7–8, 60; moral hazard and, 123; private-label mortgage-backed securities production, 41, 46–49, 55–56; proprietary trading by or Volcker rule, 96; prudential regulation of, 2, 9–10, 16–17, 21, 59, 86–88, 93, 98, 101–104; Securities and Exchange Commission supervision of, 95, 102, 106, 110; subprime lending and, 6, 34, 47, 53–54, 56; structured finance and, 6, 71–73. See also Glass-Steagall wall, Primary dealer JP Morgan, 89, 143 JPMorgan Chase, 9, 54, 110 Kane, Edward, 106 Katrina, Hurricane, 13, 15, 17 Keynes, John Maynard, 133, 137 Kidder Peabody, 60–61 Kocherlakota, Narayana, 106 Kohn, Donald, 21, 120, 145 Kroszner, Randall, 21, 60, 81, 100, 104 Lacker, Jeffrey, 117, 123, 129, 131 Learning: after crisis 13–14, 129–130, 142–143; at the Fed, 60–61, 64, 67, 81, 131; in networks, 15; in organizations, 18; obstacles to, 84–85, 135, 140–141, 146–147; policy change and, 1–3, 22 Lehman Brothers: bankruptcy of, 1, 8–11, 20, 83, 87, 107; complexity of, 102; implications of Dodd-Frank for resolution of firms similar to, 124; legal claims against, 53–54; money market mutual fund links to, 105–106, 121; oversight of, 101–102; participation in the private-label mortgage-backed securities market, 48, 53; subprime lending and, 34 Lender of last resort, 12, 106, 113–116, 122, 128 Liquidation authority. See Resolution of failing financial institutions

178

Index

Long Term Capital Management, 10, 87, 90–92, 123 Lubke, Theodore, 93 Macroprudential regulation, 109–110 Maiden Lane, 9, 56–57, 121, 125–127, 131 Managed Funds Association, 70, 104 Martin, William, 19, 45, 125 McDonough, William, 80 Meltzer, Allan, 88 Merrill Lynch, 97, 101 Michigan, state of, 33 Microprudential regulation, 67, 109 Minsky, Hyman, 42, 137–139 Mission: agency performance and, 14–15; bank supervision (“safety and soundness”), 33–35, 42, 67. 81, 101–102, 109, 128, 146; broadening of Fed, 3, 9, 22–23, 61, 121, 134, 145; consumer protection, 26–27, 34, 37–40, 135; housing finance, 42, 51, 56–58; price stability, 109, 116, 117, 136; systemic risk, 89, 107–111, 135 Money Market Investor Funding Facility, 121 Money market mutual funds: failure of, 9, 105, 121; lending and support for, 117, 121–122; prudential regulation and supervision of, 17, 86, 88–89, 98, 105–106 Moody’s Corporation, 54–55, 74 Moral hazard, 58, 115–116, 122–124, 141 Morgan Stanley, 73, 101, 121 Mortgage-backed securities. See Privatelabel mortgage-backed securities and Agency mortgage-backed securities Mortgage Bankers Association, 6, 45. See also Council to Shape Change Mortgage Interest Rate Commission (c.1969), 45, 51 National Aeronautics and Space Administration: Challenger accident and, 18, 42 ,135; Columbia accident and, 18, 135, 139 National Association of Home Builders, 45 National Association of Mutual Savings Banks, 45 National Credit Union Administration, 38 National Housing Conference, 45, Navy, US, nuclear propulsion program, 139–140 Networks: bias in and cooptation of, 16; coordination in, 18, 143; impact of, on

Fed policy choices, 21–22, 88, 107, 108 (c.1975), 131–133; policy change and, 16–17; structure of, in the financial sector 3, 15–17, 38, 84, 97–98 New York Fed. See Federal Reserve Bank of New York Normalization of deviance, 18, 42, 60, 138–139 Norton, Joseph, 80–81, 92 Obama, Barack (Obama administration), 12, 35, 100, 117, 145 Occupy Wall Street, 130 Open market operations, 11, 115, 120–126 Paul, Ron, 126 Pecora Commission, 132, 143 Plosser, Charles, 129 Power: of the Board of Governors of the Fed, 3, 20, 22, 88, 107, 123; of the Federal Reserve Bank of New York, 17, 65–67, 80, 110, 133; of the financial sector and Wall Street, 15–16, 80, 94, 130, 132–134, 141–146 Predatory Lending, 5, 26, 33–35 Primary dealer, 120, 154 Primary Dealer Credit Facility, 120 Private-label mortgage-backed securities: defined, 154; failure of market for, 52–55; Fed purchases of, 56–57, 120–121; Fed support for, 6, 12, 49–52, 138; market for, 10, 21, 63; origins of 46–48; risks inherent in, 41–43, 59–60, 138 Proxmire, William, 45, 51 Prudential regulation: Basel Accords and, 65–68, 77; of depository institutions, 12, 15–17, 21–22, 42, 67, 79–81, 86–89, 94; Fed expertise in, 109–110; general role in the crisis, 10, 12; of hedge funds, 101–104, of investment banks, 87–88 Quantitative easing, 56, 117–118 Rajan, Raghuram, 140 Raskin, Sarah Bloom, 111 Rating agencies. See credit rating agencies Regulation W (Transactions between member banks and their affiliates), 97 Regulation X (Mortgage credit, c. 1950), 31, 37 Regulation Y (Bank Holding Companies…), 96 Regulation Z (Truth in Lending), 33, 37

Index

Regulatory arbitrage, 66, 71, 73, 82 Reserve Fund, 105–106, 121 Resolution of failing financial institutions: anticipated under Dodd-Frank, 103, 107, 124, 146; federal experience with, 18, 121; implications for prudential regulation, 106; moral hazard and, 123–124, 146; with substantial derivatives exposures, 90 RFI/C(D) ratings, 96, 150 Roberts, Alasdair, 135–136 Rural Housing Alliance, 45 Ryan, Paul, 128 Schwarz, Anna, 123 Secondary Mortgage Market Enhancement Act of 1984, 43 Securities Act of 1933, 144 Securities and Exchange Commission: collaboration with the Fed, 110; credit rating agencies and, 54; derivatives and, 92–94; Financial Stability Oversight Council and, 107–108, 124; investigation of Bear Stearns hedge funds, 7; investigation of subprime lending, 53–54; monetary market mutual fund oversight and disclosures, 105; origins of, 144; prudential regulation of investment banks by, 101–102; supervisory role of, 42, 53, 87, 95 Securities Exchange Act of 1934, 144 Self-regulation, 75, 77, 84, 86, 92, 138. See also internal risk model Senate, United States, 31, 35, 45–46, 51, 125, 130, 143–144 Shadow banking system, 89, 97–99, 108, 131 Shelby, Richard, 138 Shiller, Robert, 4, 136 Simons, Henry, 139 Social Security Administration, 14, 110 Special-purpose vehicle: capital requirements for, 101; defined, 55, 98, 154–155; derivative markets and, 98–99; Fed use of, 121; regulation of, 86, 89; role in the crisis, 75 Stern, Gary, 136 Structured finance products: capital treatment of, 65–67, 73; defined, 64–65; monitoring risks associated with, 6, 85–86, 139–140, 144; role in the crisis, 2, 8–10, 22, 97, 132 Structured investment vehicle (SIV): defined, 155; exposure to subprime

179

mortgage risk, 75; rating agencies and, 100; regulation of, 98–99, 101, 144; role in the crisis, 99–100 Student loans, 126 Subprime loans: defined, 155; Fannie Mae and Freddie Mac exposure to, 48–49; Fed regulation of, 33–34, 36–37; origins and growth of, 27–30; as primary cause of the 2008 crisis, 1, 3–5, 11; private mortgage-backed securities and, 6, 10, 41–42, 46–47, 52–55 Subterranean politics, 65, 70, 144 Super senior risk (or Super senior tranche), 73–77, 84, 100, 155 Supervisory Capital Assessment Program, 96 Synthetic securities. 6, 63–66, 71–75, 84–86, 153, 155 Systemic risk: defined, 87; derivatives and, 89–90, 93, 137; Fed regulation of, 10–12, 86–88, 98, 107–109, 135–136, 142; Financial Stability Oversight Council and, 17, 107, 124; warnings about 84, 91 Tarullo, Daniel, 21, 65, 68, 111; on Basel II, 80; on costs of internal risk models, 85; on expansion of Fed regulation and supervision, 108, 111 Tavakoli, Janet, 72–74, 140 Term Asset-backed Securities Lending Facility, 57, 120 Term auction credit: amount extended during the crisis, 116–117, 124, borrowers of, 20, 57, 126; for depository institutions, 118–119, for Primary Dealers, 120 Term Auction Facility, 118 Term Securities Lending Facility, 57, 75, 118, 120, 151 Tett, Gillian, 74, 89, 91, 99 13 Bankers, 16, 80, 130–132, 141 Thrift Supervision, Office of, 38, 53, 94–95 Todd, Walker, 122 Too big to fail, 94, 107, 123 Treasury Accord, 19 Treasury, Department of: consumer protection initiatives, 34–35; coordination with the Fed, 3, 27, 19, 120, 131; housing finance reform proposals, 12, 43, 56–58; response to the crisis, 9, 21, 95, 113, 106, 142; review of Fed governance structure, 144; role in bank supervision, 67, 76–77, 104; role on the Financial Stability Oversight Council, 107, 124; role in

180

Index

establishing the secondary mortgage market, 44–46; regulation of derivatives, 92–93; support for money market mutual funds, 106, 121 Troubled Asset Relief Program, 9, 21, 87, 95, 110, 120, 142 Truth in Lending Act. 26, 33 2/28 loans, 28, 30

Volcker, Paul, 19, 44, 46 Volcker rule, 96

Usury laws, 21, 61

Yellen, Janet, 20, 136

Value-at-risk. See internal risk management Veterans Administration (or Veterans Affairs), Department of, 29–31, 44–45

Wall Street–Washington Corridor, 132 Watters v. Wachovia, 33 Weicher, John, 30, 48 Wells Fargo, 28, 81 Williams, Julie, 36, 140

About the Book

What was the role of the Federal Reserve System in the 2008 financial

crisis—as a cause of the crisis, as the most important government agency to respond, and as the center of federal efforts to prevent another crisis? J. Kevin Corder provides an incisive account of the Fed choices that contributed to the “crash of 2008.” Centering his analysis on the oversight of mortgage lending and the regulation/supervision of financial institutions and instruments, Corder draws out the implications of the crisis for the Fed’s mission. Equally, he charts the new political and technical challenges that the system faces as the financial sector recovers. J. Kevin Corder is professor of political science at Western Michigan University. He is the author of Central Bank Autonomy: The Federal Reserve System in American Politics.

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