Frederick J. Sheehan
is the author of Panderer to Power: The Untold Story of How Alan Greenspan
Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The
Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)
The 2007 Federal Open Market Committee
(FOMC) transcripts were released last week. Media reports have concentrated on
the Fed's forbearance during the credit meltdown. Implied, but not stated (in
what I have read) is the major reason for such nonchalance: The Fed only
acknowledges flows, not stocks. This might sound boring. It is also very
important to understand.
This approach to central banking has not changed. All of the major central
banks use the same framework. The media and Wall Street spend most of their
time interpreting the meaning of central-bank talk. Central banks will never
mention a growing concern about loan defaults since the academics can always
thwart potential catastrophes by modeling preventive flows (e.g., liquidity).
The catastrophic financial failure that most of us endured in 2007 and 2008 was
not a failure at all, according to central bankers. Their models still conclude
there is always a central-banking solution that will prevent any catastrophe.
In conclusion: when the current financial bubble topples, there will no
forewarning from central bankers, the media, or Wall Street. Given their
processes of thinking, they will be more surprised than the average
"Stocks," in this case, does not refer to common stocks, but the
accounts and categories in which assets (and their liabilities) accumulate. The
Fed, a creature of academia, knows everything. Knowing everything limits policy
to sufficient "liquidity": flows. It - to be more precise - its DSGE
model, does not care about accumulations: stocks.
The Fed was taken unaware when credit cracked up in
the summer of 2007. Unlike many local realtors and carpenters, the FOMC did not
understand the connection between flows (bad loans pouring into off-balance
sheet Special Investment Vehicles) and stocks (of mushrooming mortgage credit
going sour). The Fed presumably noticed pieces of the mortgage machine
(subprime lenders, appraisers, Fannie Mae, commercial banks, investment banks,
CDOs) even though it did not comprehend the artificiality of this contrived
structure. Hence, the Fed missed the connection between the economic expansion
of the mid-oughts and its artificial nature. (As we know now, the Fed does not
blanch at running an economy by rigging its prices, so, we know now, central
banks do not understand an artificial economy is unsustainable.)
All of which is to say the Fed and its FOMC did not
know a loss of forward momentum would be followed by an abrupt shift to
backward momentum. Again, this has not changed. Despite talk of deleveraging,
the U.S. economy has continued to lever up since the non-catastrophe of 2007
and 2008. Total non-financial debt has risen from 240% of GDP in the fourth
quarter of 2008 to 249% of GDP after the second quarter of 2012.
The Fed does not understand the artificial credit
created by central banks that has flowed since 1971 has coagulated into
unsustainable imbalances around the world. The FOMC will be in the caboose when
government debt loses its imaginary, "riskless" character (e.g.,
banks do not need to reserve against most sovereign bonds). As in 2007 and
2008, the stated price of artificially produced assets is illusory, so the
assets cannot stand on their own without ever increasing flows to support
prices. The flows accumulate in stocks, the artificial composition of which
The rate of non-financial debt production in the U.S.
economy has slowed down. It increased by 4.6% in the first quarter and 5.1% in
the second quarter of 2012. Third quarter growth was 2.4%. When forward
momentum is lost, backward momentum will prevail.
The jig was up by the summer of 2007. Those monitoring
the Mortgage Lender Implode-o-Meter website were waiting. The mortgage-makers
on parade were not necessarily bankrupt but had, at least, abandoned a major
segment of their lending activities. By the end of March 2007, the
Implode-o-Meter list had grown to 49, including some of the largest vacuums
that fed the machine: HSBC Mortgage Services, Ameriquest, ACC Wholesale, New
Century, Wachovia Mortgage. Except for those who worshiped liquidity flows, it
was impossible to miss the credit crash.
Yet, following are comments from the August 7, 2007,
CHAIRMAN BERNANKE: "I think the odds are that the market will
stabilize. Most credits are pretty strong except for parts of the mortgage
Of course, this is to be expected. Bernanke was quoted in October 2008 as not
knowing if there was a housing bubble.
More importantly, the man with his hand on the tiller, who should have
enlightened the professors, was just as dense:
DUDLEY: "We've done quite a bit of work trying
to identify some of the funding questions surrounding Bear Stearns,
Countrywide, and some of the commercial-paper programs. There is some strain,
but so far it looks as though nothing is really imminent in those areas. Now,
could that change quickly? Absolutely."
Dudley ran the New York Fed's open-market
desk. He is now President of the New York Fed. He had been an economist at
Goldman Sachs. It is expected the academics are out-to-lunch, but Dudley had
dealt in money from Goldman. His misunderstanding is appalling. (On August 16, 2007, Countrywide drew down its entire
credit line of $11.5 billion. On August 17, 2007, there was a bank run on
Countrywide. This was the real McCoy. The Los Angeles Times published
pictures of customers lined up outside branches. The Federal Reserve cut its
discount rate (not the fed funds rate) from 6.25% to 5.75% on the same day.
After the August 7, 2007, meeting, the FOMC announced: "Economic growth
was moderate during the first part of the year." Eight days later (the
FOMC held emergency telephone calls on August 10, 2007, and August 16, 2007),
the Fed justified the discount-rate cut by declaring: "Financial market
conditions have deteriorated and tighter credit conditions and increased
uncertainty have the potential to restrain economic growth.")
To conclude, a flavor of what was happening when the
FOMC met in August 2007:
July 31, 2007 - "Mortgage insurers MGIC Investment Corp. and Radian Group
Inc. said they might write off their combined $1.03-billion stake in a venture
that invests in subprime mortgages on which payments were past due."
July 31, 2007 - "American Home Mortgage Investment Corp., which lends to
people close to the sub-prime category, postponed payment of its dividend, took
'major' write-downs and said its lenders were demanding that it put up more
cash. Its stock plunged 39%. 'Bankruptcy
is not out of the question' for American Home, said Matt Howlett, an analyst at
Fox-Pitt Kelton Inc. in New York. 'It needs to find a partner with alternative
funding and hope the market turns around.'"
July 31, 2007 - "Insurer CNA Financial Corp. wrote down $20 million in
July 31, 2007 - "In Germany, shares of IKB Deutsche Industriebank,
which 10 days earlier said the [U.S.] sub-prime crisis wouldn't affect it, fell
20% in Frankfurt on Monday after it reported problems with investments in U.S.
1, 2007 - "American Home Mortgage Investment Corp. shares yesterday
plunged 90 percent after the Melville, New York-based lender said it doesn't
have cash to fund new loans, stranding thousands of home buyers and putting the
company on the brink of failure."
1, 2007 - "Bear Stearns Cos., the New York-based manager of two hedge
funds that collapsed last month, blocked investors from pulling money out of a
third fund as losses in the credit markets expand beyond securities related to
3, 2007 - (Reuters): "AMERICAN HOME MORTGAGE TO CLOSE FRIDAY" -
American Home Mortgage Investment Corp plans to close most operations on Friday
and said nearly 7,000 employees will lose their jobs.... American Home
originated $59 billion in loans last year, and mostly to people with
better credit than risky subprime borrowers. About half of those mortgages
were adjustable-rate loans, whose defining feature is an interest rate that can
be adjusted upward. 'It is with great sadness that American Home has had to
take this action which involves so many dedicated employees,' Chief Executive
Michael Strauss said in a statement." [My italics - FJS]
3, 2007 - "Moody's Investors Service said this week it plans to take a
harder look at bonds backed by those Alt-A mortgages, which are turning out to
look more like subprime loans than it expected."
9, 2007 - (Reuters) - "American International Group, one of the biggest
U.S. mortgage lenders, warned on Thursday that mortgage defaults are spreading.
While saying most of its mortgage insurance and residential loans were safe,
AIG made a presentation to analysts and investors that showed delinquencies are
becoming more common among borrowers in the category just above subprime.
Although acknowledging the "significant declines" in subprime
securities, Chief Executive Martin Sullivan said AIG's tight underwriting
standards had minimized losses and he was 'poised to take advantage of
opportunities' in the mortgage market.'"
A final note: Some media reviews of the 2007 FOMC
transcripts have given San Francisco Fed President (as she was then) Janet
Yellen an A+ for anticipating the mortgage crash at early 2007 FOMC meetings. I
doubt this. Since serving as Federal Reserve governor in 2004, Yellen has
consistently wanted to cut rates. At one meeting, she was aghast when she learned
the consumer savings rate had risen, since this would reduce consumption, push
the economy into recession, so let's cut rates before the world ends. She's as
witless as Simple Ben.