A Brief Honeymoon
It is often said that new jobs, or new responsibilities, tend to begin with a ‘honeymoon period’, however brief, in which the true challenges remain either unknown, hidden from view, or just lie so far out in the future as to not require any meaningful present thought, planning or action. As it happens, this appears to be the case with the biggest job in the world of economic policy: Chairman of the Board of Governors of the US Federal Reserve System.
Ben Bernanke’s honeymoon lasted longer than most, but just over a year after he assumed the chairmanship in February 2006, there arrived the first foreshock of the global financial crisis, namely, the sudden illiquidity of numerous subprime Collaterized Debt Obligations (CDOs). Although Treasury Secretary Paulson and others subsequently spoke of the subprime crisis being ‘contained’, we know now that it was anything but; rather, as we learned in the ensuing year and a half, it permeated most of the developed economies’ financial systems.
As it happens, around the time that Bernanke assumed the chairmanship, I attended a dinner event for about fifteen hedge fund executives in London’s Belgravia neighborhood. The venue was a well-known Italian restaurant, which had a large private dining room downstairs in the wine cellar, surrounded by racks and racks of fine Italian vintages, purportedly the largest such cellar in London.
The primary topic of the evening was macro credit strategy, in particular, whether the various ‘carry trades’ in subprime and other structured credit instruments remained attractive, or whether these securities were dangerously overvalued and subject to a sharp correction, say, in the event that the US housing market began to slow down.
Well, unbeknownst to the attendees at the time, the US housing market had, in fact, already begun to slow. Yet the market for subprime debt securities kept chugging along as if everything was fine. Why?
As we now know, the major banks that were the primary originators of subprime securities had their own dedicated mortgage origination conduits and also their own investment funds that in turn invested in such paper. These vertically-integrated structures impeded price discovery and created the illusion of market liquidity where, in fact there was relatively little. In some cases, a degree of fraud also appears to have been present, with subprime traders deliberately mismarking books, rather than merely ‘marking to model’ or to ‘make-believe’, as some were suggesting at the time.
By June 2007, however, the deterioration of subprime collateral values became plain for all to see. The ratings agencies began to downgrade risky CDOs and Bear Stearns suspended redemptions from its structured credit funds. (It would subsequently liquidate these funds. Their holdings would be assumed by the Federal Reserve as part of the deal negotiated for JP Morgan to take over Bear Stearns.)
Returning now to the dinner, in my prepared remarks I made several observations that provoked an active debate. First, with reference to some inventory and sales data, I suggested that the housing market was slowing down, although I was unaware just how sharply. Second, I pointed out how the subprime housing market had all the classic characteristics of a market with ‘directional liquidity’, that is, the appearance of a liquid market as long as prices were stable or rising, but the rapid disappearance of liquidity on the downside.
Third, I pointed out that Greenspan was about to retire and that the financial markets might be concerned about how his successor would deal with a housing market slowdown and subprime crisis.
It was at this point that one of the executives interjected. As I recall, he said something along the lines of “Here you are talking about all these big macro risks, of housing, of subprime, of leverage, of financial market structure, and yet now you suggest, amidst all that, that just ONE GUY, ONE GUY somehow makes a difference! Bernanke is just ONE GUY! How does he change anything? If it is all going to blow up, it is all going to blow up. If things are fine, things are fine. ONE GUY doesn’t matter!”
He had a point. I responded by mentioning that not only Greenspan, but an unusually large number of other Fed governors and regional bank presidents were also retiring over the coming months; that there was a general ‘changing of the Fed guard’ about to take place. But his point remained valid. Why should just one guy, or a handful of guys, make such a difference? If there is something amiss in the economy, the financial markets will eventually sniff it out and react accordingly, regardless of who is in charge at the time at the Fed, at the Treasury, or in the White House for that matter.
As mentioned above, by June 2007 the financial markets had indeed sniffed something out, and it didn’t smell particularly nice. All of a sudden everyone was aware that the price (and risk) discovery in the subprime securities market was not only suboptimal, it was essentially non-existent, and so the subprime market seized up.
In the following months, US economic officials worked to reassure financial market participants that the subprime meltdown was ‘contained’. What they didn’t realize, however, was that banks now didn’t trust one another. This was because they were well aware that their counterparties were holding as much or more now-illiquid subprime junk as they themselves were and that, as a result, one or more of their counterparties might be insolvent. So eventually the interbank lending market in general seized up, restricting banks’ access to funds and increasing rollover risk. The first casualty was Bear Stearns but, as we know, Lehman Brothers, Merrill Lynch, Wachovia, Countrywide and WaMu all followed.
Chairman Bernanke may have enjoyed an unusually long honeymoon but he has spent the bulk of his tenure in crisis-fighting mode. Initially, he oversaw the creation of various emergency lending facilities, most of which have now been wound down. Subsequently, he stonewalled repeated requests by journalists and the US Congress to provide some transparency into those facilities. (At one point the Fed even invoked ‘national security’!) The courts eventually forced the Fed to provide a degree of disclosure, but Bernanke still managed to keep things under wraps for a prolonged period of time.
Throughout, Bernanke has overseen the greatest expansion of the US money supply in history. This is primarily through the creation of so-called excess reserves, which do not flow through the economy, at