“When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment.”
-Chairman Ben S. Bernanke, Federal Reserve
The buzz this morning seems to be all about Bernanke’s speech yesterday, defending Greenspan’s ultra-low rates, and lamenting the lack of regulation and poor supervision over mortgages:
• Lax Oversight Caused Crisis, Bernanke Says (NYT)
• Bernanke Says Regulation Came ‘Too Late’ to Curb Housing Bubble (Bloomberg)
• Fed Chief Edges Closer to Using Rates to Pop Bubbles (WSJ)
• Rate hikes not best way to burst bubbles: Bernanke (Reuters)
Unfortunately, it appears to me that the Fed Chief is defending his institution and the judgment of his immediate predecessor, rather than making an honest appraisal of what went wrong.
As I have argued in this space for nearly 2 years, one cannot fix what’s broken until there is a full understanding of what went wrong and how. In the case of systemic failure, a proper diagnosis requires a full understanding of more than what a healthy system should look like. It also requires recognition of all of the causative factors — what is significant, what is incidental, the elements that enabled other factors, the “but fors” that the crisis could not have occurred without.
What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages (Yes, I laid all this out in the book).
An honest assessment of the crisis’ causation (and timeline) would look something like the following:
1. Ultra low interest rates led to a scramble for yield by fund managers;
2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;
3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;
4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.
5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.
6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.
7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;
8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.
9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.
10. Once home prices began to fall, all of the above fell apart.
It became readily clear to me once I dug into the data, legislative history, market activities, etc, that there was no one single factor that caused the collapse. Rather, an honest reading of events was that there were many, many failures occurring in a very specific order that contributed to what occurred.
Inadequate regulations and “nonfeasance” in enforcing existing regs were, as Chairman Bernanke asserts, a major factor. But in the crisis timeline, the regulatory and supervisory failures came about AFTER the 1% Fed rates had set off a mad scramble for yields. Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates.
If the Fed Chief wants to avoid seeing this occur again, he needs to recognize that this was not a single factor event; rather, this was a complex event set off by numerous factors.
The sooner we learn that, the better a grasp we will have on what actually happened . . .