What Was the Chicago Fed Thinking?

Good Evening: After spending much of Tuesday consolidating Monday’s huge gains, U.S. stocks roared ahead once more on Wednesday. Many investors and quite a few pundits have openly wondered whether the EU rescue package is substantial enough to work, but the immediate effects were evident in today’s trading (see below). Central bank purchases of Greek, Spanish, and Portuguese bonds were reported in Europe, and the sightings gave rise to a lift for equities on the Continent as well. The ECB’s exercise in moneyprinting also buoyed the precious metals. Gold set a new, all-time high today. If gold continues to rise, there will undoubtedly be fresh calls that gold is in bubble territory. The yellow metal is still a long way from going parabolic, but the bubble chatter and an article about lax lending supervision by the Chicago Fed back when housing was a bubble took me on a stroll down memory lane. The Chicago Fed president at the time, Michael Moskow, told an audience all about the Fed’s culpability way back in April of 2007.

Europe may still be a mess, but throwing a ton of money at a problem tends to work wonders for asset prices in the short run. The details of who will pay for what, as well as how the ECB plans to someday extricate itself will be left for another time, even if their actions may cause a bigger problem down the road. Equities in Europe were higher overnight, as were the Club Med bond markets. U.S. stocks simply followed along. Opening 0.5% higher, the major U.S. averages see-sawed higher for the rest of the session. The closing gains were between 1.4% (S&P 500) and 3% (Russell 2000). Treasurys didn’t benefit from a decent 10 year note auction, as yields rose anywhere from 3 to 6 bps. More weakness for the euro helped the dollar index rise 0.44%, but commodity prices managed a gain in spite of the greenback’s strength. The aforementioned rally in precious metals paced the 0.7% advance in the CRB index on Wednesday.

Chicago Fed Failed to Halt Speculative Bank Lending

As Congress continues to hold hearings about the Fed and how it supervises its charges in the commercial banking system, I came across the story you see above. I wanted to write about this nugget last week, but events (remember the mini-crash?) overtook the story. Now that things have settled down somewhat, I want to revisit the inept supervisory role played by my own Chicago Fed during the housing bubble. At issue are the costly failures of two financial institutions within the Chicago Fed district, and though there undoubtedly more like it, I’d like to focus on just one, Indiana’s Irwin Union Bank. The following excerpt from the Bloomberg story will have you wondering what the Chicago Fed was thinking between 2002 and 2009:

“Irwin Union Bank’s failure resulted in an estimated loss to the FDIC’s deposit insurance fund of $552.4 million, or 20.5 percent of the bank’s $2.7 billion in total assets.
“A borrower could receive as much as 125 percent of his/her home’s value” at the bank, the report said. “This product creates high credit risk because of the lack of collateral support.”
Credit Risk
“While most of Irwin’s borrowers didn’t pose a significant credit risk, home equity loans with low collateral were offered to “subprime customers who presented a heightened risk of default, which further increased the credit risk associated with these loans.” The company also “developed a risky loan program that did not require borrower income verification.” (source: Bloomberg News article above)

Obviously, the short answer to the “what were they thinking” question is “not much”. No wide awake regulator would ever let a bank offer its customers the ability to borrow as much as 125% of the value of their homes. Only a policy mandate from Washington could cause such willful neglect, Policy-driven or not, the shameful lending standards for home loans at Irwin Union and other banks during the mid 2000’s brought to mind a fascinating exchange I once had with then Chicago Fed president, Michael Moskow, in April of 2007. Instead of relying on my memory, let me instead relay what I wrote about the encounter in the commentaries of April 11 and 12, 2007. I was angry the Fed had allowed mortgage lending standards to slip as badly as they had, and I was convinced that problems just starting to be revealed in subprime were but the tip of a dangerous iceberg.

What Would You Ask the Fed? 04/11/07 (excerpt)
“I blame the current state of affairs on the Alan Greenspan Fed, and I may get the chance tonight to do something about it. Chicago Fed President, Michael Moskow, will be speaking at my church this evening. Not only will I attend, but I hope to be called upon if Mr. Moskow takes questions from the audience. If you had this chance what question would you ask of this current voting member of the FOMC? My own inclination is to ask him what responsibility the Fed feels for the problems in the housing sector, given:

1. They fostered a housing bubble by keeping rates so low for so long earlier in the decade
2. They spoke encouragingly about the creation of exotic mortgage products and the Maestro himself advised folks to take out ARMs in February, 2004
3. They abrogated their oversight responsibility for mortgage lending practices until the end of last year — when it was far too late to prevent the problems were seeing now.”

The Greenspan/Bernanke Put Lives 04/12/07 (excerpt)
“As I arrived full of anticipation at my church for Chicago Fed president Michael Moskow’s speech last night, I was offered a keepsake gift. The Chicago Fed passed out to the audience bags of shredded dollar bills. My youngest son is infatuated with all things currency, so while I pocketed the keepsake for him, I didn’t let my local Fed District’s kindness deter me from asking Mr. Moskow the (3 part) question I shared with you in last night’s comment…(his paraphrased answers follow each dash):

“Mr. Moskow, what responsibility does the Fed feel for the problems in the housing sector, given:

1. The Fed fostered a housing bubble by keeping rates so low for so long earlier in the decade
— Answer: “We did keep interest rates low, but I think everyone agrees that it was necessary and the right thing to do at the time.”
2. The Fed spoke encouragingly about the creation of exotic mortgage products and the Maestro himself advised folks to take out ARMs in February, 2004
— Answer: “Innovations in the mortgage market were very important; they allowed home ownership to reach higher levels than ever before. Yes, some people took on mortgages they couldn’t afford, but on balance, and I think you’ll all agree, the rise in home ownership was worth it.”
3. The Fed abrogated their oversight responsibility for mortgage lending practices until the end of last year — when it was far too late to prevent the problems were seeing now
— Answer: No direct response, as expected.”

“Limited as it was, I found his response interesting in that he implied the Fed welcomed (either through low interest rates or innovations in mortgage “affordability products”) an increase in home ownership by American citizens. This goal is a matter of legislative policy and only very weakly related to the Fed’s mandate of full employment. Taken one step further, it also implies that the Fed did indeed want to foster a housing bubble to bail out the broken stock market bubble. That’s a stretch, I admit, but Mr. Moskow’s response gave ammunition to those who feel the Fed takes asset prices into account when forming policy.”

Looking back, I should have done more probing and should have been more angry. Here we are, more than three years and trillions in bailouts later, and we now have a much better idea of what the Chicago Fed was actually thinking during the bubble years. The Chicago Fed (and every other Fed district) was promoting home ownership, which is a power vested only to Congress. The Maestro in Washington and his minions out in the districts didn’t just let the housing bubble inflate, they provided much of the air! Not only were interest rates kept far too low for far too long, but — as can be seen in both the Bloomberg article and in Mr. Moskow’s comments — they let mortgage underwriting standards slip on purpose so more Americans could afford to buy homes!

Unfortunately for all of us, it turned out that many of these former renters (not to mention speculators and condo-flippers) actually couldn’t afford their new houses. The rest is now one of the saddest chapters in financial history. It wasn’t just Wall Street that was reckless in the run up to the 2007-2009 financial crisis, the Fed was its commander-in-chief! I’m guessing this dangerous “let’s promote home ownership” policy of the FOMC during the bubble years will someday be revealed in the official minutes of those meetings, and I hope some enterprizing reporter exposes it. Let me close by quoting the last line of my April 12, 2007 comment, a sentence meant to capture the foreshadowing value of the keepsake gifts Mr. Moskow gave his audience members that night in 2007. “It’s of little wonder that the Fed is passing out bags of shredded U.S. currency.”

— Jack McHugh

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