ECONOMY
JANUARY 13, 2012
Little Alarm Shown at Fed At Dawn of
Housing Bust
By JON HILSENRATH, LUCA DI LEO and MICHAEL S. DERBY
In his second meeting as chairman of the Federal Reserve in May 2006, Ben Bernanke
heard a Fed governor warn about the nation's mortgage market. But Mr. Bernanke
described the cooling of the housing boom as a "healthy thing."
"So far we are seeing, at worst, an orderly decline in the housing
market," he said.
Mr. Bernanke's words were contained in 1,197 pages of transcripts released Thursday of
closed-door Fed meetings from that year. The transcripts paint the most detailed picture
yet of how top officials at the central bank didn't anticipate the storm about to hit the U.S.
economy and the global financial system.
A handful of Fed officials warned of trouble brewing. But, for the most part, officials
were expecting a manageable slowdown in the housing sector, with little damage to the
financial system or broader economy, the transcripts show. Mr. Bernanke predicted a
"soft landing" for the economy as 2006 ended, not a housing bust that would trigger the
worst financial crisis since the Great Depression.
Mr. Bernanke has acknowledged the Fed's failings as a bank overseer before the crisis,
and he has vowed to do better now that the Fed has emerged from the 2010 Dodd-Frank
regulatory overhaul with more supervisory power. A Fed spokesman Thursday pointed to
Mr. Bernanke's earlier comments on the matter.
Richard Fisher, president of the Dallas Fed, said Thursday that once the economic
turmoil hit in 2007, "the Fed did react to the crisis in a most effective way. That has now
been proven. Whether we were, as a group, late to get on the stick is of course debatable."
More
View the transcripts on the Fed's website
Governor Cautioned Fed About Mortgages
Economists Split on Action
The transcripts show Fed officials offering praise for outgoing Fed Chairman Alan
Greenspan, who attended his final Fed meeting in January 2006. Timothy Geithner, then
president of the Federal Reserve Bank of New York and now Treasury Secretary,
playfully offered this forecast about Mr. Greenspan's legacy: "I think the risk that we
decide in the future that you're even better than we think is higher than the alternative."
Mr. Greenspan's reputation subsequently was tarnished by the financial crisis.
The Fed is under attack by some Republican lawmakers, presidential candidates and
other critics who say its easy-money policies, particularly under Mr. Greenspan, fueled
the credit bubble that led to the crisis. Mr. Bernanke has said that while bad regulation
contributed to the crisis, the Fed's interest-rate policies did not. On Tuesday, supporters
of Republican presidential hopeful and Fed critic Ron Paul celebrated his second-place
finish in the New Hampshire primary by chanting, "End the Fed!"
The transcripts have the potential to fuel the criticism. "This reads like a broken record,"
said Allan Meltzer, an economist who has written a history of the Fed through 1986. The
Fed, he said, "One, gives too much weight to short-term forecasts; two, never discusses
the medium-term consequences of its decisions; and three, ignores without any discussion
warnings such as those that others tried to bring up."
There is no doubt that Mr. Bernanke and most of his Fed colleagues were concerned
about the growing weakness in the housing market in 2006, which led them to pause that
August after raising interest rates for two years. Mr. Bernanke often noted that housing
looked particularly uncertain.
Home prices peaked in May 2006, according to an S&P Case-Shiller home-price index,
and have since fallen 33%. Very few economists, either inside or outside the Fed,
imagined at the time that such a steep decline was possible.
The transcripts suggest the Fed underestimated the extent to which the housing boom had
strained the financial-services industry, particularly through exotic mortgage securities.
"We have not seen—and don't expect—a broad deterioration in mortgage credit quality,"
the Fed staff said in a June 2006 report to policy makers.
The transcripts also suggest that Fed officials misgauged the potential for housing
problems to spill over into the broader economy.
"Our recent financial-market data don't, in my view, provide a convincing case for a
substantial increase in the probability of a much weaker path for growth going forward,"
Mr. Geithner said at a meeting in December 2006.
Over the ensuing six months, subprime-mortgage lenders began failing and investors
shed risky mortgage debt. "Secretary Geithner was an early source of initiative at the Fed
to reduce risk and make the financial system more resilient even before 2006," Treasury
spokesman Anthony Coley said Thursday.
On Thursday, after the transcripts were released, some analysts expressed sympathy for
the Fed. Pierpont Securities chief economist Stephen Stanley said the Fed's view at the
time "was a pretty consensus view" among analysts.
The Fed spent the first part of 2006 raising short-term interest rates, a process begun
under Mr. Greenspan, but that did little to increase long-term interest rates or tame the
housing boom.
The transcripts show some Fed officials suggesting markets understood the risks of the
housing slowdown.
"As one CEO told me, the only subject that has been more analyzed than the housing
situation is the birth of Brad Pitt's baby," Dallas Fed president Richard Fisher said in a
September 2006 meeting.
On Thursday, Mr. Fisher said he wasn't dismissive of the housing threat. In that same
September meeting, he noted that he was more pessimistic about the housing outlook
than was the Fed's economics staff in Washington. The previous month, he noted that one
home builder said the housing correction was the "roughest and most sudden" he had
seen.
Susan Bies, a former banker who served as a Fed governor from 2001 until 2007, comes
across in the transcripts as the most attuned to the brewing trouble. In May 2006, she
warned that households were taking on so much debt that they might be vulnerable to
financial shocks, such as layoffs or medical problems. She expressed dismay about the
exotic mortgages that banks were offering to borrowers, particularly those in which debt
grew, rather than got paid off, over time.
Later in 2006, she warned about exotic mortgage securities. "A lot of the private
mortgages that have been securitized during the past few years really do have much more
risk than the investors have been focusing on," she said.
Janet Yellen, the Fed vice chairwoman who headed the San Francisco Fed in 2006,
warned the slowdown could become an "unwelcome housing slump."
Economists disagree about what the central bank should have done had it decided to be
more aggressive about the housing bubble.
Mr. Bernanke has said he favors using regulatory tools to fight future bubbles. Some
economists say the Fed should use higher interest rates.
Many Fed officials acknowledge, however, that prior to the crisis their economic models
and their own world views gave too little weight to how strains in the banking sector
could spill over into the broader economy.
Write to Jon Hilsenrath at jon.hilsenrath@wsj.com, Luca Di Leo at
luca.dileo@dowjones.com and Michael S. Derby at michael.derby@dowjones.com
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