fcic_final_report_full--432 Commission focused thousands of staff hours on investigation, and not nearly enough on analyzing these critical economic questions. The investigations were in many cases productive and informative, but there should have been more balance be- tween investigation and analysis. Conclusions: • The credit bubble was an essential cause of the financial crisis. • Global capital flows lowered the price of capital in the United States and much of Europe. • Over time, investors lowered the return they required for risky investments. Their preferences may have changed, they may have adopted an irrational bub- ble mentality, or they may have mistakenly assumed that the world had become safer. This inflated prices for risky assets. • U.S. monetary policy may have contributed to the credit bubble but did not cause it. THE HOUSING BUBBLE The housing bubble had two components: the actual homes and the mortgages that financed them. We look briefly at each component and its possible causes. There was a housing bubble in the United States—the price of U.S. housing in- creased by more than could be explained by market developments. This included both a national housing bubble and more concentrated regional bubbles in four “Sand States”: California, Nevada, Arizona, and Florida. Conventional wisdom is that a bubble is hard to spot while you’re in one, and painfully obvious after it has burst. Even after the U.S. housing bubble burst, there is no consensus on what caused it. While we still don’t know the relative importance of the possible causes of the housing bubble, we can at least identify some of the most important hypotheses: • Population growth. Arizona, Florida, Nevada, and parts of California all expe- rienced population growth that far exceeded the national average. More people fueled more demand for houses. • Land use restrictions. In some areas, local zoning rules and other land use re- strictions, as well as natural barriers to building, made it hard to build new houses to meet increased demand resulting from population growth. When supply is constrained and demand increases, prices go up. • Over-optimism. Even absent market fundamentals driving up prices, shared expectations of future price increases can generate booms. This is the classic explanation of a bubble. • Easy financing. Nontraditional (and higher risk) mortgages made it easier for potential homebuyers to borrow enough to buy more expensive homes. This doesn’t mean they could afford those homes or future mortgage payments in the long run, but only that someone was willing to provide the initial loan. Mortgage originators often had insufficient incentive to encourage borrowers to get sustainable mortgages. fcic_final_report_full--434 The Commission heard convincing testimony of serious mortgage fraud prob- lems. Excruciating anecdotes showed that mortgage fraud increased substantially during the housing bubble. There is no question that this fraud did tremendous harm. But while that fraud is infuriating and may have been significant in certain ar- eas (like Florida), the Commission was unable to measure the impact of fraud rela- tive to the overall housing bubble. The explosion of legal but questionable lending is an easier explanation for the creation of so many bad mortgages. Lending standards were lax enough that lenders could remain within the law but still generate huge volumes of bad mortgages. It is likely that the housing bubble and the crisis would have occurred even if there had been no mortgage fraud. We therefore classify mortgage fraud not as an essential cause of the crisis but as a contributing factor and a deplorable effect of the bubble. Even if the number of fraudulent loans was not substantial enough to have a large im- pact on the bubble, the increase in fraudulent activity should have been a leading in- dicator of deeper structural problems in the market. Conclusions: • Beginning in the late s and accelerating in the s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by more rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. • There was also a contemporaneous mortgage bubble, caused primarily by the broader credit bubble. • The causes of the housing bubble are still poorly understood. Explanations in- clude population growth, land use restrictions, bubble psychology, and easy fi- nancing. • The causes of the mortgage bubble and its relationship to the housing bubble are also still poorly understood. Important factors include weak disclosure standards and underwriting rules for bank and nonbank mortgage lenders alike, the way in which mortgage brokers were compensated, borrowers who bought too much house and didn’t understand or ignored the terms of their mortgages, and elected officials who over years piled on layer upon layer of gov- ernment housing subsidies. • Mortgage fraud increased substantially, but the evidence gathered by the Com- mission does not show that it was quantitatively significant enough to conclude that it was an essential cause. fcic_final_report_full--463 Figure 1 below, based on the data of Robert J. Shiller, shows the dramatic growth of the 1997-2007 housing bubble in the United States. By mid-2007, home prices in the U.S. had increased substantially for ten years. The growth in real dollar terms had been almost 90 percent, ten times greater than any other housing bubble in modern times. As discussed below, there is good reason to believe that the 1997- 2007 bubble grew larger and extended longer in time than previous bubbles because of the government’s housing policies, which artificially increased the demand for housing by funneling more money into the housing market than would have been available if traditional lending standards had been maintained and the government had not promoted the growth of subprime lending. Figure 1. The Bubble According to Shiller That the 1997-2007 bubble lasted about twice as long as the prior housing bubbles is significant in itself. Mortgage quality declines as a housing bubble grows and originators try to structure mortgages that will allow buyers to meet monthly payments for more expensive homes; the fact that the most recent bubble was so long-lived was an important element in its ultimate destructiveness when it deflated. Why did this bubble last so long? Housing bubbles deflate when delinquencies and defaults begin to appear in unusual numbers. Investors and creditors realize that the risks of a collapse are mounting. One by one, investors cash in and leave. Eventually, the bubble tops out, those who are still in the game run for the doors, and a deflation in prices sets in. Generally, in the past, this process took three or four years. In the case of the most recent bubble, it took ten. The reason for this longevity is that one major participant in the market was not in it for profit and was not worried about the risks to itself or to those it was controlling. It was the U.S. government, pursuing a social policy—increasing homeownership by making mortgage credit available to low and moderate income borrowers—and requiring the agencies and financial institutions it controlled or could influence through regulation to keep pumping money into housing long after the bubble, left to itself, would have deflated. Economists have been vigorously debating whether the Fed’s monetary policy in the early 2000s caused the bubble by keeping interest rates too low for too long. Naturally enough, Ben Bernanke and Alan Greenspan have argued that the Fed was not at fault. On the other hand, John Taylor, author of the Taylor rule, contends that the Fed’s violation of the Taylor rule was the principal cause of the bubble. Raghuram Rajan, a professor at the Chicago Booth School of Business, argues that the Fed’s low interest rates caused the bubble, but that the Fed actually followed this policy in order to combat unemployment rather than deflation. 19 Other theories blame huge inflows of funds from emerging markets or from countries that were recycling the dollars they received from trade surpluses with the U.S. These debates, however, may be missing the point. It doesn’t matter where the funds that built the bubble actually originated; the important question is why they were transformed into the NTMs that were prone to failure as soon as the great bubble deflated. Figure 2 illustrates clearly that the 1997-2007 bubble was built on a foundation of 27 million subprime and Alt-A mortgages and shows the relationship between the cumulative growth in the dollar amount of NTMs and the growth of the bubble over time. It includes both GSE and CRA contributions to the number of outstanding NTMs above the normal baseline of 30 percent, 20 and estimated CRA lending under the merger-related commitments of the four large banks—Bank of America, Wells Fargo, Citibank and JPMorgan Chase—that, with their predecessors, made most of the commitments. As noted above, these commitments were made in connection with applications to federal regulators for approvals of mergers or acquisitions. The dollar amounts involved were taken from a 2007 report by the NCRC, 21 and adjusted for announced loans and likely rates of lending. The cumulative estimated CRA 19 fcic_final_report_full--478 When the housing bubble began to deflate in mid-2007, delinquency rates among NTMs began to increase substantially. Previously, although these mortgages were weak and high risk, their delinquency rates were relatively low. This was a consequence of the bubble itself, which inflated housing prices so that homes could be sold with no loss in cases where borrowers could not meet their mortgage obligations. Alternatively, rising housing prices—coupled with liberal appraisal rules—created a form of free equity in a home, allowing the home to be refinanced easily, perhaps even at a lower interest rate. However, rising housing prices eventually reached the point where even easy credit terms could no longer keep the good times rolling, and at that point the bubble flattened and weak mortgages became exposed for what they were. As Warren Buffett has said, when the tide goes out, you can see who’s swimming naked. The role of the government’s housing policy is crucial at this point. As discussed earlier, if the government had not been directing money into the mortgage markets in order to foster growth in home ownership, NTMs in the bubble would have begun to default relatively soon after they were originated. The continuous inflow of government or government-backed funds, however, kept the bubble growing—not only in size but over time—and this tended to suppress the significant delinquencies and defaults that had brought previous bubbles to an end in only three or four years. That explains why PMBS based on NTMs could become so numerous and so risky without triggering the delinquencies and defaults that caused earlier bubbles to deflate within a shorter period. With losses few and time to continue originations, Countrywide and others were able to securitize subprime PMBS in increasingly large amounts from 2002 ($134 billion) to 2006 ($483 billion) without engendering the substantial increase in delinquencies that would ordinarily have alarmed investors and brought the bubble to a halt. 46 Indeed, the absence of delinquencies had the opposite effect. As investors around the world saw housing prices rise in the U.S. without any significant losses even among subprime and other high-yielding loans, they were encouraged to buy PMBS that—although rated AAA—still offered attractive yields. In other words, as shown in Figure 2, government housing policies—AH goals imposed on the GSEs, the decline in FHA lending standards, HUD’s pressure for reduced underwriting standards among mortgage bankers, and CRA requirements for insured banks— by encouraging the growth of the bubble, increased the worldwide demand for subprime PMBS. Then, in mid-2007, the bubble began to deflate, with catastrophic consequences. 46 Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual—Volume II , MBS database. 473 2. The Defaults Begin fcic_final_report_full--425 House Price Appreciation in Selected Countries, 2002-2008 The United States was one of many countries to experience rapid house price growth 2002 INDEX = 100 United States United Kingdom Spain 200 192 150 158 118 100 ’02 ’04 ’08 ’02 ’04 ’08 ’02 ’04 ’08 200 150 Australia France Ireland 168 152 142 100 ’02 ’04 ’08 ’02 ’04 ’08 ’02 ’04 ’08 SOURCES: Standard and Poors, Nationwide, Banco de España, AusStats, FNAIM, Permanent TSB • The report largely ignores the credit bubble beyond housing. Credit spreads de- clined not just for housing, but also for other asset classes like commercial real estate. This tells us to look to the credit bubble as an essential cause of the U.S. housing bubble. It also tells us that problems with U.S. housing policy or mar- kets do not by themselves explain the U.S. housing bubble. • There were housing bubbles in the United Kingdom, Spain, Australia, France and Ireland, some more pronounced than in the United States. Some nations with housing bubbles relied little on American-style mortgage securitization. A good explanation of the U.S. housing bubble should also take into account its parallels in other nations. This leads us to explanations broader than just U.S. housing policy, regulation, or supervision. It also tells us that while failures in U.S. securitization markets may be an essential cause, we must look for other things that went wrong as well. • Large financial firms failed in Iceland, Spain, Germany, and the United King- dom, among others. Not all of these firms bet solely on U.S. housing assets, and they operated in different regulatory and supervisory regimes than U.S. com- mercial and investment banks. In many cases these European systems have stricter regulation than the United States, and still they faced financial firm fail- ures similar to those in the United States. fcic_final_report_full--452 In this environment, the government’s rescue of Bear Stearns in March of 2008 temporarily calmed investor fears but created a significant moral hazard; investors and other market participants reasonably believed after the rescue of Bear that all large financial institutions would also be rescued if they encountered financial diffi culties. However, when Lehman Brothers—an investment bank even larger than Bear—was allowed to fail, market participants were shocked; suddenly, they were forced to consider the financial health of their counterparties, many of which appeared weakened by losses and the capital writedowns required by mark- to-market accounting. This caused a halt to lending and a hoarding of cash—a virtually unprecedented period of market paralysis and panic that we know as the financial crisis of 2008. Weren’t There Other Causes of the Financial Crisis? Many other causes of the financial crisis have been cited, including some in the report of the Commission’s majority, but for the reasons outlined below none of them alone—or all in combination—provides a plausible explanation of the crisis. Low interest rates and a flow of funds from abroad . Claims that various policies or phenomena—such as low interest rates in the early 2000s or financial flows from abroad—were responsible for the growth of the housing bubble, do not adequately explain either the bubble or the destruction that occurred when the bubble deflated. The U.S. has had housing bubbles in the past—most recently in the late 1970s and late 1980s—but when these bubbles deflated they did not cause a financial crisis. Similarly, other developed countries experienced housing bubbles in the 2000s, some even larger than the U.S. bubble, but when their bubbles deflated the housing losses were small. Only in the U.S. did the deflation of the most recent housing bubble cause a financial meltdown and a serious financial crisis. The reason for this is that only in the U.S. did subprime and other risky loans constitute half of all outstanding mortgages when the bubble deflated. It wasn’t the size of the bubble that was the key; it was its content. The 1997-2007 U.S. housing bubble was in a class by itself. Nevertheless, demand by investors for the high yields offered by subprime loans stimulated the growth of a market for securities backed by these loans. This was an important element in the financial crisis, although the number of mortgages in this market was considerably smaller than the number fostered directly by government policy. Without the huge number of defaults that arose out of U.S. housing policy, defaults among the mortgages in the private market would not have caused a financial crisis. Deregulation or lax regulation . Explanations that rely on lack of regulation or deregulation as a cause of the financial crisis are also deficient. First, no significant deregulation of financial institutions occurred in the last 30 years. The repeal of a portion of the Glass-Steagall Act, frequently cited as an example of deregulation, had no role in the financial crisis. 1 The repeal was accomplished through the Gramm-Leach-Bliley Act of 1999, which allowed banks to affi liate for the first time since the New Deal with firms engaged in underwriting or dealing in securities. There is no evidence, however, that any bank got into trouble because of a securities affi liate. The banks that suffered losses because they held low quality mortgages or MBS were engaged in activities—mortgage lending—always permitted by Glass- Steagall; the investment banks that got into trouble—Bear Stearns, Lehman and Merrill Lynch—were not affi liated with large banks, although they had small bank affi liates that do not appear to have played any role in mortgage lending or securities trading. Moreover, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially increased the regulation of banks and savings and loan institutions (S&Ls) after the S&L debacle in the late 1980s and early 1990s, and it is noteworthy that FDICIA—the most stringent bank regulation since the adoption of deposit insurance—failed to prevent the financial crisis. CHRG-111shrg50564--72 Mr. Volcker," What about the opposite? The price isn't high enough to stimulate the---- Senator Bennett. That is right. It has gone from $145 a barrel to $35 a barrel and then bounced around. But that is a bubble that burst and a collapse that happened very rapidly and the American motorist is delighted. The housing bubble has burst and we don't know where the bottom is. It is uneven across the country, and that is why I am a little suspect of the Case-Shiller number, because that takes the worst parts. There are some places in the country where housing prices have actually risen, but the mortgage problem remains very much a difficulty because nobody knows what the securities are worth. They don't know how much toxic paper they have, and so on. Let us talk about the credit bubble. It is different from the classic bubbles of the housing bubble and the oil bubble, but we still don't have a firm handle on what is happening with respect to credit. We don't have any kind of normalcy. There was a time when credit was enormously available. Now, it is almost not available at all, except again, like the housing thing, there are some parts of the country where it is available, or there are some markets where it is available and others where it is not. Look into your crystal ball and tell me, or tell us what it is going to take for the credit bubble to resolve itself and how long you think that might be. " fcic_final_report_full--430 China and other Asian economies grew, their savings grew as well. In addition, boosted by high global oil prices, the largest oil-producing nations built up large cap- ital surpluses and looked to invest in the United States and Europe. Massive amounts of inexpensive capital flowed into the United States, making borrowing inexpensive. Americans used the cheap credit to make riskier investments than in the past. The same dynamic was at work in Europe. Germany saved, and its capital flowed to Ire- land, Italy, Spain and Portugal. Fed Chairman Ben Bernanke describes the strong relationship between financial account surplus growth (the mirror of current account deficit growth) and house price appreciation: “Countries in which current accounts worsened and capital in- flows rose . . . had greater house price appreciation [from  to ] . . . The rela- tionship is highly significant, both statistically and economically, and about  percent of the variability in house price appreciation across countries is explained.”  Global imbalances are an essential cause of the crisis and the most important macroeconomic explanation. Steady and large increases in capital inflows into the U.S. and European economies encouraged significant increases in domestic lending, especially in high-risk mortgages. The repricing of risk Low-cost capital can but does not necessarily have to lead to an increase in risky in- vestments. Increased capital flows to the United States and Europe cannot alone ex- plain the credit bubble. We still don’t know whether the credit bubble was the result of rational or irra- tional behavior. Investors may have been rational—their preferences may have changed, making them willing to accept lower returns for high-risk investments. They may have collectively been irrational—they may have adopted a bubble mental- ity and assumed that, while they were paying a higher price for risky assets, they could resell them later for even more. Or they may have mistakenly assumed that the world had gotten safer and that the risk of bad outcomes (especially in U.S. housing markets) had declined. For some combination of these reasons, over a period of many years leading up to the crisis, investors grew willing to pay more for risky assets. When the housing bub- ble burst and the financial shock hit, investors everywhere reassessed what return they would demand for a risky investment, and therefore what price they were willing to pay for a risky asset. Credit spreads for all types of risk around the world increased suddenly and sharply, and the prices of risky assets plummeted. This was most evident in but not limited to the U.S. market for financial assets backed by high-risk, nontradi- tional mortgages. The credit bubble burst and caused tremendous damage. Monetary policy The Federal Reserve significantly affects the availability and price of capital. This leads some to argue that the Fed contributed to the increased demand for risky in- vestments by keeping interest rates too low for too long. Critics of Fed policy argue that, beginning under Chairman Greenspan and continuing under Chairman Bernanke, the Fed kept rates too low for too long and created a bubble in housing. Dr. John B. Taylor is a proponent of this argument. He argues that the Fed set in- terest rates too low in – and that these low rates fueled the housing bubble as measured by housing starts. He suggests that this Fed-created housing bubble was the essential cause of the financial crisis. He further argues that, had federal funds rates instead followed the path recommended by the Taylor Rule (a monetary policy formula for setting the funds rate), the housing boom and subsequent bust would have been much smaller. He also applies this analysis to European economies and concludes that similar forces were at play. CHRG-111hhrg74090--188 Mr. Stinebert," Well, I think when you go back, and there is plenty of history to point fingers at what was the cause of the subprime mortgage crisis and currently economic crisis but I don't think you would get anybody that would predict that whatever is done here today or by Congress that you can control every bubble that is going to occur in the future. Most economists would agree that yes, this bubble is a housing bubble, before it was a tech bubble, before that it was a savings and loan bubble. You cannot have government totally controlling financial markets unless they can totally control potential bubbles, unless you totally stymie innovation and all you have is a plain vanilla standard product out there, and I don't think that is good for the very consumers that we are trying to protect here. " fcic_final_report_full--465 Figure 2. The Effect of Government Policies on the Growth of the Bubble It is not true that every bubble--even a large bubble-- has the potential to cause a financial crisis when it deflates. This is clear in Table 2 below, prepared by Professor Dwight Jaffee of the Haas Business School at U.C. Berkley. The table shows that in other developed countries—many of which also had large bubbles during the 1997-2007 period—the losses associated with mortgage delinquencies and defaults when these bubbles deflated were far lower than the losses suffered in the U.S. when the 1997-2007 deflated. 22 See note 144. CHRG-110shrg50414--7 STATEMENT OF SENATOR ROBERT F. BENNETT Senator Bennett. Thank you, Mr. Chairman. We have had a housing bubble, and the bubble has burst. And every time we have a bubble, whether it is housing or dotcom stocks or anything else, when the bubble bursts there is disaster. And we will have bubbles in the future because the human propensity to believe that the market will always go up is still there. Let us understand that. The economy runs on credit, credit is granted on confidence, and confidence is based on one of two assumptions: the collateral is worth it or the cash-flow will be sufficient. One way or the other, the loan will be repaid. What we are faced with now is finding a way to restore the confidence in the system so that credit can start to flow again. That is what we are here to try to do. Thank you, Mr. Chairman. " fcic_final_report_full--451 What Caused the Financial Crisis? George Santayana is often quoted for the aphorism that “Those who cannot remember the past are condemned to repeat it.” Looking back on the financial crisis, we can see why the study of history is often so contentious and why revisionist histories are so easy to construct. There are always many factors that could have caused an historical event; the diffi cult task is to discern which, among a welter of possible causes, were the significant ones—the ones without which history would have been different. Using this standard, I believe that the sine qua non of the financial crisis was U.S. government housing policy, which led to the creation of 27 million subprime and other risky loans—half of all mortgages in the United States— which were ready to default as soon as the massive 1997-2007 housing bubble began to deflate. If the U.S. government had not chosen this policy path—fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high risk residential mortgages—the great financial crisis of 2008 would never have occurred. Initiated by Congress in 1992 and pressed by HUD in both the Clinton and George W. Bush Administrations, the U.S. government’s housing policy sought to increase home ownership in the United States through an intensive effort to reduce mortgage underwriting standards. In pursuit of this policy, HUD used (i) the affordable housing requirements imposed by Congress in 1992 on the government- sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the policies of the Federal Housing Administration (FHA), and (iii) a “Best Practices Initiative” for subprime lenders and mortgage banks, to encourage greater subprime and other high risk lending. HUD’s key role in the growth of subprime and other high risk mortgage lending is covered in detail in Part III. Ultimately, all these entities, as well as insured banks covered by the CRA, were compelled to compete for mortgage borrowers who were at or below the median income in the areas in which they lived. This competition caused underwriting standards to decline, increased the numbers of weak and high risk loans far beyond what the market would produce without government influence, and contributed importantly to the growth of the 1997-2007 housing bubble. When the bubble began to deflate in mid-2007, the low quality and high risk loans engendered by government policies failed in unprecedented numbers. The effect of these defaults was exacerbated by the fact that few if any investors— including housing market analysts—understood at the time that Fannie Mae and Freddie Mac had been acquiring large numbers of subprime and other high risk loans in order to meet HUD’s affordable housing goals. Alarmed by the unexpected delinquencies and defaults that began to appear in mid-2007, investors fled the multi-trillion dollar market for mortgage-backed 445 securities (MBS), dropping MBS values—and especially those MBS backed by subprime and other risky loans—to fractions of their former prices. Mark-to- market accounting then required financial institutions to write down the value of their assets—reducing their capital positions and causing great investor and creditor unease. The mechanism by which the defaults and delinquencies on subprime and other high risk mortgages were transmitted to the financial system as a whole is covered in detail in Part II. CHRG-111hhrg53245--154 Mr. Marchant," Mr. Zandi, would you comment on the fact that this last bubble was created in large part by financial instruments that did not exist maybe 20 years ago, and especially the derivative part of the mortgage part of it, and how it sustained a bubble in the housing market, which really sustained the mortgage market, which continued to sustain the housing market? " FinancialCrisisInquiry--226 ROSEN: I—I think the dot com bubble—the—the main problem there was again, I think related to the underwriting of unprofitable companies. It used to be you had to have, you know, a year of profit under your belt before you could go public. That was the Wall Street standard. They enforced it. Then that all changed. So it’s really the same thing. The lowering of standards, because you could get it done, and there were investors to buy it. This housing problem is much more serious though, because it is such a large sector as Mark said -- $11 trillion. It’s—every financial institution has this. It is larger than the public debt that we have, you know? And that’s why it’s so important, and so why the bubble is so much bigger. I would say the dot com bubble set up this bubble though. Because to clean up the last bubble, the Fed kept at rates too low too long. Their idea of not trying to do something about the bubble is either regulatory or through policy I think is—really is the core of the problem. Monetary policy is poorly—was poorly done under the last chairman. THOMPSON: So you would give monetary policy a shot in the eye for its... ROSEN: Oh I think... THOMPSON: ... role here? ROSEN: ... there’s no question about it that they set this one up, and used the wrong words. Matter of fact in 2007 the chairman who I respect a lot did say that it is demographic demand that was causing the housing market. I wrote a paper that he had read that said it wasn’t true. It was the credit bubble. But based—these demographic demand, all these other things which just the data don’t support it. fcic_final_report_full--467 Association (MBA). 25 This data allows a comparison between the foreclosure starts that have thus far come out of the 1997-2007 bubble and the foreclosure starts in the two most recent housing bubbles (1977-1979 and 1985-1989) shown in Figure 1. After the housing bubble that ended in 1979, when almost all mortgages were prime loans of the traditional type, foreclosure starts in the ensuing downturn reached a high point of only .87 percent in 1983. After the next bubble, which ended in 1989 and in which a high proportion of the loans were the traditional type, foreclosure starts reached a high of 1.32 percent in 1994. However, after the collapse of the 1997-2007 bubble—in which half of all mortgages were NTMs—foreclosure starts reached the unprecedented level (thus far) of 5.3 percent in 2009. And this was true despite numerous government and bank efforts to prevent or delay foreclosures. All the foregoing data is significant for a proper analysis of the role of government policy and NTMs in the financial crisis. What it suggests is that whatever effect low interest rates or money flows from abroad might have had in creating the great U.S. housing bubble, the deflation of that bubble need not have been destructive. It wasn’t just the size of the bubble; it was also the content. The enormous delinquency rates in the U.S. (see Table 3 below) were not replicated elsewhere, primarily because other developed countries did not have the numbers of NTMs that were present in the U.S. financial system when the bubble deflated. As shown in later sections of this dissent, these mortgage defaults were translated into huge housing price declines and from there—through the PMBS they were holding—into actual or apparent financial weakness in the banks and other firms that held these securities. Accordingly, if the 1997-2007 housing bubble had not been seeded with an unprecedented number of NTMs, it is likely that the financial crisis would never have occurred. 3. Delinquency Rates on Nontraditional Mortgages NTMs are non-traditional because, for many years before the government adopted affordable housing policies, mortgages of this kind constituted only a small portion of all housing loans in the United States. 26 The traditional residential mortgage—known as a conventional mortgage—generally had a fixed rate, often for 15 or 30 years, a downpayment of 10 to 20 percent, and was made to a borrower who had a job, a steady income and a good credit record. Before the GSE Act, even subprime loans, although made to borrowers with impaired credit, often involved substantial downpayments or existing equity in homes. 27 Table 3 shows the delinquency rates of the NTMs that were outstanding on June 30, 2008. The grayed area contains virtually all the NTMs. The contrast in quality, based on delinquency rates, between these loans and Fannie and Freddie prime loans in lines 9 and 10 is clear. 25 26 Mortgage Bankers Association National Delinquency Survey. See Pinto, “Government Housing Policies in the Lead-Up to the Financial Crisis: A Forensic Study,” November 4, 2010, p.58, http://www.aei.org/docLib/Government-Housing-Policies-Financial-Crisis- Pinto-102110.pdf. 27 Id., p.42. CHRG-111shrg50564--71 Chairman Dodd," Thank you. Senator Bennett? Senator Bennett. Thank you, Mr. Chairman. Dr. Volcker, welcome. We have had three simultaneous bubbles. They haven't burst simultaneously, but they were going on simultaneously. We have had the housing bubble. We had the oil bubble. And then we had a credit bubble. The oil bubble, everyone who pumps gas is delighted that it has burst. Everyone who produces gas and oil is probably a little sorry that it has burst. But all of the dire consequences that we heard predicted with respect to the oil bubble are now no longer on the front page and we no longer talk about the oil shock and its impact on the economy and the rest of us because the price---- " CHRG-110hhrg46591--269 Mr. Yingling," It was not covered particularly in the Blueprint, but as I testified, I do think there is a real need for a regulator who looks over the economy. Now, that may be different than the regulator who actually regulates day-to-day, but we had not had somebody looking over the economy and identifying these incredible types of growth and these bubbles, such as the mortgage bubble and other bubbles. So we do need a regulator who has the charter to look across the economy and to identify problems before they occur. " fcic_final_report_full--470 First, the gradual increase of the AH goals, the competition between the GSEs and the FHA, the effect of HUD’s Best Practices Initiative, and bank lending under the CRA, assured a continuing flow of funds into weaker and weaker mortgages. This had the effect of extending the life of the housing bubble as well as increasing its size. The growth of the bubble in turn disguised the weakness of the subprime mortgages it contained; as housing prices rose, subprime borrowers who might otherwise have defaulted were able to refinance their mortgages, using the equity that had developed in their homes solely through rising home prices. Without the continuous infusion of government or government-directed funds, delinquencies and defaults would have begun showing up within a year or two, bringing the subprime PMBS market to a halt. Instead, the bubble lasted ten years, permitting that market to grow until it reached almost $2 trillion. Second, as housing prices rose in the bubble, it was necessary for borrowers to seek riskier mortgages so they could afford the monthly payments on more expensive homes. This gave rise to new and riskier forms of mortgage debt, such as option ARMs (resulting in negative amortization) and interest-only mortgages. Mortgages of this kind could be suitable for some borrowers, but not for those who were only eligible for subprime loans. Nevertheless, subprime loans were necessary for PMBS, because they generally bore higher interest rates and thus could support the yields that investors were expecting. As subprime loans were originated, Fannie and Freddie were willing consumers of those that might meet the AH goals; moreover, because of their lower cost of funds, they were able to buy the “best of the worst,” the highest quality among the NTMs on offer. These factors—the need for higher yielding loans and the ability of Fannie and Freddie to pay up for the loans they wanted—drove private sector issuers further out on the risk curve as they sought to meet the demands of investors who were seeking exposure to subprime PMBS. From the investors’ perspective, as long as the bubble kept growing, PMBS were offering the high yields associated with risk but were not showing commensurate numbers of delinquencies and defaults. 5. What was Known About NTMs Prior to the Crisis? Virtually everyone who testified before the Commission agreed that the financial crisis was initiated by the mortgage meltdown that began when the housing bubble began to deflate in 2007. None of these witnesses, however, including the academics consulted by the Commission, the representatives of the rating agencies, the offi cers of financial institutions that were ultimately endangered by the mortgage downdraft, regulators and supervisors of financial institutions and even the renowned investor Warren Buffett, 33 seems to have understood the dimensions 33 See Buffett, testimony before the FCIC, June 2, 2010. 465 of the NTM problem or recognized its significance before the bubble deflated. The Commission majority’s report notes that “there were warning signs.” There always are if one searches for them; they are most visible in hindsight, in which the Commission majority, and many of the opinions it cites for this proposition, happily engaged. However, as Michael Lewis’s acclaimed book, The Big Short , showed so vividly, very few people in the financial world were actually willing to bet money— even at enormously favorable odds—that the bubble would burst with huge losses. Most seem to have assumed that NTMs were present in the financial system, but not in unusually large numbers. fcic_final_report_full--431 Current Fed Chairman Bernanke and former Fed Chairman Greenspan disagree with Taylor’s analysis. Chairman Bernanke argues that the Taylor Rule is a descriptive rule of thumb, but that “simple policy rules” are insufficient for making monetary policy decisions.  He further argues that, depending on the construction of the par- ticular Taylor Rule, the monetary policy stance of the Fed may not have diverged sig- nificantly from its historical path. Former Chairman Greenspan adds that the connection between short-term interest rates and house prices is weak—that even if the Fed’s target for overnight lending between banks was too low, this has little power to explain why rates on thirty-year mortgages were also too low. This debate intertwines several monetary policy questions: • How heavily should the Fed weigh a policy rule in its decisions to set interest rates? Should monetary policy be mostly rule-based or mostly discretionary? • If the Fed thinks an asset bubble is developing, should it use monetary policy to try to pop or prevent it? • Were interest rates too low in –? • Did too-low federal funds rates cause or contribute to the housing bubble? This debate is complex and thus far unresolved. Loose monetary policy does not necessarily lead to smaller credit spreads. There are open questions about the link be- tween short-term interest rates and house price appreciation, whether housing starts are the best measure of the housing bubble, the timing of housing price increases rel- ative to the interest rates in –, the European comparison, and whether the magnitude of the bubble can be explained by the gap between the Taylor Rule pre- scription and historic rates. At the same time, many observers argue that Taylor is right that short-term interest rates were too low during this period, and therefore that his argument is at least plausible if not provable. We conclude that global capital flows and risk repricing caused the credit bubble, and we consider them essential to explaining the crisis. U.S. monetary policy may have been an amplifying factor, but it did not by itself cause the credit bubble, nor was it essential to causing the crisis. The Commission should have focused more time and energy on exploring these questions about global capital flows, risk repricing, and monetary policy. Instead, the CHRG-109hhrg22160--146 Mr. Garrett," That raises the side question then, as you allude to, that, I guess the way I am thinking about it is potentially in the area for the housing market maybe we are--that proverbial bubble that is out there, that they say could someday be down the road that eventually collapses. Could you just touch on that as far as how that would impact on it and where we are going as far as the slight increases that we see in interest rates? Are we getting to that proverbial bubble then, that is potentially out there in the housing market? " FinancialCrisisInquiry--734 ROSEN: I—I think the dot com bubble—the—the main problem there was again, I think related to the underwriting of unprofitable companies. It used to be you had to have, you know, a year of profit under your belt before you could go public. That was the Wall Street standard. They enforced it. Then that all changed. So it’s really the same thing. The lowering of standards, because you could get it done, and there were investors to buy it. This housing problem is much more serious though, because it is such a large sector as Mark said -- $11 trillion. It’s—every financial institution has this. It is larger than the public debt that we have, you know? And that’s why it’s so important, and so why the bubble is so much bigger. I would say the dot com bubble set up this bubble though. Because to clean up the last bubble, the Fed kept at rates too low too long. Their idea of not trying to do something about the bubble is either regulatory or through policy I think is—really is the core of the problem. Monetary policy is poorly—was poorly done under the last chairman. fcic_final_report_full--481 PMBS are Connected to All Other NTMs Through Housing Prices But this does not mean that only the failure of the PMBS was responsible for the financial crisis. In a sense, all mortgages are linked to one another through housing prices, and housing prices in turn are highly sensitive to delinquencies and defaults on mortgages. This is a characteristic of mortgages that is not present in other securitized assets. If a credit card holder defaults on his obligations it has little effect on other credit card holders, but if a homeowner defaults on a mortgage the resulting foreclosure has an effect on the value of all homes in the vicinity and thus on the quality of all mortgages on those homes. Accordingly, the PMBS were intimately connected—through housing prices—to the NTMs securitized by the Agencies. Because there were so many more NTMs held or securitized by the Agencies (see Table 1), their unprecedented numbers—even in cases where they had a lower average rate of delinquency and default than the NTMs that backed the PMBS—was the major source of downward pressure on housing prices throughout the United States. Weakening housing prices, in turn, caused more mortgage defaults, among both NTMs in general and the particular NTMs that were the collateral for PMBS. In other words, the NTMs underlying the PMBS were weakened by the delinquencies and defaults among the much larger number of mortgages held or guaranteed as MBS by the Agencies. In reality, then, the losses on the PMBS were much higher than they would have been if the government’s housing policies had not brought into being 19 million other NTMs that were failing in unprecedented numbers. These failures drove down housing prices by 30 percent--an unprecedented decline—which multiplied the losses on the PMBS. Finally, the funds that the government directed into the housing market in pursuit of its social policies enlarged the housing bubble and extended it in time. The longer housing bubbles grow, the riskier the mortgages they contain; lenders are constantly trying to find ways to keep monthly mortgage payments down while borrowers are buying more expensive houses. While the bubble was growing, the risks that were building within it were obscured. Borrowers who would otherwise have defaulted on their loans, bringing an end to the bubble, were able to use the rising home prices to refinance, sometimes at lower interest rates. With delinquency rates relatively low, investors did not have a reason to exit the mortgage markets, and the continuing flow of funds into mortgages allowed the bubble to extend for an unprecedented 10 years. This in turn enabled the PMBS market to grow to enormous size and thus to have a more calamitous effect when it finally collapsed. If the government policies that provided a continuing source of funding for the bubble had not been pursued, it is doubtful that there would have been a PMBS market remotely as large as the one that developed, or that—when the housing bubble collapsed—the losses to financial institutions would have been as great. PMBS, as Securities, are Vulnerable to Investor Sentiment In addition to their link to the Agencies’ NTMs through housing prices, PMBS were particularly vulnerable to changes in investor sentiment about mortgages. The fact that the mortgages underlying the PMBS were held in securitized form was an important element of the crisis. There are many reasons for the popularity of mortgage securitization. Beginning in 2002, for example, the Basel regulations provided that mortgages held in the form of MBS—presumably because of their superior liquidity compared to whole mortgages—required a bank to hold only 1.6 percent risk-based capital, while whole mortgages required risk-based capital backing of four percent. This made all forms of MBS, including PMBS, much less expensive to hold than whole mortgages. In addition, mortgages in securitized form could be traded more easily, and used more readily as a source of liquidity through repurchase agreements. fcic_final_report_full--428 II. Housing bubble. Beginning in the late s and accelerating in the s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. Many factors contributed to the housing bubble, the bursting of which created enormous losses for home- owners and investors. III. Nontraditional mortgages. Tightening credit spreads, overly optimistic as- sumptions about U.S. housing prices, and flaws in primary and secondary mortgage markets led to poor origination practices and combined to in- crease the flow of credit to U.S. housing finance. Fueled by cheap credit, firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance originated vast numbers of high-risk, nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers’ ability to repay. At the same time, many homebuyers and homeowners did not live up to their responsibilities to understand the terms of their mort- gages and to make prudent financial decisions. These factors further ampli- fied the housing bubble. IV. Credit ratings and securitization. Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies er- roneously rated mortgage-backed securities and their derivatives as safe in- vestments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages. V. Financial institutions concentrated correlated risk. Managers of many large and midsize financial institutions in the United States amassed enor- mous concentrations of highly correlated housing risk. Some did this know- ingly by betting on rising housing prices, while others paid insufficient attention to the potential risk of carrying large amounts of housing risk on their balance sheets. This enabled large but seemingly manageable mortgage losses to precipitate the collapse of large financial institutions. VI. Leverage and liquidity risk. Managers of these financial firms amplified this concentrated housing risk by holding too little capital relative to the risks they were carrying on their balance sheets. Many placed their firms on a hair trigger by relying heavily on short-term financing in repo and commercial paper markets for their day-to-day liquidity. They placed solvency bets (sometimes unknowingly) that their housing investments were solid, and liq- uidity bets that overnight money would always be available. Both turned out to be bad bets. In several cases, failed solvency bets triggered liquidity crises, causing some of the largest financial firms to fail or nearly fail. Firms were in- sufficiently transparent about their housing risk, creating uncertainty in mar- kets that made it difficult for some to access additional capital and liquidity when needed. CHRG-111hhrg51698--172 Mr. Gooch," I would say in any bubble there is always going to be some level of fraud at the peak of the bubble. I am not blaming the person who tried to buy a home and couldn't afford it. I would blame the unscrupulous mortgage broker who encouraged someone to take a mortgage they couldn't afford, on a house that wasn't worth the mortgage, simply because they were going to get a $3,000 commission. In this circumstance where you have had 7 years of extremely cheap credit and the global, spectacular growth throughout the world's economies, that is what has driven all of these commodity prices up to record levels. I don't know enough about those energy companies. I wouldn't jump to the conclusion that they were involved in insider trading because they imagined the price of oil would go up. I mean, frankly, who knew? Right? Sitting here today we all can see that everybody right up to the highest levels of government isn't able to predict the future that clearly. " CHRG-111hhrg53245--128 Mr. Garrett," Sure. You are where I was going next. Ms. Rivlin. I think there is a difference between the bubble in the 1990's in the stock market and the housing market bubble. I was at the Fed in the 1990's. We did not miss the stock market bubble. We knew it was there. We talked about it. Mr. Greenspan made the speech. We did not do enough about it, in my opinion. We could have raised margin requirements. It would have been largely symbolic, but we should have done it. We did not have the right tool. Raising the short-term interest rate in the middle of the bubble, we also had the Asian financial crisis and a lot of other things going on, so you do not have the right tool if you are relying entirely on the short-term interest rate. " CHRG-111shrg57319--522 Mr. Killinger," Yes. Senator Coburn. Did you see a bubble in housing prices before March 2005? " CHRG-110shrg38109--70 Chairman Bernanke," Senator, as I indicated, I do think that we should be trying to reduce regulatory burden, and in particular ensuring that the costs of the burden are commensurate with the benefits. With respect to Sarbanes-Oxley, my intent was to say that I do believe that there are benefits from that legislation, including improved controls, improved disclosures, improved governance of corporations. So there are certainly some benefits. It is important to decide whether we can reduce the costs and retain the benefits, and in that respect, I think that the proposed change in one audit standard being put forth by the SEC and the PCAOB is a step in the right direction because it attempts to focus on the most materially important issues, and it also makes allowance for the size and complexity of a firm in setting up the audit standard. So to try to summarize, Sarbanes-Oxley accomplishes some important objectives, but I do believe those objectives can be accomplished at lower cost, and I think the new audit standard moves in that direction. And in all other regulatory areas, including those the Federal Reserve is involved, we should continually be looking to find ways to accomplish the social or economic objectives of the regulation at a lower cost. Senator Martinez. Well, I agree that there are many good features to Sarbanes-Oxley. What I was speaking of is some of the excesses, particularly in the auditing arena and some of the areas that have caused such an overburden of costs. So, I appreciate your comment on that. Shifting to the issue of home sales, I used to sit in that very chair when I was Housing Secretary before this Committee, and at times, I would be asked a question about a housing bubble and in the overheated housing market whether, in fact, we were headed for a collapse and a bubble that would burst. In fact, we have seen as significant decrease in housing starts. We have seen the market cool down significantly, but we have not seen a bursting bubble. I always said at the time that the fears of a bubble were misplaced and that the housing market is more regional than it is national, and there were many different features between that and a localized market. But do you feel that the fear of a bubble has receded given the fact that the market cooled off, that it has done so in a fairly modest way without any cataclysmic consequences? " CHRG-111hhrg56766--266 Mr. Foster," Thank you. In this week's Economists magazine, there was an interesting article on Canada and the situation they are in, where they are seeing an incipient housing bubble re-emerge. They have kept interest rates very low for the same reasons we are doing, to try to restart industrial and business spending, and because if this persists for a long time, some of that money is going to leak out and could make a housing bubble. China is also facing similar problems where they have responded, as has Canada, by actually increasing the amount of money you have to put down on a real estate investment, an investment, as opposed to one you live in. I was wondering do you have contingency planning? Are there tools available that you are thinking of in case you keep interest rates low for an extended period of time, and all of a sudden, in regions of the United States, this starts to show up as a local or national real estate bubble? " CHRG-111shrg57322--1096 Mr. Blankfein," There are disclosure materials, yes. Senator Pryor. OK. In the past 25 years, America has seen an increasing number and severity of financial crises. You have the savings and loan crisis, Enron, the dot-com bubble, the housing bubble. What steps will Wall Street take to assure that there is not another financial crisis? " fcic_final_report_full--538 This dissenting statement argues that the U.S. government’s housing policies were the major contributor to the financial crisis of 2008. These policies fostered the development of a massive housing bubble between 1997 and 2007 and the creation of 27 million subprime and Alt-A loans, many of which were ready to default as soon as the housing bubble began to deflate. The losses associated with these weak and high risk loans caused either the real or apparent weakness of the major financial institutions around the world that held these mortgages—or PMBS backed by these mortgages—as investments or as sources of liquidity. Deregulation, lack of regulation, predatory lending or the other factors that were cited in the report of the FCIC’s majority were not determinative factors. The policy implications of this conclusion are significant. If the crisis could have been prevented simply by eliminating or changing the government policies and programs that were primarily responsible for the financial crisis, then there was no need for the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, adopted by Congress in July 2010 and often cited as one of the important achievements of the Obama administration and the 111 th Congress. The stringent regulation that the Dodd-Frank Act imposes on the U.S. economy will almost certainly have a major adverse effect on economic growth and job creation in the United States during the balance of this decade. If this was the price that had to be paid for preventing another financial crisis then perhaps it’s one that will have to be borne. But if it was not necessary to prevent another crisis—and it would not have been necessary if the crisis was caused by actions of the government itself—then the Dodd-Frank Act seriously overreached. Finally, if the principal cause of the financial crisis was ultimately the government’s involvement in the housing finance system, housing finance policy in the future should be adjusted accordingly. 533 -----------------------------------------------------Page 562-----------------------------------------------------  CHRG-111hhrg53244--161 The Chairman," Next--I have to apologize, I forgot that the seniority system here was designed by the choreographer of the Bunny Hop, and it goes this way. And I made a mistake. I told you I was getting old. So I am now at the gentlewoman from Wisconsin. Ms. Moore of Wisconsin. Thank you, Mr. Chairman. And thank you. I was really pleased to see in your testimony, under the regulatory reform section, that you realize that systemic risk is not just too-big-to-fail institutions, but activities and practices that provide systemic risk. Many of us--and, certainly, this article was given to me by Congresswoman Maxine Waters--have been reading the recent Rolling Stone article by Matt Taibbi, ``The Great American Bubble Machine.'' And while it is very critical of a particular firm, I think there are things that we all notice with respect to the housing bubble and the dot-com bubble and the oil bubble that all seem to be activities that seem to be systemic risks. For example, allowing an entity to sort of manipulate the price of an entity, of the housing prices, to ratchet the prices up and then just sort of hedge against their own products. So I guess I would like to ask your opinion about credit default swaps and also the practice of spinning, where executive compensation seems to be a systemic risk factor, as well. So can you tell us what we can do in our regulatory reform to prevent the creation of these bubbles? " CHRG-111hhrg56776--241 Mr. Foster," Thank you. And, let's see, countercyclical mortgage underwriting standards are being implemented at various levels in different countries around the world. And, simply put, what this means, when a housing bubble begins to develop, you turn up the downpayment that's required. And I guess my first question to Chairman Bernanke is that had these type of policies been in place in the previous decade, how effect would they have been at damping down the housing bubble, even in the presence of very loose monetary policy? And more--and secondly, in respect to the subject of this hearing, would countercyclical underwriting requirements be easier to implement in the context of consolidated Fed supervision? " fcic_final_report_full--489 This analysis lays the principal cause of the financial crisis squarely at the feet of the unprecedented number of NTMs that were brought into the U.S. financial markets by government housing policy. These weak and high risk loans helped to build the bubble, and when the bubble deflated they defaulted in unprecedented numbers. This threatened losses in the PMBS that were held by financial institutions in the U.S. and around the world, impairing both their liquidity and their apparent stability. The accumulation of 27 million subprime and Alt-A mortgages was not a random event, or even the result of major forces such as global financial imbalances or excessively low interest rates. Instead, these loans and the bubble to which they contributed were the direct consequence of something far more mundane: U.S. government housing policy, which—led by HUD over two administrations— deliberately reduced mortgage underwriting standards so that more people could buy homes. While this process was going on, everyone was pleased. Homeownership in the U.S. actually grew to the highest level ever recorded. But the result was a financial catastrophe from which the U.S. has still not recovered. -----------------------------------------------------Page 512-----------------------------------------------------  CHRG-111shrg57322--314 Mr. Birnbaum," I want to answer your questions precisely. Senator Tester. I will rephrase it. Why, how, and when did you become convinced that there was a housing bubble that was in decline? " CHRG-111shrg57321--169 Mr. McDaniel," First, Senator, we did not identify a housing bubble in 2003. We certainly---- Senator Kaufman. No. I mean you saw the oncoming. " CHRG-111shrg57319--521 Mr. Killinger," Again, I just do not recall the specifics of this at all. Senator Coburn. OK. Exhibit 78a,\2\ in this email exchange from March 10, 2005, with Jim Vanasek, you wrote, ``I have never seen such a high risk housing market as market after market thinks they are unique and for whatever reason are not likely to experience price decline. This typically signifies a bubble.''--------------------------------------------------------------------------- \2\ See Exhibit 78a, which appears in the Appendix on page 790.--------------------------------------------------------------------------- Is it accurate to say that you saw a bubble in housing prices as early as March 2005? " fcic_final_report_full--257 COMMISSION CONCLUSIONS ON CHAPTER 12 The Commission concludes that entities such as Bear Stearns’s hedge funds and AIG Financial Products that had significant subprime exposure were affected by the collapse of the housing bubble first, creating financial pressures on their par- ent companies. The commercial paper and repo markets—two key components of the shadow banking lending markets—quickly reflected the impact of the housing bubble collapse because of the decline in collateral asset values and con- cern about financial firms’ subprime exposure. fcic_final_report_full--115 COMMISSION CONCLUSIONS ON CHAPTER 6 The Commission concludes that there was untrammeled growth in risky mort- gages. Unsustainable, toxic loans polluted the financial system and fueled the housing bubble. Subprime lending was supported in significant ways by major financial insti- tutions. Some firms, such as Citigroup, Lehman Brothers, and Morgan Stanley, acquired subprime lenders. In addition, major financial institutions facilitated the growth in subprime mortgage–lending companies with lines of credit, securitiza- tion, purchase guarantees and other mechanisms. Regulators failed to rein in risky home mortgage lending. In particular, the Federal Reserve failed to meet its statutory obligation to establish and maintain prudent mortgage lending standards and to protect against predatory lending. FOMC20050630meeting--137 135,MR. MOSKOW.," Thank you, Mr. Chairman. I wanted to make a few comments and then ask a question. First, I’d say that with all of the concerns about froth in housing markets, I found these presentations to be very informative, and I want to congratulate the people who spent a lot of time preparing them. I thought they were all very good presentations. But I also found the information comforting. We’ve all talked about the possibility of local housing bubbles and regional housing bubbles, and clearly there are some in the United States. But we never really looked at it on a national basis before. The net result for me was that I come away from the analysis not feeling any worse than I did before and probably a little better. First, I thought it was very helpful to see quantified—I think this was in Josh’s memo—the size of the potential bubble. He talked about a 20 percent drop in housing prices. But that was equal to only about 30 percent of GDP as compared to the drop in equity prices we had, which was more than twice that. Also, I had the feeling that appropriate monetary policy, as John said, could mitigate much of the distress that might occur. Moreover, the credit risk associated with home mortgages seems to be spread out across many institutions. Governor Bies said that a lot of analysis is being done now, and we’ll want to see the results of the analysis that the Board and the Comptroller are doing. But on the whole, the financial institutions seem to be in pretty good shape. The role of securitizing mortgages is to lay off risks to parties who are willing and able to bear the risks. Capital levels of the financial institutions are relatively high, so it appears that these markets are performing their roles well. And in the event of a sharp drop in housing prices, the odds of a spillover to financial institutions seem limited. And as I mentioned, it was helpful to hear the June 29-30, 2005 48 of 234 housing prices. So I come away somewhat less concerned about the size and consequences of a housing bubble than I was before. The question I had relates to what Governor Yellen was asking about—financial innovation. I was going to make a similar point. The fact is that there has been a great deal of financial innovation in housing markets in the United States. The average person can borrow very easily on his home these days. And I was wondering if there have been—or if it is possible to do—any international comparisons on this. I wondered whether the price-rent ratios in other countries that may not have had the same degree of financial innovation we’ve had differ substantially from ours." CHRG-110shrg50369--23 Chairman Dodd," I do not want to put words in your mouth, obviously, at all here, but I am looking at--obviously the housing burst or bubble, the burst of that bubble is, I think, far more dangerous than a high-tech problem, as you make those comparisons. Inflation and trade deficits are worse. Am I hearing you correctly that we are actually in a worse position today to respond to this than we were 8 years ago? Is that how I hear what you are saying? " CHRG-111shrg57321--170 Mr. McDaniel," Yes, we saw loosening underwriting standards---- Senator Kaufman. Right. Mr. McDaniel [continuing]. And we were certainly aware that home price appreciation was occurring through this period. Senator Kaufman. So, it is hard--Ms. Corbet, I will get back to it and maybe the two of you can work together. There is the chart. Oh, that bubble just came on. Look, I am not saying we are all victims of our own personal experience. In 2005, I sent my children a printout from Merrill Lynch of essentially that chart, and I sent with them what Merrill Lynch said. People say that this is because there are so many more people buying houses, but if that was true, they showed another chart and it showed then rental use would go up, too, and rental use was rock solid. So we have a housing bubble. That is what Merrill Lynch sent out to me as a Merrill Lynch investor and I sent it to my kids. The fact that we were coming onto a bubble, as you say, you didn't say it in 2003, but you are talking about it generally and you are still--do you see my point? These products are still rolling off the assembly lines with AAA on them. " CHRG-110shrg46629--99 STATEMENT OF SENATOR ROBERT F. BENNETT Senator Bennett. Thank you very much, Mr. Chairman. Chairman Bernanke, welcome. I have two issues I want to pursue with you and get your thoughts on, but I want to make just an observation prior. I have been on this Committee now for over a dozen years. And we see the pressure going one way and then the other. First, the requirement on or the desire on the part of Members of this Committee to make capital available to the people that are poor. We have to do everything we can to make capital available to them and push in the direction. No, you are holding capital just for the rich. You have to make it available to the poor. Then when we get into the subprime problem, I understand, at least on the House side, there is legislation to hold the lender responsible for the fact that they pushed money at people who could not afford to pay it. And now that the homes are being foreclosed on it is the lender's fault and we have to punish the lender for making the capital available in the first place. It is an interesting pendulum to watch it swing back and forth in this debate. I hope we do not end up saying to the counselor, the counselor is liable if the counselor said you should make this deal rather than that deal and then the counselor has to pay the damages if, in fact, there is a problem and the people cannot pay their mortgage. The two issues I want to talk to you about are labor and housing. In my home State of Utah, the unemployment rate is two-point-something percent and the something does not really matter. When you get down that low it is a very, very serious problem. We have a labor shortage. Nationwide the unemployment rate is at levels approaching historic lows. I would like your reaction to that problem and what it might do with respect to inflation. Your predecessor, Chairman Greenspan, talked about tight labor markets and the impact of that on inflation. Productivity is going up so we have to have a different historic benchmark on unemployment figures. I was taught in college that 6 percent was full employment, that you got below 6 percent and you were facing serious inflationary pressures. Interestingly enough, at the height of the last recession the unemployment was in the 6 percent range. And now we are at 4 percent or something. So, I would like your comment on that. And then on housing, the housing bubble has the potential, in my view, of triggering an economic downturn just as the dot-com bubble that we were all excited about and thrilled about in the late 1990s triggered the recession that began in 2000 as that bubble started to burst. Everyone was delighted to see his house value go up, particularly if he did not have to buy a new one. And you referred to the number of people who took home equity loans and went out and went on a spending binge. Now the housing prices have flattened, if not fallen, in many areas. There has to be a shakeout just as there was a shakeout from the dot-com bubble there has to be a shakeout from the housing bubble. Look into your crystal ball and see if it is, in fact, going to create an economic downturn? If so, any ideas as to how severe or when? I know you do not make those specific prophecies and I am not asking you to. But just in a general term what you might see as the housing shakeout works its way through the economy. If you could address those two, I would appreciate it. " FinancialCrisisInquiry--717 THOMPSON: Thank you, Mr. Chairman. Many of the questions I had have been addressed, but I do want to ask a few specifics. Ms. Gordon, to what extent, in your opinion, might CRA have been a contributor in any way to the housing bubble? FOMC20050630meeting--382 380,MR. GRAMLICH.," Thank you, Mr. Chairman. I’ll let Tom respond on behalf of the Kansas City Royals. [Laughter] This will be my 62nd and last statement at one of these meetings, and if you’ll bear with me I’d like to give a few parting thoughts before I ride off into the sunset. I believe most of us think about monetary policy in terms of what I will call a modified Taylor rule. We don’t necessarily follow the explicit Taylor rule outcomes of the Bluebook but we look at inflation and unemployment and try to make them hit our target values, at least over some horizon. From time to time, we may shade our judgments based on some other factor that may seem relevant, which is fine. But the basic focus remains on inflation and unemployment. I strongly agree with this basic focus, and I get very irritated when I see columns suggesting that we are trying to inspire or should be trying to prick a housing bubble, for example. There is no way to do that and still maximize the inflation/unemployment outcome. Monetary policy is broad and has broad effects. When we take rates down in a soft economy, we probably will be creating some bubbles, or at least mini bubbles here and there—not because we want to, but because it is inevitable. In the late ’90s, holding out against raising rates and hence letting the economy achieve very low unemployment rates probably did add to the June 29-30, 2005 156 of 234 add to the housing bubble, if, in fact, there is a housing bubble. Given our primary focus on inflation and unemployment, I’m not sure there is anything we could have done about either bubble, and I am sure it would not have been wise to go out of our way to try to prick either bubble. Today’s policy challenge is to reverse the highly accommodative policy we followed a few years ago in response to what I still think was a real threat of deflation. There has been lots of speculation about the so-called neutral level of the federal funds rate, as if once we hit neutrality we can stop raising rates. First off, this speculation is naive in the sense that whatever neutrality is, it is more likely a zone than a precise rate. Moreover, neutrality would only be desirable if the rest of the economy were in balance, which is probably never strictly true, and certainly isn’t true now. For these reasons, I’ve always been disdainful of the search for neutrality. Whatever neutrality is, I think in the current circumstance we ought to take rates somewhere north of it. The reason is simple: lags. We have taken the funds rate very low in response to threats of deflation. That means that at the magic moment when we hit neutrality there will be still some accommodative policy in the pipeline—policy that would have to be offset with at least a slight overshooting on the other side. This is a well-known shower problem that has enlivened countless macro classrooms. One can also see this overshooting in the optimal policy simulations in the Bluebook. One issue that has always been important to me involves national saving. I continue to be a national saving freak. Our rate is too low; no two ways about it. Continued low national saving implies either a drop in investment, which is undesirable, or continued international borrowing, which is unreliable. Like others, I would greatly prefer to correct the problem through fiscal austerity. But despite some welcome bulges in federal revenue, we all know that this is not real June 29-30, 2005 157 of 234 Given that fiscal policy is not measuring up, can we do something about national saving with monetary policy? Unfortunately, I think the answer is no, at least as long as we are operating under a modified Taylor rule. Basically, our approach can determine the level of total output but not its composition between consumption and investment. Regarding this composition, there is an interesting new development resulting from the financial innovation we talked about yesterday. I admit to having always been skeptical of the empirical importance of interest rates on consumption. I would have thought that the form of housing wealth, whether cash or not, should not matter to rational consumers and that these consumers should realize that interest rates have ambiguous effects on their lifetime optimization decision. However, if consumption in fact does depend strongly on interest rates, as our econometricians say, at least some of the crowding-out impact of higher interest rates will be felt by consumption. So I will swallow my empirical misgivings and at least hope that our present easy fiscal and slightly harder monetary regime will be at least slightly less restrictive on investment and slightly more restrictive on consumption. Another issue is, of course, the housing bubble. My own view is that there probably is now a slight macro housing bubble, with the problem obviously being worse in selected real estate markets. As argued above, it would be a great mistake for the Fed to renounce its primary focus on inflation and unemployment and start fighting bubbles. But might it be possible to shape policy in the direction of fighting bubbles? The question sounds very reasonable. The problem comes when one tries to get specific. A few months ago there was a conference at Princeton to address this very question. What should monetary policy do about bubbles? I was enlisted as a speaker in this session, and I then characterized my views in Gilbert & Sullivan terms as, “Well, never. Oh, hardly June 29-30, 2005 158 of 234 There are several arguments why we should hardly ever try to prick bubbles. Asset bubbles may be too small to matter much in macro terms; they may be endogenous—the result of expansionary policy we have consciously followed; and pricking bubbles may run at cross-purposes with the monetary policy properly based on inflation and unemployment. But I think the real problem with pricking bubbles can be seen from yesterday’s discussion. How can we make that type of policy stabilizing? If one reads the press or listens to Europeans—and I did that this weekend at Basel—the high level of house prices should lead us to raise interest rates higher than we otherwise would. If one reads the Greenbook or the staff documents we talked about yesterday, the high level of house prices relative to rents leads to the expectation that house prices are more likely to decline than to rise, so that stabilizing policy would be to keep interest rates lower than we otherwise would. In that sense, the bubble policy conundrum is similar to the bond market conundrum. Great analysis, guys, but do we move rates up or down? In general, I think we aren’t going to know. House prices are high. Do we respond to the expectation by lowering rates to fight the anticipated collapse? To put it mildly, this policy would be very hard to explain and carries the risk that our more accommodative policy would drive house prices even higher. Imagine what Steve Roach and John Makin would say about that! If I can coin a term, this would be viewed as a Greenspan “shotput.” [Laughter] On the other hand, do we do what the press would have us do—raise rates and likely destabilize? This is a tough, perhaps impossible, question. And our best approach is most likely to June 29-30, 2005 159 of 234 Whatever the case, I’m happy to raise the funds rate another notch today and to continue with the “measured pace” rhetoric. For the future, my own five dollars says that you will never figure out what neutrality is, but I am confident that you will be able to tell when to stop raising rates. This leads me to my final point, which is to say how much I’ve enjoyed working with all of you. These meetings have been interesting, challenging, and productive. I can’t say that monetary policy is the hardest thing I’ve ever done in my life, because I did spend three years trying to get diverse people to agree about Social Security, but it was hard. And I think we did well. The staff has been superb. I can’t imagine better preparation for meetings like this than from reading the Greenbook and the Bluebook. All of you have been consistently interesting and sensible. And the Chairman has run great meetings and has admirably melded our diverse views into a coherent and effective monetary policy. I will be eternally grateful for having been a part of it. [Applause] Thank you." CHRG-111shrg57322--270 Mr. Birnbaum," Look, I think that, not working in a lot of areas of Goldman, there are things that may have happened that multiple investment banks and commercial banks may have provided too much credit, and that may have contributed to a bubble. And I would second what Mr. Sparks said. We are all sympathetic to the negative impact of that bubble. There was a lot of human pain and suffering that came from the bursting of the housing bubble. And to the extent that investment banks and commercial banks may have extended too much credit at certain periods of time--and, again, that is just--I do not have any personal witnessing of that--then it is possible. Senator Pryor. I guess what I am hoping to hear from the answers here is that you all take responsibility for your actions, and I have not heard that really so far in the first two, but I would like to ask the third. Mr. Swenson, did--or excuse me---- " FinancialCrisisReport--68 Mr. Vanasek was the senior-most risk officer at WaMu, and had frequent interactions with Mr. Killinger and the Board of Directors. While his concerns may have been heard, they were not heeded. Mr. Vanasek told the Subcommittee that, because of his predictions of a collapse in the housing market, he earned the derisive nickname “Dr. Doom.” 175 But evidence of a housing bubble was overwhelming by 2005. Over the prior ten years, housing prices had skyrocketed in an unprecedented fashion, as the following chart prepared by Paulson & Co. Inc., based on data from the Bureau of Economic Analysis and the Office of Federal Housing Enterprise Oversight, demonstrates. 176 174 9/2/2004 Washington Mutual memorandum from Jim Vanasek, “Perspective,” Hearing Exhibit 4/13-78b. 175 Subcommittee interview of Jim Vanasek (12/18/2009). 176 “Estimation of Housing Bubble,” PSI-Paulson&Co-02-00003, Hearing Exhibit 4/13-1j. fcic_final_report_full--426 These facts tell us that our explanation for the credit bubble should focus on fac- tors common to both the United States and Europe, that the credit bubble is likely an essential cause of the U.S. housing bubble, and that U.S. housing policy is by itself an insufficient explanation of the crisis. Furthermore, any explanation that relies too heavily on a unique element of the U.S. regulatory or supervisory system is likely to be insufficient to explain why the same thing happened in parts of Europe. This moves inadequate international capital and liquidity standards up our list of causes, and it moves the differences between the regulation of U.S. commercial and invest- ment banks down that list. Applying these international comparisons directly to the majority’s conclusions provokes these questions: • If the political influence of the financial sector in Washington was an essential cause of the crisis, how does that explain similar financial institution failures in the United Kingdom, Germany, Iceland, Belgium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark? • How can the “runaway mortgage securitization train” detailed in the majority’s report explain housing bubbles in Spain, Australia, and the United Kingdom, countries with mortgage finance systems vastly different than that in the United States? • How can the corporate and regulatory structures of investment banks explain the decisions of many U.S. commercial banks, several large American univer- sity endowments, and some state public employee pension funds, not to men- tion a number of large and midsize German banks, to take on too much U.S. housing risk? • How did former Fed Chairman Alan Greenspan’s “deregulatory ideology” also precipitate bank regulatory failures across Europe? Not all of these factors identified by the majority were irrelevant; they were just not essential. The Commission’s statutory mission is “to examine the causes, domestic and global, of the current financial and economic crisis in the United States.” By fo- cusing too narrowly on U.S. regulatory policy and supervision, ignoring interna- tional parallels, emphasizing only arguments for greater regulation, failing to prioritize the causes, and failing to distinguish sufficiently between causes and ef- fects, the majority’s report is unbalanced and leads to incorrect conclusions about what caused the crisis. We begin our explanation by briefly describing the stages of the crisis. FinancialCrisisReport--272 The FBI’s fraud warnings were repeated by industry analysts. The Mortgage Bankers Association’s Mortgage Asset Research Institute (MARI), for example, had been reporting increasing fraud in mortgages for years. In April 2007, MARI reported a 30% increase in 2006 in loans with suspected mortgage fraud. The report also noted that while 55% of overall fraud incidents reported to MARI involved loan application fraud, the percentage of subprime loans with loan application fraud was even higher at 65%. 1053 Press Reports. Warnings in the national press concerning the threat posed by deteriorating mortgages and unsustainable housing prices were also prevalent. A University of Florida website has collected dozens of these articles, many of which were published in 2005. The headlines include: “Fed Debates Pricking the U.S. Housing ‘Bubble’,” New York Times , May 31, 2005; “Yale Professor Predicts Housing ‘Bubble’ Will Burst,” NPR, June 3, 2005; “Cover Story: Bubble Bath of Doom” [warning of overheated real estate market], Washington Post , July 4, 2005; “Housing Affordability Hits 14-Year Low,” The Wall Street Journal, December 22, 2005; “Foreclosure Rates Rise Across the U.S.,” NPR, May 30, 2006; “For Sale Signs Multiply Across U.S.,” The Wall Street Journal , July 20, 2006; and “Housing Gets Ugly,” New York Times , August 25, 2006. 1054 Had Moody’s and S&P heeded their own warnings as well as the warnings in government reports and the national press, they might have issued more conservative, including fewer AAA, ratings for RMBS and CDO securities from 2005 to 2007; required additional credit enhancements earlier; and issued ratings downgrades earlier and with greater frequency, gradually letting the air out of the housing bubble instead of puncturing it with the mass downgrades that began in July 2007. The problem, however, was that neither company had a financial incentive to assign tougher credit ratings to the very securities that for a short while increased their revenues, boosted their stock prices, and expanded their executive compensation. Instead, ongoing conflicts of interest, inaccurate credit rating models, and inadequate rating and surveillance resources made it possible for Moody’s and S&P to ignore their own warnings about the U.S. mortgage market. In the longer run, these decisions cost both companies dearly. Between January 2007 and January 2009, the stock price for both The McGraw-Hill Companies (S&P’s parent company) and Moody’s fell nearly 70%, and neither share price has fully recovered. (2) CRA Conflicts of Interest In transitioning from the fact that the rating agencies issued inaccurate ratings to the question of why they did, one of the primary issues is the conflicts of interest inherent in the “issuer-pays” model. Under this system, the firm interested in profiting from an RMBS or CDO security is required to pay for the credit rating needed to sell the security. Moreover, it requires the credit rating agencies to obtain business from the very companies paying for their rating 1053 4/2007 “Ninth Periodic Mortgage Fraud Case Report to Mortgage Bankers Association,” prepared by the Mortgage Asset Research Institute, LLC, at 10. 1054 “Business Library – The Housing Bubble,” University of Florida George A. Smathers Libraries, http://www.uflib.ufl.edu/cm/business/cases/housing_bubble.htm. judgment. The result is a system that creates strong incentives for the rating agencies to inflate their ratings to attract business, and for the issuers and arrangers of the securities to engage in “ratings shopping” to obtain the highest ratings for their financial products. FinancialCrisisInquiry--185 So this bubble bursting is what’s caused I think the bad loan issues in the financial sector with mortgages being a big part of it. The chart below that though is what was referred to by Mr. Bass earlier—key thing—housing became unaffordable during 2003, 4 and 5. The affordability—that is the income relative to the payments you had to make wasn’t there. And so that is why we had these new mortgage instruments come about. Because people could not afford to buy the house. And so they had to find an instrument that allowed them to make a lower initial payment. This would not have been a bad thing if they had fully verified the person’s income, they’d have laid down 20 percent, did all the things that made sense. Unfortunately we layered these risks, and that did not happen. So it was the affordability problem that really and partly caused the bubble. But because the bubble itself made people go to these instruments that were at least much more risky. From the investment community side, of course as you said earlier, that people wanted to get higher yields. They weren’t getting them cause the interest rates were so low. So they—investor also wanted these instruments. The fall out is figure five, which is unfortunately not over. In a way you’re investigating what caused this, but we’re still in the middle of this crisis from the point of view of the consumer, and—and Main Street. Wall Street feels great, but Main Street does not feel great. And this just shows you that the delinquency and foreclosure the total non-performing loans continue to mount for all of the—both the risky loans, and also for non-risky loans. Remember, there’s $11 trillion of mortgages. There are about $3 trillion of the risky category. There’s $7 trillion of what is called prime mortgages. And those are going bad because house prices have dropped so much, people have lost their jobs, and there’s no end in sight of this. I think 2010 is going to be a bigger year than 2009. CHRG-111hhrg51698--391 Mr. Goodlatte," Thank you, Mr. Chairman. Mr. Masters, just to clarify your testimony, the CFTC, by allowing an excessive speculation bubble, amplified and deepened the housing and banking crisis. Is that your conclusion? " FOMC20050630meeting--79 77,MR. POOLE.," But the point is that there could be a little bubble component or a big bubble component. Obviously, policymakers wouldn’t apply the instrument when prices are regarded as reflecting the fundamentals, but the instrument would be continuously available. The whole point June 29-30, 2005 34 of 234 change the whole nature of asset pricing in a market economy. I think a proper policy analysis really can’t be done on a one-off basis in cases such as the stock market in the ’90s or house prices today." CHRG-111hhrg53245--118 Mr. Garrett," You would put it in the Federal Reserve. The reason why I want to clarify that is if you look at the history of the Federal Reserve on each one of those points, you have to raise the question, why them? On the asset bubbles, someone else raised a question to Ms. Rivlin with regard to the housing bubble that we had, I am going back even further than that with the tech bubble. Alan Greenspan later on said maybe I missed that one and he sort of re-wrote history, some would say, as far as his review, whether he knew about that or not, but if you look at the minutes of the Federal Reserve, not just him but the entire Federal Reserve, they all missed that. There was no discussion whatsoever with regard to an asset bubble during the entire time. They were looking at it purely as an increase in productivity. On the countercylical aspect of it, the Federal Reserve was out front for a long time on Basel II; were they not? Which would go in the wrong direction with regard to that. As far as on the capital requirements, did not the Federal Reserve have the ability with regard to institutions under them, Citi and Bank of America, and did they do anything? The answer is no, regarding raising capital requirements. Here is an entity that you are nodding your head to, with a ``dismal'' track record in each one of those, but you, sir, would suggest they are the ones we are going to give the authority to. " CHRG-111shrg57322--315 Mr. Birnbaum," My sentiment that I expressed in my opening statement was that there was a market in residential mortgage-backed securities in subprime that I thought was overvalued. Senator Tester. OK. So it was based on the housing bubble, and its decline or collapse, however you want to put--however I want to put it. " FinancialCrisisInquiry--184 You can see here that we had—hopefully you have it, but if not I’ll describe the numbers. We were producing in single-family starts about 1.1 million a year on average. That’s roughly the average level of single-family starts. And that’s the demographic demand. During the peak moments here, we produced 1.7 million. So we were producing about -- we produced during this whole bubble about a million more new starts then demographic demand would have you produced. And one of the reasons for that was that these—basically people were able to put down $1,000 or $2,000 or $3,000 to control a $100,000 to $200,000 house. It was a—basically a call option. And homebuilders sold them this house. They took an order, and of course they didn’t have to fulfill that order. If prices went up, they take the order and flip the house. So we built about a million too many. We are now building about 500,000 houses, and as you know in many markets this has led to lots of layoffs. I think roughly 15 percent of the decline in employment is in the construction industry. So this is a—a very big negative. But we’ve begun to come back a little bit, and my guess is we’ll slowly recover. I would agree with Mark. It’s going to take three to four years to get recovery here. Maybe a little bit longer. If we skip to this figure three—there was some reference to this earlier—is the house price bubble, which is on the second page there. And the house price bubble I think is really why we’ve had all this fallout. House prices went up in nominal terms dramatically. And in real terms also very dramatically. We’ve had big house price inflations before. In the late 70s we had that happen. But that was accompanied by overall inflation. This time house prices went up, and we did not have overall inflation. So real house prices went up dramatically. And only one other period of time have we ever seen a—a drop in house prices that was in a big way, and that was in the 1930s. It really didn’t happen in the post-war period. But we’ve seen a cumulative price decline based on realtor data of about 21 percent based on another index Kay short about 30 percent. fcic_final_report_full--429 VII. Risk of contagion. The risk of contagion was an essential cause of the crisis. In some cases, the financial system was vulnerable because policymakers were afraid of a large firm’s sudden and disorderly failure triggering balance- sheet losses in its counterparties. These institutions were deemed too big and interconnected to other firms through counterparty credit risk for policy- makers to be willing to allow them to fail suddenly. VIII. Common shock. In other cases, unrelated financial institutions failed be- cause of a common shock: they made similar failed bets on housing. Uncon- nected financial firms failed for the same reason and at roughly the same time because they had the same problem: large housing losses. This common shock meant that the problem was broader than a single failed bank–key large financial institutions were undercapitalized because of this common shock. IX. Financial shock and panic. In quick succession in September , the fail- ures, near-failures, and restructurings of ten firms triggered a global financial panic. Confidence and trust in the financial system began to evaporate as the health of almost every large and midsize financial institution in the United States and Europe was questioned. X. Financial crisis causes economic crisis. The financial shock and panic caused a severe contraction in the real economy. The shock and panic ended in early . Harm to the real economy continues through today. We now describe these ten essential causes of the crisis in more detail. THE CREDIT BUBBLE: GLOBAL CAPITAL FLOWS, UNDERPRICED RISK, AND FEDERAL RESERVE POLICY The financial and economic crisis began with a credit bubble in the United States and Europe. Credit spreads narrowed significantly, meaning that the cost of borrowing to finance risky investments declined relative to safe assets such as U.S. Treasury securi- ties. The most notable of these risky investments were high-risk mortgages. The U.S. housing bubble was the most visible effect of the credit bubble but not the only one. Commercial real estate, high-yield debt, and leveraged loans were all boosted by the surplus of inexpensive credit. There are three major possible explanations for the credit bubble: global capital flows, the repricing of risk, and monetary policy. Global capital flows Starting in the late s, China, other large developing countries, and the big oil- producing nations consumed and invested domestically less than they earned. As fcic_final_report_full--170 ALL IN CONTENTS The bubble: “A credit-induced boom” ................................................................  Mortgage fraud: “Crime-facilitative environments” ..........................................  Disclosure and due diligence: “A quality control issue in the factory” ................  Regulators: “Markets will always self-correct” ...................................................  Leveraged loans and commercial real estate: “You’ve got to get up and dance” ...................................................................  Lehman: From “moving” to “storage” ................................................................  Fannie Mae and Freddie Mac: “Two stark choices” ...........................................  In , the Bakersfield, California, homebuilder Warren Peterson was paying as lit- tle as , for a ,-square-foot lot, about the size of three tennis courts. The next year the cost more than tripled to ,, as real estate boomed. Over the pre- vious quarter century, Peterson had built between  and  custom and semi-custom homes a year. For a while, he was building as many as . And then came the crash. “I have built exactly one new home since late ,” he told the FCIC five years later.  In , the average price was , for a new house in Bakersfield, at the southern end of California’s agricultural center, the San Joaquin Valley. That jumped to almost , by June .  “By , money seemed to be coming in very fast and from everywhere,” said Lloyd Plank, a Bakersfield real estate broker. “They would purchase a house in Bakersfield, keep it for a short period and resell it. Some- times they would flip the house while it was still in escrow, and would still make  to .”  Nationally, housing prices jumped  between  and their peak in ,  more than in any decade since at least .  It would be catastrophically downhill from there—yet the mortgage machine kept churning well into , apparently in- different to the fact that housing prices were starting to fall and lending standards to deteriorate. Newspaper stories highlighted the weakness in the housing market— even suggesting this was a bubble that could burst anytime. Checks were in place, but  they were failing. Loan purchasers and securitizers ignored their own due diligence on what they were buying. The Federal Reserve and the other regulators increasingly recognized the impending troubles in housing but thought their impact would be contained. Increased securitization, lower underwriting standards, and easier access to credit were common in other markets, too. For example, credit was flowing into commercial real estate and corporate loans. How to react to what increasingly ap- peared to be a credit bubble? Many enterprises, such as Lehman Brothers and Fannie Mae, pushed deeper. FinancialCrisisInquiry--598 ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on January 13, 2010 the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. And then we had wide-spread speculation. And I submitted an article to you as a commission, which I wrote in 2006 that was published in 2007. Nearly 30 percent of all home sales in the hot markets were just speculators. And this is not a bad thing, but the speculators put down almost no money. They were flipping houses. And our mortgage system was not able to distinguish between a homeowner and a speculator. And I think we really need to do a much better job of that in the future. We already are trying to. We’re— nothing wrong with speculating, but you’ve got to put down hard money -- 30 percent down. Some big number so they’re not destroying the market for the people who want to own and live in houses. There was a regulatory failure, and everybody knew this was happening. Everybody in the country knew this was happening by the middle of 2006 -- late 2006. One of the unregulated institutions—New Century—a mortgage broker—went bankrupt in early 2007. Everybody knew this, but it kept on going on. I tried very hard and others as well to talk to regulators about this—inform them of this—and within institutions—the Fed in particular. There was a big debate going on. Should they do something about it? And it was decided not to. They didn’t think they had the power. They didn’t really believe it was as bad as it was. But there was a big debate with board members about doing something about this. I think really the whole system of a non-recourse loan in both commercial and residential while desirable by the people borrowing has really created this problem. That there is a belief that it’s a—a put option. Things go well, great. If not, I can give it back. And this misalignment of interest at this level—the consumer level, the borrower level—and the misalignment of—of interest throughout the entire system where risk and rewards are disconnected is really how we’re going to fix this. So if I were to summarize I would say too much leverage, poor underwriting and lax regulation. But I want to take you through some of the charts I have. I know I’ve got January 13, 2010 about five more minutes, but tell you where we are today. And I think you have these at the end of the testimony. They’re figures. And let’s take the first one, which is the housing bubble. It says, “Figure One—U.S. Housing, Single Family Starts.” You can see here that we had—hopefully you have it, but if not I’ll describe the numbers. We were producing in single-family starts about 1.1 million a year on average. That’s roughly the average level of single-family starts. And that’s the demographic demand. During the peak moments here, we produced 1.7 million. So we were producing about -- we produced during this whole bubble about a million more new starts then demographic demand would have you produced. And one of the reasons for that was that these—basically people were able to put down $1,000 or $2,000 or $3,000 to control a $100,000 to $200,000 house. It was a—basically a call option. And homebuilders sold them this house. They took an order, and of course they didn’t have to fulfill that order. If prices went up, they take the order and flip the house. So we built about a million too many. We are now building about 500,000 houses, and as you know in many markets this has led to lots of layoffs. I think roughly 15 percent of the decline in employment is in the construction industry. So this is a—a very big negative. But we’ve begun to come back a little bit, and my guess is we’ll slowly recover. I would agree with Mark. It’s going to take three to four years to get recovery here. Maybe a little bit longer. If we skip to this figure three—there was some reference to this earlier—is the house price bubble, which is on the second page there. And the house price bubble I think is really why we’ve had all this fallout. House prices went up in nominal terms dramatically. And in real terms also very dramatically. We’ve had big house price inflations before. In the late 70s we had that happen. But that was accompanied by overall inflation. This time house prices went up, and we did not have overall inflation. So real house prices went up dramatically. And only one other period of time have we ever seen a—a January 13, 2010 drop in house prices that was in a big way, and that was in the 1930s. It really didn’t happen in the post-war period. But we’ve seen a cumulative price decline based on realtor data of about 21 percent based on another index Kay short about 30 percent. So this bubble bursting is what’s caused I think the bad loan issues in the financial sector with mortgages being a big part of it. The chart below that though is what was referred to by Mr. Bass earlier—key thing—housing became unaffordable during 2003, 4 and 5. The affordability—that is the income relative to the payments you had to make wasn’t there. And so that is why we had these new mortgage instruments come about. Because people could not afford to buy the house. And so they had to find an instrument that allowed them to make a lower initial payment. This would not have been a bad thing if they had fully verified the person’s income, they’d have laid down 20 percent, did all the things that made sense. Unfortunately we layered these risks, and that did not happen. So it was the affordability problem that really and partly caused the bubble. But because the bubble itself made people go to these instruments that were at least much more risky. From the investment community side, of course as you said earlier, that people wanted to get higher yields. They weren’t getting them cause the interest rates were so low. So they—investor also wanted these instruments. The fall out is figure five, which is unfortunately not over. In a way you’re investigating what caused this, but we’re still in the middle of this crisis from the point of view of the consumer, and—and Main Street. Wall Street feels great, but Main Street does not feel great. And this just shows you that the delinquency and foreclosure the total non-performing loans continue to mount for all of the—both the risky loans, and also for non-risky loans. Remember, there’s $11 trillion of mortgages. There are about $3 trillion of the risky category. There’s $7 trillion of what is called prime mortgages. And those are going bad January 13, 2010 because house prices have dropped so much, people have lost their jobs, and there’s no end in sight of this. I think 2010 is going to be a bigger year than 2009. And then of course our friends at Fannie Mae and Freddie Mac. Again you can see delinquency rates are rising there dramatically. They are much lower than the—the risky mortgage types even though after some time these numbers are going to continue to rise as far as we can see. The next figure on figure seven shows you the same thing is happening with FHA. Big rises in delinquencies in the FHA mortgage program. So to summarize, we’re not done by any means. The cost to the government so far has been large with the bailouts. But I think that we—we see continual further losses over the next year, year and a half, in the residential mortgage market. So we’re not at all done. I do have some other data which we’ll be able to take in questions. But I— I’m hoping that I will be able to give you some advice in how this happened, and how it—we can make it not happen again. Thank you very much. FOMC20050630meeting--11 9,MR. RUDEBUSCH.," I will review some general issues related to monetary policy and asset prices. Let me start—at the top of page 1—by assuming that an asset price can, in theory at least, be separated into a component determined by underlying economic fundamentals and a non-fundamental or bubble component. An asset price may be in line with its fundamentals, so the bubble component is zero, or bubbles could be positive or negative—perhaps representing irrational euphoria or pessimism. June 29-30, 2005 15 of 234 of monetary policy. For example, a booming stock market is usually followed by higher demand and increased inflationary pressures, so tighter policy would be needed to offset these consequences. Even for the Standard Policy response, it will likely be useful to identify, if possible, the separate components of the asset price. In particular, the bubble component may exhibit more volatile dynamics and be a pernicious source of macroeconomic risk, so optimal policy would likely react more to bubbles than to movements in the fundamental component. The second type of response, the “Bubble Policy,” follows the Standard Policy as a base case, but, in certain circumstances, it also takes steps to contain or reduce the asset price bubble. Proponents of a Bubble Policy argue that movements in the bubble component can have serious adverse consequences for macroeconomic performance that monetary policy cannot readily offset after the fact, so it is preferable to try to eliminate this source of macroeconomic fluctuations directly. Furthermore, because bubbles often seem to display a self-reinforcing behavior, a little preemption and prevention early on can avoid later excesses. A best-case scenario for these two policies is illustrated in the lower half of the first page. Under ideal circumstances, the policymaker knows the fundamental and bubble components, and as history unfolds, the Standard Policy would likely recommend higher interest rates to offset any economic stimulus generated by the bubble before the crash and lower rates afterward. A Bubble Policy would go further and try to mitigate the fluctuations in the bubble and achieve an asset price path like AP′t . This would likely require higher interest rates than the Standard Policy before the crash and lower rates afterward, and it will likely trade off near- term deviations from the central bank’s macroeconomic goals for better overall macroeconomic performance later on. The fundamental difference between the two policies is that the Standard Policy takes the bubble component essentially as given or exogenous, while the Bubble Policy takes into account the endogenous nature of the bubble component—specifically, a linkage between the policy instrument and the bubble. A decision tree for choosing between the Standard and Bubble Policies is shown on page 2. In brief, it asks three questions: (1) Can policymakers identify a bubble? (2) Will fallout from a bubble be significant and hard to rectify ex post? and (3) Is monetary policy the right method to use to deflate the bubble? The answer to the first question—can policymakers identify a bubble?—is “no” if the particular asset price appears aligned with fundamentals. Some have argued that this is nearly always the case because estimates of fundamentals are so imprecise and because asset prices reflect the collective information and wisdom of professional traders in organized markets. If policymakers cannot discern a bubble, then the Standard Policy is the only feasible response. June 29-30, 2005 16 of 234 policy cannot readily offset after the fact. A negative answer to this question is appropriate in two situations. First, if the bubble is in an asset market that is small in domestic economic terms—for example, a localized real estate market—then a central banker should avoid attempts at asset price realignment. Second, even when there are significant macroeconomic consequences from an asset price bubble boom and bust, if they occur with a sufficient lag so the policymaker can adopt a wait-and­ see attitude, then the Standard Policy is again appropriate. This second case seems relevant if fluctuations in the bubble component have only conventional effects on aggregate demand and supply through changes in wealth, the cost of capital, and balance sheets. Then, to a first approximation, the lags involved in these channels are about as long as the lags in the monetary transmission mechanism; therefore, the Standard Policy should suffice. For example, fluctuations in equity prices will affect wealth and consumer demand, but a nimble central banker can essentially offset these consequences by changing interest rates in reaction to—that is, after—the equity price movements. Now to the case where asset price movements have significant macroeconomic consequences and those consequences are hard to clean up after the fact through monetary policy. The most often mentioned possibility is that a bursting asset price bubble will lead to a broad financial crisis and credit crunch. Such financial instability is likely to be transmitted to the economy much more quickly than can be offset by interest rate policy. This may set the stage for invoking a Bubble Policy. Another example is when the asset price misalignment results in significant misallocations of resources, which distort aggregate demand and supply across sectors and over time and impede the achievement of the highest possible long-run economic growth. For example, the dot-com bubble spurred overinvestment in fiber optic cable and decimated the provision of venture capital for new technology startups for years. Of course, after the fact, it is difficult to unwind these problems with the blunt instrument of monetary policy, and, depending on the specifics, it is possible to conceive of a situation in which reducing the bubble in advance is a preferred policy strategy. The final hurdle before invoking a Bubble Policy involves assessing whether monetary policy is the right way to deflate the asset price bubble. Ideally, for the Bubble Policy, a moderate adjustment of interest rates could constrain the bubble and greatly reduce the risk of severe future macroeconomic dislocations. However, bubbles, even if identified, often do not appear influenced by monetary policy actions in a predictable way. Furthermore, even if changing interest rates could alter the bubble path, such a strategy may involve substantial costs, including near-term deviations from the macroeconomic goals of the central bank as well as potential political or moral hazard complications. Finally, even if monetary policy can affect the bubble, alternative strategies to deflate it, such as changes in financial regulations or supervision, may be more targeted and have a lower cost. June 29-30, 2005 17 of 234 questions for two historical episodes. The first episode is the run-up in the stock market during the late 1990s. In 1999 and 2000, one could have made the case that there was an equity price bubble in the high-technology sector and perhaps in the overall market as well. Also, during that time, the possible capital misallocation from the run-up in prices and the possible financial instability that might have followed a bursting of the bubble may have appeared difficult to rectify. However, it was also unlikely that monetary policy could have deflated the equity price bubble without substantial costs to the economy. In the event, of course, a Bubble Policy was not followed, but arguably, the consequences from any bubble boom and bust have been manageable. A different example is provided by the bond market collapse in 1994. One could argue that this “inflation scare,” which pushed up yields on 30-year bonds by over 2 percentage points, resulted in an asset price misalignment that was fairly apparent to the FOMC during the second half of 1994. If this bond bubble had persisted, the widespread propagation of the associated fears of higher inflation could have had severe consequences that would have been costly to unwind with monetary policy later on. Finally, with regard to deflatability, it did appear likely that monetary policy could guide bond prices back to fundamentals. Indeed, one interpretation of the FOMC’s actions in 1994 is that it purposefully and successfully contained a bond market bubble with sizable increases in the funds rate. It is an open question which of these two episodes is the more relevant one today. That concludes my remarks." CHRG-109hhrg28024--179 Mr. Gillmor," Thank you, Mr. Chairman. Let me ask you, in terms of what has been happening in housing, and some people think we have a housing bubble, some don't. I think the Fed position is we don't. One of the things that has been happening is a great proliferation in zero percent down loans, adjustment of rate mortgages, and that was happening in a time of very low short term rates. Now, those are going up. Do you see any dangers to the system and what impact is this going to have on those borrowers? " FinancialCrisisInquiry--738 ROSEN: ... there’s no question about it that they set this one up, and used the wrong words. Matter of fact in 2007 the chairman who I respect a lot did say that it is demographic demand that was causing the housing market. I wrote a January 13, 2010 paper that he had read that said it wasn’t true. It was the credit bubble. But based—these demographic demand, all these other things which just the data don’t support it. CHRG-111hhrg53240--115 Chairman Watt," The gentleman's time has expired. The gentleman from Texas is recognized for 5 minutes. Dr. Paul. I thank you, Mr. Chairman. I have a question for Mr. Carr on how optimistic he might be about what we are trying to do. I tend toward pessimism at times; and I think the problem is almost bigger than what we are dealing with here, and we are just dealing on the edge of the basic problem. So the system that we have had has been around a long time. We have had a system--some people refer to it as capitalism that was unregulated. I happen to think that it doesn't have much to do with capitalism; it has to do with corporatism, where corporations seem to get the benefits of some of the programs that are designed to help the poor. We have multiple programs that have been going on for a long time designed to help the poor, and yet sometimes I think that is so superficial. The poor seem to become more numerous and the poor--especially since the crisis has hit; but it is always on a pretense to help the poor, and yet the corporations stand to make the money. So they make the money and they have the power and they have the insight with some of our financial institutions, including the Federal Reserve; and when the bubble forms, they benefit, and nobody complains too much if it seems to satisfy a lot of people. But when the bust comes, then we have a bailout. Who does the bailout serve? Do we immediately go out and bail out the people that we tried to get houses for? No. We immediately go out and bail out the system. So--the system is so deeply flawed, so they make the money when the bubble is being formed and they get bailed out when the bubble bursts. We come along with a new system that we hope will work. But for housing programs, for instance, you know, we want houses for the poor people, but developers make a lot of money, builders make a lot of money, mortgage companies make a lot of money, the banks make a lot of money. And all of a sudden the system doesn't work very well and the poor get wiped out and they lose their houses. So if we don't address that major problem, the structure of the system, this corporatism which has invaded us, how can this idea that, well, we will regulate a little bit in order to protect the consumer--I guess I am rather cynical, and I want you to tell me whether you share any of that concern, whether my cynicism sometimes is justified or not. " fcic_final_report_full--433 Some combination of the first two factors may apply in parts of the Sand States, but these don’t explain the nationwide increase in prices. The closely related and nationwide mortgage bubble was the largest and most sig- nificant manifestation of a more generalized credit bubble in the United States and Eu- rope. Mortgage rates were low relative to the risk of losses, and risky borrowers, who in the past would have been turned down, found it possible to obtain a mortgage.  In addition to the credit bubble, the proliferation of nontraditional mortgage products was a key cause of this surge in mortgage lending. Use of these products in- creased rapidly from the early part of the decade through . There was a steady deterioration in mortgage underwriting standards (enabled by securitizers that low- ered the credit quality of the mortgages they would accept, and credit rating agencies that overrated the subsequent securities and derivatives). There was a contemporane- ous increase in mortgages that required little to no documentation. As house prices rose, declining affordability would normally have constrained demand, but lenders and borrowers increasingly relied on nontraditional mortgage products to paper over this affordability issue. These mortgage products included interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave bor- rowers flexibility on the size of early monthly payments, and negative amortization products in which the initial payment did not even cover interest costs. These exotic mortgage products would often result in significant reductions in the initial monthly payment compared with even a standard ARM. Not surprisingly, they were the mortgages of choice for many lenders and borrowers focused on minimizing initial monthly payments. Fed Chairman Bernanke sums up the situation this way: “At some point, both lenders and borrowers became convinced that house prices would only go up. Bor- rowers chose, and were extended, mortgages that they could not be expected to serv- ice in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ulti- mately, further appreciation could not be sustained and house prices collapsed.”  This explanation posits a relationship between the surge in housing prices and the surge in mortgage lending. There is not yet a consensus on which was the cause and which the effect. They appear to have been mutually reinforcing. In understanding the growth of nontraditional mortgages, it is also difficult to de- termine the relative importance of causal factors, but again we can at least list those that are important: • Nonbank mortgage lenders like New Century and Ameriquest flourished un- der ineffective regulatory regimes, especially at the state level. Weak disclosure standards and underwriting rules made it easy for irresponsible lenders to issue mortgages that would probably never be repaid. Federally regulated bank and thrift lenders, such as Countrywide, Wachovia, and Washington Mutual, had lenient regulatory oversight on mortgage origination as well. • Mortgage brokers were paid for new originations but did not ultimately bear the losses on poorly performing mortgages. Mortgage brokers therefore had an incentive to ignore negative information about borrowers. • Many borrowers neither understood the terms of their mortgage nor appreci- ated the risk that home values could fall significantly, while others borrowed too much and bought bigger houses than they could ever reasonably expect to afford. • All these factors were supplemented by government policies, many of which had been in effect for decades, that subsidized homeownership but created hid- den costs to taxpayers and the economy. Elected officials of both parties pushed housing subsidies too far. CHRG-111hhrg53245--130 Mr. Wallison," Yes. I have a comment on the question of bubbles. I think we have to distinguish this bubble from every other bubble. We will always have them. We are human beings. We tend to believe that when things are going in one direction, they will continue to go in one direction. That is both up and down. This bubble was completely different. In this bubble, we had 25 million subprime and non-traditional loans that are failing at rates that we have never seen before. The question we have to answer is, why did that happen? That is one of the major reasons that this particular bubble turned into a worldwide financial crisis. " fcic_final_report_full--475 Indeed, the Commission’s entire investigation seemed to be directed at minimizing the role of NTMs and the role of government housing policy. In this telling, the NTMs were a “trigger” for the financial crisis, but once the collapse of the bubble had occurred the “weaknesses and vulnerabilities” of the financial system— which had been there all along—caused the crisis. These alleged deficiencies included a lack of adequate regulation of the so-called “shadow banking system” and over-the-counter derivatives, the overly generous compensation arrangements on Wall Street, and securitization (characterized as “the originate to distribute model”). Coincidentally, all these purported weaknesses and vulnerabilities then required more government regulation, although their baleful presence hadn’t been noted until the unprecedented number of subprime and Alt-A loans, created largely to comply with government housing policies, defaulted. 6. Conclusion What is surprising about the many views of the causes of the financial crisis that have been published since the Lehman bankruptcy, including the Commission’s own inquiry, is the juxtaposition of two facts: (i) a general agreement that the bubble and the mortgage meltdown that followed its deflation were the precipitating causes—sometimes characterized as the “trigger”—of the financial crisis, and (ii) a seemingly studious effort to avoid examining how it came to be that mortgage underwriting standards declined to the point that the bubble contained so many NTMs that were ready to fail as soon as the bubble began to deflate. Instead of thinking through what would almost certainly happen when these assets virtually disappeared from balance sheets, many observers—including the Commission majority in their report—pivoted immediately to blame the “weaknesses and vulnerabilities” of the free market or the financial or regulatory system, without considering whether any system could have survived such a blow. One of the most striking examples of this approach was presented by Larry Summers, the head of the White House economic council and one of the President’s key advisers. In a private interview with a few of the members of the Commission (I was not informed of the interview), Summers was asked whether the mortgage meltdown was the cause of the financial crisis. His response was that the financial crisis was like a forest fire and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest? 44 The Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time—the absence 44 FCIC, Summers interview, p.77. of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, ineffective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “30 years of deregulation” had “stripped away key safeguards” against a crisis; this ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the FDIC Improvement Act, which was by far the toughest bank regulatory law since the advent of deposit insurance and was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises. CHRG-111hhrg56776--54 Mr. Watt," I thank the gentleman. The gentleman from Texas, Dr. Paul, the ranking member of the subcommittee. Dr. Paul. Thank you, Mr. Chairman. I have a question for Chairman Bernanke. During the early part of the decade, a lot of the free market economists keet saying, well, interest rates have been too low for too long, and there was a financial bubble and a housing bubble, and there had to be a correction. Of course, we did in 2008. Since 2008, many of the mainstream economists have more or less agreed with that assessment because frequently we will hear them say interest rates were held too low for too long, and I think even Secretary Geithner has made that statement. Where do you come down on that perception? Do you think interest rates were held too low for too long? " CHRG-110shrg50369--140 PREPARED STATEMENT OF SENATOR JIM BUNNING Thank you, Mr. Chairman. The health of our economy and financial markets is a concern to everyone here today. Growth has slowed and we have been through a rough patch in the credit markets. Everyone wants to see stability and growth return. Congress has acted to restore confidence in the economy. The Fed has taken steps to thaw the credit freeze. We hope that these policy actions will head off further damage, but no policy can reverse the busting of the housing bubble and we are not going to regulate away problems in the economy. While I have supported actions taken to respond to our economic problems, I fear they will have unintended consequences. I am most concerned about inflation and the fall of the dollar. We need to think beyond what we have already done and take steps to encourage long term growth. Congress can give taxpayers, businesses, and investors certainty that their taxes are not going to go up. Congress can knock down roadblocks to growth such as artificial limits on our energy supply. Congress can make it more appealing for corporations to stay in the United States by easing regulations and lowering the corporate tax rate. Only with long term permanent policies can we ensure a healthy economy for our grandchildren. I look forward to hearing from the Chairman. ______ fcic_final_report_full--139 Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not. Alt-A mortgages were not gener- ally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from count- ing toward affordability goals.  Levin told the FCIC that they believed that the pur- chase of Alt-A securities “did not have a net positive effect on Fannie Mae’s housing goals.”  Instead, they had to be offset with more mortgages for low- and moderate- income borrowers to meet the goals. Fannie and Freddie continued to purchase subprime and Alt-A mortgage–backed securities from  to  and also bought and securitized greater numbers of riskier mortgages. The results would be disastrous for the companies, their share- holders, and American taxpayers. COMMISSION CONCLUSIONS ON CHAPTER 7 The Commission concludes that the monetary policy of the Federal Reserve, along with capital flows from abroad, created conditions in which a housing bub- ble could develop. However, these conditions need not have led to a crisis. The Federal Reserve and other regulators did not take actions necessary to constrain the credit bubble. In addition, the Federal Reserve’s policies and pronouncements encouraged rather than inhibited the growth of mortgage debt and the housing bubble. Lending standards collapsed, and there was a significant failure of accounta- bility and responsibility throughout each level of the lending system. This in- cluded borrowers, mortgage brokers, appraisers, originators, securitizers, credit rating agencies, and investors, and ranged from corporate boardrooms to individ- uals. Loans were often premised on ever-rising home prices and were made re- gardless of ability to pay. The nonprime mortgage securitization process created a pipeline through which risky mortgages were conveyed and sold throughout the financial system. This pipeline was essential to the origination of the burgeoning numbers of high- risk mortgages. The originate-to-distribute model undermined responsibility and accountability for the long-term viability of mortgages and mortgage-related se- curities and contributed to the poor quality of mortgage loans. (continues) (continued) CHRG-111shrg57322--1219 Mr. Blankfein," In the context---- Senator Levin. The bubble burst in 2007. We are looking at the causes of that bubble bursting. " CHRG-111hhrg48674--266 Mr. McCotter," Thank you, Mr. Chairman. People in my district woke up one day sometime late last year and found out that the world, as they knew it economically, was going to end because someone had done something wrong to seize up the credit markets. And since that time they have witnessed disorder in the sense of the government's response. They have perceived this to be an unjust appropriation of their money, spent on the very people who caused the problem, and they see a long-term loss of economic freedom due to government intervention. And most importantly, they don't see much benefit to their daily lives from all the things that the government has done. My concern in studying human nature is twofold: one, the concept of ``too big to fail.'' When you tell people they are too big to fail, they will, because they know there is no responsibility to be incurred, no accountability if they do. Where is the stigma for the people who failed and put us in this mess? Where are the measures taken to ensure that they pay a price for their problems that they have put onto us? I don't see any. I don't see any at this point. And the second part of my question is kind of that these people thought they could go on forever doing what they were doing, that it would just keep going, that the dot-com bubble was replaced by a housing bubble, and it would never end. Now we are talking about creating a government bubble to fix the housing bubble, but they never thought they were wrong. I asked you and Mr. Paulson once, ``What happened?'' The answer was, ``Mistakes were made.'' Well, I understand human beings are fallible. But the problem is, if people think they are too big to fail or they are too important, the hubris that enters into the prognostications that they make and the actions that they take leads them to make very, very big mistakes. So my question is this: If these people were wrong and we are suffering the consequences of their bad decisions; if people like Mr. Greenspan, who has admitted he was wrong, have caused us to suffer the consequences of his bad decisions; if--as you have written a book about the Great Depression--the people at the Federal Reserve were wrong and the people at the time had to live with their bad decisions, what in the odd chance happens if you are wrong? What is your worst-case scenario for the decisions and the actions that you have made and taken being incorrect, how will that affect the people who sent me here to work for them? " FOMC20050630meeting--191 189,MR. LACKER.," Yes. I have just a couple of comments and a question. Clearly, there are some perspectives from which housing prices seem to have drifted out of the usual relationship with indicators of fundamentals, and Joshua documented some of them. But it seems to me as if there are a lot of plausible stories one can tell about fundamentals that would explain or rationalize housing prices. Obviously, low interest rates have to top the list. Strong income growth among homeowning populations would be on the list, as would land use restrictions, which were mentioned earlier, and the recent surge in spending on home improvement. I found President Yellen’s suggestions intriguing. I’d like to offer my own, just in the spirit of adding potential explanations here. And it’s really a version of something Governor Kohn observed, which is that housing prices are relative prices. I’ve been struck by the fact that a collection of large metropolitan areas increasingly dominates the national housing figures and that house-price appreciation seems different across various urban regions. It suggests to me that housing values may be affected significantly by—I don’t know exactly how to phrase this—sort of the relative microeconomic value of agglomeration. By that I mean the value of the amenities in a city or the enhanced productivity associated with living in or near where one works. Now, in this age of telecommuting and the Internet, it’s easy to deduce that the value of living in a city has declined. But it seems plausible to me that the value of a thick labor market might be increasingly important for certain skill specialties. And it also seems June 29-30, 2005 63 of 234 urban cores. So I’d be interested if any of our housing data experts have any information relevant to that issue. While I have the floor, I’d like to make just an observation. It seems to me likely that a confluence of several fundamental factors might rationalize the current level of housing prices. So from that point of view, it’s hard for me to see how it would be reasonable to place a great deal of certainty on the notion that housing is significantly overvalued, or that there’s a bubble, or that it’s going to collapse really soon. I think these markets—this is echoing President Poole’s discussion—are too complex. I think our quantitative understanding of them is too limited to warrant second-guessing market forces. And beyond that, the models that we have of bubbles—Glenn wrote it down—are just some statistical noise added to an equation. I don’t think we have any models that give us any reason to hope that we can understand how interest rate changes would affect this little random statistical term added on to these equations. Having said that, housing prices pose a dilemma for us and are going to pose challenges for us soon, I think. Rapid appreciations in asset prices can make monetary policy more difficult. They tend to be associated with tightening labor markets. At the same time, there is a rise in the downside risk. So, even though I’m not very far down Glenn’s decision tree, these are still issues I’m paying attention to. It feels as if it could well occupy our attention here. But I’d be interested in your reaction to this agglomeration story." CHRG-111hhrg48674--99 Mr. Hensarling," Not by way of criticism, but by way of observation, many economists believe that but for the actions of the Federal Reserve earlier in this decade fueling the then existing housing bubble, that we would not have the economic turmoil we have today. Again, nothing is quite as clear to us as 20-20 hindsight. But do you have an opinion on, if we had had explicit inflation targets earlier in the decade, whether or not we might have avoided the present economic turmoil? " CHRG-111shrg57319--92 Mr. Vanasek," Yes, it was. Senator Coburn. How do you account for the fact that somebody has seen a bubble, and by definition, a bubble is going to burst, and then their corporate strategy is to jump into the middle of that bubble? " CHRG-110hhrg46593--379 Mr. Feldstein," Housing prices have to fall further. So I don't think that government should be trying to stabilize house prices at the current level. They overshot on the way up. They have come partly down. They have to come down further. The danger is that they can way overshoot on the way down. And that would be a bad thing. That would destroy financial institutions that are holding mortgage-backed securities. It would destroy household wealth, which, in turn, would make people cut back on their spending. That, in turn, would drag the economy down. So the ideal thing would be to see house prices come down to a sustainable level but not overshoot on the way down. And that is why I talk about this firewall as a way of stopping house prices from falling beyond the amount that is necessary to get back to pre-bubble levels. " fcic_final_report_full--200 Looking back at how the targeted affordable portfolio performed in comparison with overall losses, the  presentation at Freddie Mac took the analysis of the goals’ costs one step further. While the outstanding  billion of these targeted af- fordable loans was only  of the total portfolio, these were relatively high-risk loans and were expected to account for  of total projected losses. In fact, as of late , they had accounted for only  of losses—meaning that they had performed better than expected in relation to the whole portfolio. The company’s major losses came from loans acquired in the normal course of business. The presentation noted that many of these defaulted loans were Alt-A.  COMMISSION CONCLUSIONS ON CHAPTER 9 The Commission concludes that firms securitizing mortgages failed to perform adequate due diligence on the mortgages they purchased and at times knowingly waived compliance with underwriting standards. Potential investors were not fully informed or were misled about the poor quality of the mortgages contained in some mortgage-related securities. These problems appear to have been signifi- cant. The Securities and Exchange Commission failed to adequately enforce its disclosure requirements governing mortgage securities, exempted some sales of such securities from its review, and preempted states from applying state law to them, thereby failing in its core mission to protect investors. The Federal Reserve failed to recognize the cataclysmic danger posed by the housing bubble to the financial system and refused to take timely action to con- strain its growth, believing that it could contain the damage from the bubble’s collapse. Lax mortgage regulation and collapsing mortgage-lending standards and practices created conditions that were ripe for mortgage fraud. CHRG-111hhrg55809--58 Mr. Royce," Let me ask you another question. Some economists are arguing that the Fed not only lost control, but its policy actions have unintentionally become procyclical--encouraging financial excesses instead of countering the extremes. And this gets to the point that has been argued by many economists. In fact, Friedrich Hayek won the Nobel Prize in 1974 for arguing that artificially low interest rates lead to the misallocation of capital and the bubbles which then lead to bursts. Looking back, do you agree that the negative real interest rate set by central banks from 2002 to 2006 had a dramatic impact on the boom and the subsequent bust, especially when you take into consideration what was already an inflating housing bubble with the drastic steps taken by the Federal Government to encourage less creditworthy borrowers to get into loans they could not afford? Do you think those combinations could have had an impact on that boom-bust? " CHRG-111shrg57322--725 Mr. Viniar," Correct. So we would have marked it down, but again, that is just an assessment which sometimes proves to be right and sometimes proves to be wrong, of what the value of holding that security would be---- Senator Kaufman. Right. Mr. Viniar [continuing]. In the future, where we think it was going to go, versus what the price would be of buying an offsetting security. Senator Kaufman. But you can understand why some people would be concerned. At the same time that a number of people in your business, in Goldman Sachs, were saying, this market is going south, which I think was--I happen to be one of those not Monday morning quarterbacking, but just at the time, the way I felt, and I am not--but just looking at where the housing market was in terms of where it had been historically, looking at the rental market and seeing the rental market wasn't growing, classic sign of a bubble, that--so there was incentive, kind of. I know you keep--there is an incentive here to go short. I mean, based on--especially, you get to 2007. Let me put it this way. I personally have a hard time believing that folks as smart as you guys didn't see the housing market was having a bubble and that the idea of going short was a good decision based on prudent managers looking at a market that was clearly falling apart. " fcic_final_report_full--172 The numbers were stark. Nationwide, house prices had never risen so far, so fast. And national indices masked important variations. House prices in the four sand states, especially California, had dramatically larger spikes—and subsequent de- clines—than did the nation. If there was a bubble, perhaps, as Fed Chairman Alan Greenspan said, it was only in certain regions. He told a congressional committee in June  that growth in nonprime mortgages was helping to push home prices in some markets to unsustainable levels, “although a ‘bubble’ in home prices for the na- tion as a whole does not appear likely.”  Globally, prices jumped in many countries around the world during the s. As Christopher Mayer, an economist from Columbia Business School, noted to the Commission, “What really sticks out is how unremarkable the United States house price experience is relative to our European peers.”  From  to , price in- creases in the United Kingdom and Spain were above those in the United States, while price increases in Ireland and France were just below. In an International Mon- etary Fund study from , more than one half of the  developed countries ana- lyzed had greater home price appreciation than the United States from late  through the third quarter of , and yet some of these countries did not suffer sharp price declines.  Notably, Canada had strong home price increases followed by a modest and temporary decline in . Researchers at the Federal Reserve Bank of Cleveland attributed Canada’s experience to tighter lending standards than in the United States as well as regulatory and structural differences in the financial system.  Other countries, such as the United Kingdom, Ireland, and Spain, saw steep house price declines. American economists and policy makers struggled to explain the house price in- creases. The good news was the economy was growing and unemployment was low. But, a Federal Reserve study in May  presented evidence that the cost of owning rather than renting was much higher than had been the case historically: home prices had risen from  times the annual cost of renting to  times.  In some cities, the change was particularly dramatic. From  to , the ratio of house prices to rents rose in Los Angeles, Miami, and New York City by , , and , re- spectively.  In , the National Association of Realtors’ affordability index—which measures whether a typical family could qualify for a mortgage on a typical home— had reached a record low.  But that was based on the cost of a traditional mortgage with a  down payment,  which was no longer required. Perhaps such measures were no longer relevant, when Americans could make lower down payments and ob- tain loans such as payment-option adjustable-rate mortgages and interest-only mort- gages, with reduced initial mortgage payments. Or perhaps buying a home continued to make financial sense, given homeowners’ expectations of further price gains. During a June meeting, the Federal Open Market Committee (FOMC), com- posed of Federal Reserve governors, four regional Federal Reserve Bank presidents, and the Federal Reserve Bank of New York president, heard five presentations on mortgage risks and the housing market. Members and staff had difficulty develop- ing a consensus on whether housing prices were overvalued and “it was hard for many FOMC participants . . . to ascribe substantial conviction to the proposition that overvaluation in the housing market posed the major systemic risks that we now know it did,” according to a letter from Fed Chairman Ben Bernanke to the FCIC. “The national mortgage system might bend but will likely not break,” and “neither borrowers nor lenders appeared particularly shaky,” one presentation ar- gued, according to the letter. In discussions about nontraditional mortgage prod- ucts, the argument was made that “interest-only mortgages are not an especially sinister development,” and their risks “could be cushioned by large down payments.” The presentation also noted that while loan-to-value ratios were rising on a portion of interest-only loans, the ratios for most remained around . Another presenta- tion suggested that housing market activity could be the result of “solid fundamen- tals.” Yet another presentation concluded that the impact of changes in household wealth on spending would be “perhaps only half as large as that of the s stock bubble.” Most FOMC participants agreed “the probability of spillovers to financial institutions seemed moderate.”  FinancialCrisisInquiry--182 Can you turn your mic on, Mr. Rosen? ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. CHRG-111hhrg61852--62 Mr. Mishel," I don't fashion myself as a housing expert, but I will offer what I can, which is I think we are still in the aftermath of the bursting of the housing bubble, and the prices haven't yet fully dropped to sort of reach the equilibrium. So there is not a lot of incentive to build more houses. The problem in the housing sector, which is one reason why I don't think monetary policy is what got us the recovery from early 2009 to now, because one of the main reasons you would expect monetary policy to lead to growth would be through restoring durable goods and construction, and that really hasn't happened. Other than that, I don't want to venture any other advice. Mr. Miller of North Carolina. Mr. Koo, we had a raging debate in this country a year and a half ago about whether the biggest banks were solvent and what to do about them if they weren't. From our distance from Japan, one of the explanations given for Japan's lost decade, now apparently going on two lost decades, was that there were zombie corporations and particularly zombie banks that were really insolvent, but no one was quite willing to pull the trigger at taking them into receivership. So they continued not to function normally. They continued to hoard cash so they could remain solvent on paper. And looking at the behavior of America's largest banks in the last year and a half, some of their behavior appears to be consistent with what is attributed to zombie banks. They are not lending normally. They are not making wholesome loans to people who are going to pay them back. They are emphasizing proprietary trading, which can kind of create a quicker profit when a bank is trying to get themselves back in the game. But most of all, their failure to make what appear to be economically sensible modifications of mortgages for people who can pay a mortgage on the house they are in, but not the one they have, for whatever reason. Does it appear to you that American banks are behaving normally, or are they behaving the way the zombie banks in Japan behaved in the 1990's? " fcic_final_report_full--487 In addition, Roubini and Parisi-Capone estimated that U.S. commercial and investment banks suffered a further mark-to-market loss of $225 billion on unsecuritized subprime and Alt-A mortgages. 57 They also estimated that mark-to- market losses for financial institutions outside the U.S. would be about 40 percent of U.S. losses, so there was likely to be a major effect on banks and other financial institutions around the world—depending, of course, on their capital position at the time the PMBS market stopped functioning. I am not aware of any data showing the mark-to-market effect of the collapse of the PMBS market on other U.S. financial institutions, but it can be assumed that they also suffered similar losses in proportion to their holdings of PMBS. Losses of this magnitude would certainly be enough—when combined with other losses on securities and loans not related to mortgages—to call into question the stability of a large number of banks, investment banks and other financial institutions in the U.S. and around the world. However, there was one other factor that exacerbated the adverse effect of the loss of a market for PMBS. Although accounting rules did not require all PMBS to be written down, investors and counterparties did not know which financial institutions were holding the weakest assets and how much of their assets would have to be written down over time. Whatever that amount, it would reduce their capital positions at a time when investors and counterparties were anxious about their stability. This was the balance sheet effect that was the third element of Chairman Bair’s summary. To summarize, then, the following are the steps through which the government’s housing policies transmitted losses—through PMBS—to the largest financial institutions: (i) the 19 million NTMs acquired or guaranteed by the Agencies were major contributors to the growth of the bubble and its extension in time; (ii) the growth of the bubble suppressed the losses that would ordinarily have brought the development of NTM-backed PMBS to a halt; (ii) competition for NTMs drove subprime lenders further out the risk curve to find high-yielding mortgages to securitize, especially when these loans did not appear to be producing losses commensurate with their risk; (iv) when the bubble finally burst, the unprecedented number of delinquencies and defaults among all NTMs—the great majority of which were held or guaranteed by the Agencies—caused investors to 56 Timothy F. Geithner, “Reducing Systemic Risk in a Dynamic Financial System,” Remarks at the Economic Club of New York, June 9, 2008, available at http://www.ny.frb.org/newsevents/speeches/2008/ tfg080609.html. 57 Nouriel Roubini and Elisa Parisi-Carbone, “Total $3.6 Trillion Projected Loan and Securities Losses,” p.7. flee the PMBS market, reducing the liquidity of the financial institutions that held the PMBS; and (v) mark-to-market accounting required these institutions to write down the value of the PMBS they held, as well as their other mortgage-related assets, reducing their capital positions and raising further questions about their stability and solvency. FOMC20050630meeting--356 354,MR. GUYNN.," Thank you, Mr. Chairman. Anecdotal reports from our regional contacts and the most recent data releases suggest that business conditions in the Southeast have remained positive since our last meeting. Florida, as has been the case for some time, has been dominant in terms of both employment growth and the pace of economic activity, given the strength in sectors such as tourism and housing. Coincident indicators, like personal income and state tax revenues, suggest that our District’s growth over the past several months has averaged about 3 percent, with major contributions coming not only from Florida but also from Alabama and, to a lesser extent, Georgia and Mississippi. District employment growth has been averaging roughly 35,000 per month until the disappointing report of only 3,000 new jobs in May. Our regional unemployment rate has been running about 0.2 percentage point below the national average. However, absent Florida, the rest of June 29-30, 2005 116 of 234 The apparent slowing in employment growth was a concern in terms of the regional outlook, although I would say that recent anecdotal reports on hiring are more encouraging than the official data. It seems to me that the key question from a policy perspective is whether there are signs of regional imbalances on either the price or the real side that might shed light on the national picture and on the broader risk to either growth or inflation. With respect to growth, the capital spending survey suggests that planned investment spending in our District remains solid. And the motivations for this are now more rooted in the expectation of increased sales rather than the need to cut costs, improve productivity, or to replace obsolete technology. Having said that, let me note that we received some interesting and sobering anecdotal comments from our directors. One director from the paper pulp and forest industry expressed concerns, perhaps selfish concerns, about the overexpansion for certain manufactured building supplies. He indicated, for example, that production capacity for building products such as gypsum wall board, concrete, and manufactured lumber was on a pace to expand 30 to 35 percent worldwide over the next three years. In the specific case of one product that is dear to his heart, oriented strand board, he said that the increase looks more like 40 percent. He characterized the industry’s very aggressive investment spending plans as preparing to, and I quote, “jump off the cliff yet again.” [Laughter] Our reports indicate that investment spending has also increased in the air cargo freight area, driven by international demand. Our bankers tell us that commercial and industrial lending remains highly competitive, with a resulting narrowing of spreads, although credit quality continues to be good. Our director from the forest product sector noted a continued softening in paper box demand, June 29-30, 2005 117 of 234 Finally, there is the housing situation, which we talked about for a long time yesterday afternoon. As I’ve been reporting for several meetings, some of our markets, especially those in coastal areas of South Florida and the Florida panhandle, are experiencing a level of building activity and price increases that are clearly, in my view, unsustainable. Nearly every major Florida city now has experienced increases in the double-digit range, and some, like Miami, Palm Beach, Sarasota, and West Palm, have been reporting increases in housing prices on a year-over-year basis of between 25 and 30 percent. While our discussion yesterday did not seem to indicate a consensus on a national housing bubble, based on past experience I’m reasonably comfortable characterizing the housing feeding frenzy in some of our markets as being a bubble or a near bubble. For example, the number of major projects planned or under construction in Miami now totals 114, most of which are high-rise developments. That includes 61,000 condo units—eight times the number that were built in the last decade—and a total of 100,000 new parking spaces. I know we don’t have any process for introducing exhibits into the record, but I’d like to pass Dave Stockton this pictorial of the new projects in Miami, so that he can continue to worry a little bit along with me. [Laughter] My supervision and regulation staff thinks this is an accident waiting to happen in our area. And while the local market excesses probably do not represent systemic national risk, the shakeouts could have serious regional consequences. My bank supervision staff points out that housing- related credit risks to our bank lenders are not so much from defaults on permanent mortgage financing that we talked about yesterday, but rather from lending for land acquisition, development, and construction. The ugly picture we have seen before—and that they think we may very likely see again June 29-30, 2005 118 of 234 developers to go ahead and complete the construction of additional units to make them saleable, further depressing the market; and speculators who had hoped to see big capital gains walking away or defaulting on their contracts, giving their properties back to the lender. Perhaps it’s because of where I sit, but I am less comforted than some of my colleagues about the housing situation. As for the national economy, my view is that real GDP growth is most likely to remain on its recent path, averaging around 3½ percent, which we judge to be very close to trend. Consumer spending seems to continue to be roughly in line with GDP growth, confidence has rebounded, investment spending is still supportive, and manufacturing has seemed a bit brighter in recent data reports. I would characterize employment growth as better than the “improving gradually” language would suggest, and I think it should be sufficient to at least keep the unemployment rate around current levels or perhaps nudge it even lower. I am less sure about the prospects for underlying inflation. But given the amount of policy accommodation that remains in place, and that will remain in place even if we raise our target rate another 25 basis points today, I believe the inflation risks are now on the upside. While the most recent monthly inflation numbers dipped a bit, the overall path for the last year has clearly been up. And the Greenbook forecast and other forecasts of inflation have been raised for the remainder of this year and into next year. Until further evidence is available, there is the risk of putting too much weight on the high-frequency numbers, such as the May PPI and CPI releases, and losing sight of the longer-run inflation path. Even more important than this, however, is the presence of the longer-term imbalances that we’ve talked about, which increase the risk to the economy. Most of these are largely beyond our June 29-30, 2005 119 of 234 troubles in our domestic auto industry and, of course, problems in the airline industry. Both of these latter problem areas may have undesirable spillover effects to financial markets. It also looks as if higher energy prices are here for a while, and this is reflected in futures prices. Higher energy costs will clearly squeeze energy-dependent businesses first, but I think we’ll also have uncertain trickle-down effects that can’t be good for other industries. I’ve already expressed my concerns about the unstable path of housing in at least some important local markets. I believe that the least risky policy strategy through these unusual times is to set monetary policy so that it does not contribute to unsustainable activities. Therefore, I believe that continuing on our recent policy path for the next few meetings would be the best course of action. Thank you, Mr. Chairman." FOMC20050630meeting--166 164,MR. KOHN.," Thank you, Mr. Chairman. I have three questions. The first one is on the price-to-rent ratio. We’ve been treating it as if most of the adjustment has come on prices. And I wanted to ask Josh particularly whether, as you’ve been looking at the micro data and thinking about this, the dynamics of some of these innovations that have led to a shift from renting to home ownership might have artificially depressed rents relative to prices. And I wondered, after that shift is over, if rents will start rising faster and close the gap that way—use up some of that 20 percent. My question is what you thought of that. And my observation is that that would present a much more difficult situation for us sitting around this table. It would be kind of like a supply shock because prices would be rising, inflation would be higher—and that homeowners’ equivalent rent June 29-30, 2005 54 of 234 if house prices fall. That’s a pure demand shock. But if rents start rising, that’s another matter. So I wondered if you’d comment on that. And then, while I have the floor, let me ask my questions of Glenn and John. Glenn, on the 1994 bubble analogy, I was surprised to see that classified as a bubble. I think there was some inflation scare then, but there was also a real rate adjustment at the same time. If you looked at any of the surveys, I think you wouldn’t have seen much of an increase in inflation expectations. I agree that we had to raise real rates in order to prevent that from happening. But that seems to me a very different animal than equity price changes or house-price changes because we are responsible for inflation. So if we see inflation moving, we’ve got to do something about that, whereas we’re not responsible for the relative prices of houses or equity and other things. So I wouldn’t have put 1994 on a list of situations we might think about as we’re looking at this issue of house-price gains. It seems to me very different. I’d like to hear your comment on that. And finally, my other question for John has to do with this point about the misallocation of resources. Doesn’t it matter what the state of the business cycle is? If we hadn’t had so many houses built and so much consumption over the last few years, we would have had more unemployment. So it’s not obvious that resources have been misallocated. The resources that went into building houses, furniture, and cars, and so forth might have been unemployed, especially if we had raised rates more in order to lean against the house-price increases. If we had, surely unemployment would be higher. So it seems to me that it’s one thing to talk about misallocating resources between two states of full employment, but it’s another thing to talk about a misallocation of resources where there would otherwise be slack in the economy. And the latter case I don’t think really is a misallocation of resources. There’s no opportunity cost. June 29-30, 2005 55 of 234 I’ve looked at the rent side of the picture. As to this idea that perhaps prices are getting too high relative to rents, I’d argue that they’re going to come back in line. Now, maybe rents are going to be doing some of the correcting, as it were. The work that I’ve done gives just a little hint of evidence that maybe rents do a bit of the correcting. So, what we might see going forward is rent growth slightly higher than it otherwise would have been. But statistically speaking, it’s basically no different from zero. Statistically, it doesn’t look like rents do any of the correcting. What really seems to be happening is that rents go up at some rate determined by economic conditions and then prices move around them." CHRG-111hhrg56847--255 Mr. Bernanke," There was a recession that began before--it came after the drop in the tech bubble, the dot-com bubble. March 2001, the recession began. " fcic_final_report_full--462 By 2008, the result of these government programs was an unprecedented number of subprime and other high risk mortgages in the U.S. financial system. Table 1 shows which agencies or firms were holding the credit risk of these mortgages- -or had distributed it to investors through mortgage-backed securities (MBS)-- immediately before the financial crisis began. As Table 1 makes clear, government agencies, or private institutions acting under government direction, either held or had guaranteed 19.2 million of the NTM loans that were outstanding at this point. By contrast, about 7.8 million NTMs had been distributed to investors through the issuance of private mortgage-backed securities, or PMBS, 16 primarily by private issuers such as Countrywide and other subprime lenders. The fact that the credit risk of two-thirds of all the NTMs in the financial system was held by the government or by entities acting under government control demonstrates the central role of the government’s policies in the development of the 1997-2007 housing bubble, the mortgage meltdown that occurred when the bubble deflated, and the financial crisis and recession that ensued. Similarly, the fact that only 7.8 million NTMs were held by investors and financial institutions in the form of PMBS shows that this group of NTMs were less important as a cause of the financial crisis than the government’s role. The Commission majority’s report focuses almost entirely on the 7.8 million PMBS, and is thus an example of its determination to ignore the government’s role in the financial crisis. Table 1. 17 Entity No. of Subprime Unpaid Principal Amount and Alt-A Loans Fannie Mae and Freddie Mac 12 million $1.8 trillion FHA and other Federal* 5 million $0.6 trillion CRA and HUD Programs 2.2 million $0.3 trillion Total Federal Government 19.2 million $2.7 trillion Other (including subprime and 7.8 million $1.9 trillion Alt-A PMBS issued by Countrywide, Wall Street and others) Total 27 million $4.6 trillion *Includes Veterans Administration, Federal Home Loan Banks and others. To be sure, the government’s efforts to increase home ownership through the AH goals succeeded. Home ownership rates in the U.S. increased from approximately 64 percent in 1994 (where it had been for 30 years) to over 69 percent in 2004. 18 Almost everyone in and out of government was pleased with this—a long term goal 16 In the process known as securitization, securities backed by a pool of mortgages (mortgage- backed securities, or MBS) and issued by private sector firms were known as private label securities (distinguishing them from securities issued by the GSEs or Ginnie Mae) or private MBS (PMBS). 17 See Edward Pinto’s analysis in Exhibit 2 to the Triggers Memo, April 21, 2010, p.4. http://www.aei.org/ docLib/Pinto-Sizing-Total-Federal-Contributions.pdf. 18 Census Bureau data. 457 of U.S. housing policy—until the true costs became clear with the collapse of the housing bubble in 2007. Then an elaborate process of shifting the blame began. 2. The Great Housing Bubble and Its Effects CHRG-111hhrg55809--195 Mr. Bernanke," In principle, it would be great. But there are two practical problems that we have to try to confront. One is actually identifying the bubble. And when the policies in question were taking place in 2003, 2004, there really was substantial disagreement among experts about whether this was a bubble and how big it was. The other problem is that by using monetary policy, which is a very blunt tool, to try to pop bubbles, you may have a side effect of having bad effects on the rest of the economy, because you can't just target one sector. That is why, even though, as I say, I am open-minded about the role of monetary policy in bubbles, in affecting bubbles, I do think that the first line of defense needs to be a stronger regulatory system that would, on the one hand, prevent excessive build-ups of risk in the first place; and if they do pop and if there is a problem like that, would make the system strong enough that it wouldn't create such an enormous crisis as we have seen recently. " CHRG-111hhrg48874--189 Mr. Foster," Yes. But you could actually imagine that someone like you would be in a position where the economy is going and the bubble is going up, and, you know, half of this committee is asking you, why are you squeezing the bubble when it's bubbling up? It seems to me that if you could establish formulas that at least provided a basis level for what the loan to value ought to be, then--and established a very high political threshold for changing that formula, that you'd have a much better defense against political pressure to, you know, not rain on the parade. " fcic_final_report_full--75 This resilience led many executives and regulators to presume the financial sys- tem had achieved unprecedented stability and strong risk management. The Wall Street banks’ pivotal role in the Enron debacle did not seem to trouble senior Fed of- ficials. In a memorandum to the FCIC, Richard Spillenkothen described a presenta- tion to the Board of Governors in which some Fed governors received details of the banks’ complicity “coolly” and were “clearly unimpressed” by analysts’ findings. “The message to some supervisory staff was neither ambiguous nor subtle,” Spillenkothen wrote. Earlier in the decade, he remembered, senior economists at the Fed had called Enron an example of a derivatives market participant successfully regulated by mar- ket discipline without government oversight.  The Fed cut interest rates aggressively in order to contain damage from the dot- com and telecom bust, the terrorist attacks, and the financial market scandals. In Jan- uary , the federal funds rate, the overnight bank-to-bank lending rate, was .. By mid-, the Fed had cut that rate to just , the lowest in half a century, where it stayed for another year. In addition, to offset the market disruptions following the / attacks, the Fed flooded the financial markets with money by purchasing more than  billion in government securities and lending  billion to banks. It also suspended restrictions on bank holding companies so the banks could make large loans to their securities affiliates. With these actions the Fed prevented a protracted liquidity crunch in the financial markets during the fall of , just as it had done during the  stock market crash and the  Russian crisis. Why wouldn’t the markets assume the central bank would act again—and again save the day? Two weeks before the Fed cut short-term rates in January , the Economist anticipated it: “the ‘Greenspan put’ is once again the talk of Wall Street. . . . The idea is that the Federal Reserve can be relied upon in times of crisis to come to the rescue, cutting interest rates and pumping in liquidity, thus providing a floor for equity prices.”  The “Greenspan put” was analysts’ shorthand for investors’ faith that the Fed would keep the capital markets functioning no matter what. The Fed’s policy was clear: to restrain growth of an asset bubble, it would take only small steps, such as warning investors some asset prices might fall; but after a bubble burst, it would use all the tools available to stabilize the markets. Greenspan argued that intentionally bursting a bubble would heavily damage the economy. “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences,” he said in , when housing prices were ballooning, “we chose . . . to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.’”  CHRG-109hhrg28024--108 Chairman Oxley," The gentleman yields back. The gentle lady from California, Ms. Waters. Ms. Waters. Thank you very much, Mr. Chairman. I'm pleased to be here with you, Mr. Bernanke. I welcome you to this committee. We are going to miss Mr. Greenspan. No one talks like him, and we don't want you to. I had a great relationship with him. He's been to my district. I'm going to invite you. I want to continue this discussion this morning about rising inequality in two ways. I'm going to talk about housing a little bit more. It's been alluded to any number of ways this morning. I want to talk about the fact that many Americans are priced out of the market. They are not able to buy homes because of the rising cost. I am going to talk about this in relationship to affordable housing and what the Government can or cannot do. Some of the policies of this Administration are such that we don't have support for low- or moderate-income housing that we thought we had, and the cuts that are being made will eliminate the opportunities for first time home buyers and others to get into the housing market. We are concerned about this iddur. I'm also concerned about the bubble. The fact is that some people are stretched to buy a house. It cost too much. They got the special product loans, interest only loans, et cetera. And what is that going to mean to the economy if in fact this bubble does burst? I'd like you to give us a little discussion about housing and housing affordability in relationship to some of the things to which I've alluded and the rising interest rates. Secondly, I want to talk about investment in poor and minority communities. I used to have this conversation with Mr. Greenspan all the time. When I invited him to my district, it was to engage entrepreneurs and business persons and the financial services community in conversation about investment in poor communities. We know we have things like the new markets initiative that's been very helpful and could be even more helpful if in fact we could do more of that. What do you envision? What advice could you give us about how we could spur investment in these poorer communities, where investment can be the only possibility for growing these communities and expanding opportunities for jobs, et cetera? Do you have any ideas about this issue? What can you advise us? What can you work on that would help to expand the idea of the new market tax credit initiative in order to grow these poor communities? " FinancialCrisisReport--69 Mr. Vanasek shared his concerns with Mr. Killinger. At the Subcommittee’s hearing, Mr. Killinger testified: “Now, beginning in 2005, 2 years before the financial crisis hit, I was publicly and repeatedly warning of the risks of a potential housing downturn.” 177 In March 2005, he engaged in an email exchange with Mr. Vanasek, in which both agreed the United States was in the midst of a housing bubble. On March, 10, 2005, Mr. Vanasek emailed Mr. Killinger about many of the issues facing his risk management team, concluding: “My group is working as hard as I can reasonably ask any group to work and in several cases they are stretched to the absolute limit. Any words of support and appreciation would be very helpful to the morale of the group. These folks have stepped up to fixing any number of issues this year, many not at all of their own making.” 178 Mr. Killinger replied: “Thanks Jim. Overall, it appears we are making some good progress. Hopefully, the Regulators will agree that we are making some progress. I suspect the toughest thing for us will be to navigate through a period of high home prices, increased competitive conditions for reduced underwriting standards, and our need to grow the balance sheet. I 177 April 13, 2010 Subcommittee Hearing at 85. 178 3/2005 WaMu internal email chain, Hearing Exhibit 4/13-78. have never seen such a high risk housing market as market after market thinks they are unique and for whatever reason are not likely to experience price declines. This typically signifies a bubble.” fcic_final_report_full--173 As one recent study argues, many economists were “agnostics” on housing, un- willing to risk their reputations or spook markets by alleging a bubble without find- ing support in economic theory.  Fed Vice Chairman Donald Kohn was one. “Identification [of a bubble] is a tricky proposition because not all the fundamental factors driving asset prices are directly observable,” Kohn said in a  speech, cit- ing research by the European Central Bank. “For this reason, any judgment by a cen- tral bank that stocks or homes are overpriced is inherently highly uncertain.”  But not all economists hesitated to sound a louder alarm. “The situation is begin- ning to look like a credit-induced boom in housing that could very well result in a systemic bust if credit conditions or economic conditions should deteriorate,” Federal Deposit Insurance Corporation Chief Economist Richard Brown wrote in a March  report. “During the past five years, the average U.S. home has risen in value by , while homes in the fastest-growing markets have approximately doubled in value.” While this increase might have been explained by strong market fundamen- tals, “the dramatic broadening of the housing boom in  strongly suggests the in- fluence of systemic factors, including the low cost and wide availability of mortgage credit.”  A couple of months later, Fed economists in an internal memo acknowledged the possibility that housing prices were overvalued, but downplayed the potential im- pacts of a downturn. Even in the face of a large price decline, they argued, defaults would not be widespread, given the large equity that many borrowers still had in their homes. Structural changes in the mortgage market made a crisis less likely, and the financial system seemed well capitalized. “Even historically large declines in house prices would be small relative to the recent decline in household wealth owing to the stock market,” the economists concluded. “From a wealth-effects perspective, this seems unlikely to create substantial macroeconomic problems.”  CHRG-111hhrg53248--19 Mr. Royce," Thank you. I think getting to the bottom of what caused the housing bubble should be our primary objective here. And in point of fact, it was the Fed that came to us, came to this committee, and came to the Senate committee, and said that because of the size of the portfolios of Fannie and Freddie and because of the leverage ratios of 100 to 1, 100 to 1 in leverage, because of the direction for them to have purchased a trillion in subprime mortgages for their political, for their affordable housing goals and so forth, that they had to be regulated for systemic risk. In 2003, I put in a bill to do that working with the Fed. In 2005, we in fact had my amendment on the Floor to try to give the regulators the ability to regulate for systemic risk. Fannie and Freddie opposed it. Franklin Raines opposed it. It was opposed by most of the Members of this House. But in 2006, in the Senate, they actually got it out of committee. But again, the Democratic Members on the Senate side opposed that regulation to give the regulators the ability to handle Fannie and Freddie for systemic risk. That is the history of this. We need to address it. " CHRG-111shrg57923--39 Mr. Mendelowitz," Yes, Senator. This discussion about the housing bubble, I think, gives us an insight into what the need for the NIF is. While Steve said back in 2007 he saw it, those of you--but basically 5 years ago, I started predicting a major credit event in the housing sector that was going to push the economy into the worst recession since the Second World War, and it was really just based upon looking at relatively small data sets that went to what was happening to housing prices, what was happening to household income, and what was happening on the delinquency and default rate on mortgages, all of which was readily available data. So it was easy to predict a major credit event in housing and it was easy to predict, because of the widespread nature of home ownership, that this was going to lead to a recession that was going to be driven by falling consumption. That was the easy piece of it. Now we are saying the fact the Fed didn't see it, because they were using the standard monetarist model, and if you can't see something with the monetarist model, you don't see it. But what I didn't see and couldn't see and couldn't understand was how what was happening in the housing sector was going to lead to the collapse in the financial sector. And it is the kind of data that we are talking about the NIF collecting that would provide that insight, and there is no substitute for that. There is no alternative. There is no shortcut. Because at the end of the day, you have to know where the concentrations of risks are and you have to know what the nature of the intertwined network of financial firms and their obligations are, because it is the combination of concentrations of risk and the exposure of the network that can produce a domino effect of multiple failures that creates a systemic risk. And so it is one thing to see a macroeconomic crisis tied to something like housing. It is something entirely different--the data needs are entirely different when it comes to understanding the systemic risk that flows from those concentrations of risk. Senator Reed. I want to thank you all for excellent testimony, thought provoking, and also for your advancing this issue. I think we leave here with, one, we need better data. We need better analysis. And if we don't achieve it in the next several months, the bubbles that might be out there percolating, if that is the right term, will once again catch us by surprise and we shouldn't let that happen. But thank you all very, very much. Thank you. " CHRG-111hhrg53245--155 Mr. Zandi," Well, I think one of the root causes of the bubble in the housing market was that the process of securitization was fundamentally broken, that no one in the chain of the process had a clear understanding of all the risks in its entirety. The lenders made the loan. They sold it to the investment banks. The investment bank's package got the rating. The rating agencies then put their stamp on it. And then it was sold to Goldman investors. And no one was really looking at the entire system, making sure that the structure was properly working, that the loans that were ultimately being made were good loans. So the process of securitization fell apart. It just was not functioning well because in my view there was not a systemic risk regulator looking at it holistically and saying, does this make sense, and will it work if it is stressed under a bad economy, under a bad housing market? " FinancialCrisisInquiry--481 THOMPSON: So a bubble mentality. fcic_final_report_full--456 The Commission’s authorizing statute required that the Commission report on or before December 15, 2010. The original plan was for us to start seeing drafts of the report in April. We didn’t see any drafts until November. We were then given an opportunity to submit comments in writing, but never had an opportunity to go over the wording as a group or to know whether our comments were accepted. We received a complete copy of the majority’s report, for the first time, on December 15. It was almost 900 double-spaced pages long. The date for approval of the report was eight days later, on December 23. That is not the way to achieve a bipartisan report, or the full agreement of any group that takes the issues seriously. This dissenting statement is organized as follows: Part I summarizes the main points of the dissent. Part II describes how the failure of subprime and other high risk mortgages drove the growth of the bubble and weakened financial institutions around the world when these mortgages began to default. Part III outlines in detail the housing policies of the U.S. government that were primarily responsible for the fact that approximately one half of all U.S. mortgages in 2007 were subprime or otherwise of low quality. Part IV is a brief conclusion. -----------------------------------------------------Page 478-----------------------------------------------------  fcic_final_report_full--423 CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS CONTENTS Introduction ......................................................................................................  How Our Approach Differs from Others’ .........................................................  Stages of the Crisis .............................................................................................  The Ten Essential Causes of the Financial and Economic Crisis .......................  The Credit Bubble: Global Capital Flows, Underpriced Risk, and Federal Reserve Policy ................................................................................  The Housing Bubble .........................................................................................  Turning Bad Mortgages into Toxic Financial Assets .........................................  Big Bank Bets and Why Banks Failed ...............................................................  Two Types of Systemic Failure ...........................................................................  The Shock and the Panic ...................................................................................  The System Freezing .........................................................................................  INTRODUCTION We have identified ten causes that are essential to explaining the crisis. In this dis- senting view: • We explain how our approach differs from others’; • We briefly describe the stages of the crisis; • We list the ten essential causes of the crisis; and • We walk through each cause in a bit more detail. We find areas of agreement with the majority’s conclusions, but unfortunately the areas of disagreement are significant enough that we dissent and present our views in this report. We wish to compliment the Commission staff for their investigative work. In many ways it helped shape our thinking and conclusions. Due to a length limitation recently imposed upon us by six members of the Com- mission,  this report focuses only on the causes essential to explaining the crisis. We regret that the limitation means that several important topics that deserve a much fuller discussion get only a brief mention here.  FinancialCrisisInquiry--221 How do you predict the long-term recovery? And how long do you think that recovery— how much longer will it take in circumstances like that? ZANDI: Well, first, let me say that one of the hallmarks of the Great Recession was how broad- based it was across industries and regions of the country. I mean, in past recessions, you always had a large region or two that avoided the recession, and that was a safety valve. People could move from Michigan and go to Florida or move from California to Nevada, and that wasn’t the case in this downturn. Now, having said that, obviously, there are some areas that are harder hit than others and those that suffer— well, were in the housing boom and bubble and now suffered the housing bust are the most severely hit, and that would include Nevada, Las Vegas, Arizona, California, particularly the Central Valley of California, Florida, Rhode Island, interestingly enough, for various reasons, and, obviously, parts of the industrial Midwest. And it will take much, much longer for an economy like Nevada and Florida to turn because its economic base is much less diversified. Obviously, it’s related to leisure and hospitality, which is a discretionary purchase and will not turn, and migration flows. And as I mentioned earlier, migration is going to be significantly impaired because one-third of homeowners with first mortgages, by my calculation, are underwater and can’t move or won’t move as easily. So Nevada’s problems are very severe and will be very long lasting. VICE CHAIRMAN THOMAS: Isn’t it also home construction? I mean, that was one of the fundamental industries in all those areas. And when that’s the problem and you can’t do it, you implode. ZANDI: Well, I—I would say housing in its totality, so that would include housing transactions, home sales. That’s demand, house prices ... and, obviously, housing construction. CHRG-111shrg57319--559 Mr. Killinger," If market conditions were satisfactory and we could execute profitably on that---- Senator Levin. That is always true about market conditions, but your plan was, ``Our Home Loans group should complete its repositioning within the next 12 months and will be in a position to profitably grow its market share of Option ARM, home equity, subprime, and Alt A.'' Those are the high-risk loans. I am just reading your own words. Now, let us turn to Exhibit 34,\1\ which is an internal WaMu review by its Risk Mitigation and Mortgage Fraud Group. This is September 8, 2008. You are right here on the brink of going out of business, but that is not the point here that I am trying to read.--------------------------------------------------------------------------- \1\ See Exhibit 34, which appears in the Appendix on page 564.--------------------------------------------------------------------------- Take a look at the first finding. This is September 8, 2008. This is, I think, a couple weeks before you were taken over. The first finding of the review, page 3. I want to get back to all the fraud here, because it is one thing to say that you could not know with certainty that there was a housing bubble that was going to burst, even though you predicted it. The issue is not that you did not know when the housing bubble would burst. The problem is what did you know about what was going on in your own company in terms of how much fraud was going on. That becomes the issue that I want to focus on, the level of fraud and what you knew or did not know about that. Here is what you were told in 2008. This is September 8, 2008. ``The controls that are intended to prevent the sale of loans that have been confirmed by Risk Mitigation to contain misrepresentations or fraud are not currently effective.'' Now, that should have set off some alarm bells. Your fraud controls and misrepresentation controls are not effective. And it says, ``There is not a systemic process to prevent a loan in the Risk Mitigation Inventory and/or confirmed to contain suspicious activity from being sold to an investor.'' And then there is a test of 25 loans; 11 reflect a sale date after the completion of the investigation which confirmed fraud. That is going on inside your company. You cannot predict with certainty the bubble. But this is what is happening inside your company when you got that report. Maybe I should ask Mr. Rotella as well. You got this report. What was your reaction? " fcic_final_report_full--169 COMMISSION CONCLUSIONS ON CHAPTER 8 The Commission concludes declining demand for riskier portions (or tranches) of mortgage-related securities led to the creation of an enormous volume of col- lateralized debt obligations (CDOs). These CDOs—composed of the riskier tranches—fueled demand for nonprime mortgage securitization and contributed to the housing bubble. Certain products also played an important role in doing so, including CDOs squared, credit default swaps, synthetic CDOs, and asset- backed commercial paper programs that invested in mortgage-backed securities and CDOs. Many of these risky assets ended up on the balance sheets of systemi- cally important institutions and contributed to their failure or near failure in the financial crisis. Credit default swaps, sold to provide protection against default to purchasers of the top-rated tranches of CDOs, facilitated the sale of those tranches by con- vincing investors of their low risk, but greatly increased the exposure of the sellers of the credit default swap protection to the housing bubble’s collapse. Synthetic CDOs, which consisted in whole or in part of credit default swaps, enabled securitization to continue and expand even as the mortgage market dried up and provided speculators with a means of betting on the housing market. By layering on correlated risk, they spread and amplified exposure to losses when the housing market collapsed. The high ratings erroneously given CDOs by credit rating agencies encour- aged investors and financial institutions to purchase them and enabled the con- tinuing securitization of nonprime mortgages. There was a clear failure of corporate governance at Moody’s, which did not ensure the quality of its ratings on tens of thousands of mortgage-backed securities and CDOs. The Securities and Exchange Commission’s poor oversight of the five largest investment banks failed to restrict their risky activities and did not require them to hold adequate capital and liquidity for their activities, contributing to the fail- ure or need for government bailouts of all five of the supervised investment banks during the financial crisis. CHRG-109shrg24852--51 Chairman Greenspan," I do not know that. That is factually capable of being ascertained, and I assume some of my colleagues do know the answer to that question. It is not, in my judgment, at least what I have heard, an issue that is critical or something that requires immediate response. But it is enough of an issue that I think we have to look at it, and that is what we are doing, we are looking very closely. Senator Allard. I appreciate your response on that. Now, on various occasions you have downplayed the idea of a national housing bubble, and have instead pointed to a situation which some regions of the country are exhibiting signs of, I quote, ``froth'' I guess. And I am pleased to hear comments that while housing prices may well decline, such a decline would not necessarily derail the economy. Would you not agree though that while this may be true for the Nation as a whole, a correction could have a significant impact within a specific community or region? Could you please elaborate what the future could hold for such a city or region, and what can or should be done to mitigate the damage such a correction could cause? " fcic_final_report_full--19 BEFORE OUR VERY EYES In examining the worst financial meltdown since the Great Depression, the Financial Crisis Inquiry Commission reviewed millions of pages of documents and questioned hundreds of individuals—financial executives, business leaders, policy makers, regu- lators, community leaders, people from all walks of life—to find out how and why it happened. In public hearings and interviews, many financial industry executives and top public officials testified that they had been blindsided by the crisis, describing it as a dramatic and mystifying turn of events. Even among those who worried that the housing bubble might burst, few—if any—foresaw the magnitude of the crisis that would ensue. Charles Prince, the former chairman and chief executive officer of Citigroup Inc., called the collapse in housing prices “wholly unanticipated.”  Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., which until  was the largest single shareholder of Moody’s Corporation, told the Commission that “very, very few people could appreciate the bubble,” which he called a “mass delusion” shared by “ million Americans.”  Lloyd Blankfein, the chairman and chief executive officer of Goldman Sachs Group, Inc., likened the financial crisis to a hurricane.  Regulators echoed a similar refrain. Ben Bernanke, the chairman of the Federal Reserve Board since , told the Commission a “perfect storm” had occurred that regulators could not have anticipated; but when asked about whether the Fed’s lack of aggressiveness in regulating the mortgage market during the housing boom was a failure, Bernanke responded, “It was, indeed. I think it was the most severe failure of the Fed in this particular episode.”  Alan Greenspan, the Fed chairman during the two decades leading up to the crash, told the Commission that it was beyond the abil- ity of regulators to ever foresee such a sharp decline. “History tells us [regulators] cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be.”  In fact, there were warning signs. In the decade preceding the collapse, there were many signs that house prices were inflated, that lending practices had spun out of control, that too many homeowners were taking on mortgages and debt they could ill afford, and that risks to the financial system were growing unchecked. Alarm bells  were clanging inside financial institutions, regulatory offices, consumer service or- ganizations, state law enforcement agencies, and corporations throughout America, as well as in neighborhoods across the country. Many knowledgeable executives saw trouble and managed to avoid the train wreck. While countless Americans joined in the financial euphoria that seized the nation, many others were shouting to govern- ment officials in Washington and within state legislatures, pointing to what would become a human disaster, not just an economic debacle. “Everybody in the whole world knew that the mortgage bubble was there,” said Richard Breeden, the former chairman of the Securities and Exchange Commission appointed by President George H. W. Bush. “I mean, it wasn’t hidden. . . . You cannot look at any of this and say that the regulators did their job. This was not some hidden problem. It wasn’t out on Mars or Pluto or somewhere. It was right here. . . . You can’t make trillions of dollars’ worth of mortgages and not have people notice.”  Paul McCulley, a managing director at PIMCO, one of the nation’s largest money management firms, told the Commission that he and his colleagues began to get wor- ried about “serious signs of bubbles” in ; they therefore sent out credit analysts to  cities to do what he called “old-fashioned shoe-leather research,” talking to real es- tate brokers, mortgage brokers, and local investors about the housing and mortgage markets. They witnessed what he called “the outright degradation of underwriting standards,” McCulley asserted, and they shared what they had learned when they got back home to the company’s Newport Beach, California, headquarters. “And when our group came back, they reported what they saw, and we adjusted our risk accord- ingly,” McCulley told the Commission. The company “severely limited” its participa- tion in risky mortgage securities.  FinancialCrisisInquiry--709 ZANDI: Well, first, let me say that one of the hallmarks of the Great Recession was how broad- based it was across industries and regions of the country. I mean, in past recessions, you always had a large region or two that avoided the recession, and that was a safety valve. People could move from Michigan and go to Florida or move from California to Nevada, and that wasn’t the case in this downturn. Now, having said that, obviously, there are some areas that are harder hit than others and those that suffer— well, were in the housing boom and bubble and now suffered the housing bust are the most severely hit, and that would include Nevada, Las Vegas, Arizona, California, particularly the Central Valley of California, Florida, Rhode Island, interestingly enough, for various reasons, and, obviously, parts of the industrial Midwest. And it will take much, much longer for an economy like Nevada and Florida to turn because its economic base is much less diversified. Obviously, it’s related to leisure and hospitality, which is a discretionary purchase and will not turn, and migration flows. And as I mentioned earlier, migration is going to be significantly impaired because one-third of homeowners with first mortgages, by my calculation, are underwater and can’t move or won’t move as easily. So Nevada’s problems are very severe and will be very long lasting. FinancialCrisisInquiry--482 BASS: Well, do we prick the bubble or not? All right? CHRG-111shrg55739--117 Mr. Coffee," Let me say you are right, Senator. You probably wanted to hear that. You are right. And I have some charts in my statement that show that the percentage of liar loans, no-document and low-document loans, in subprime mortgages went from in the year 2001 about 28 percent to the year 2006 about 51 percent. That is a very sharp jump, and no one noticed because no one really wanted to look. The loan originators had no interest because they got rid of the entire loan. Senator Bunning. But the Federal Reserve was responsible for overseeing the banks that made those loans, and/or the mortgage brokers, we gave that power to the Fed and just because they did not write any regulations, we ran into all this mischief. And so the housing bubble and the bursting of it was caused by some not doing their homework. " CHRG-111hhrg49968--136 Mr. Nunes," There is some concern out there and there are some numbers that float out there that basically the Federal Government, in some form or fashion, is involved in 75 percent of all mortgage-backed securities, of all mortgages out there. And I think there is a concern out there that this could create another bubble, a different type of bubble long term where essentially you have the Federal Government owning everyone's home or their mortgage. Do you see this trend continuing? Do you agree with the 75 percent number? Is it lower than that? " fcic_final_report_full--117 The origination and securitization of these mortgages also relied on short-term fi- nancing from the shadow banking system. Unlike banks and thrifts with access to de- posits, investment banks relied more on money market funds and other investors for cash; commercial paper and repo loans were the main sources. With house prices al- ready up  from  to , this flood of money and the securitization appara- tus helped boost home prices another  from the beginning of  until the peak in April —even as homeownership was falling. The biggest gains over this pe- riod were in the “sand states”: places like the Los Angeles suburbs (), Las Vegas (), and Orlando (). FOREIGN INVESTORS: “AN IRRESISTIBLE PROFIT OPPORTUNITY ” From June  through June , the Federal Reserve kept the federal funds rate low at  to stimulate the economy following the  recession. Over the next two years, as deflation fears waned, the Fed gradually raised rates to . in  quarter- point increases. In the view of some, the Fed simply kept rates too low too long. John Taylor, a Stanford economist and former under secretary of treasury for international affairs, blamed the crisis primarily on this action. If the Fed had followed its usual pattern, he told the FCIC, short-term interest rates would have been much higher, discourag- ing excessive investment in mortgages. “The boom in housing construction starts would have been much more mild, might not even call it a boom, and the bust as well would have been mild,” Taylor said.  Others were more blunt: “Greenspan bailed out the world’s largest equity bubble with the world’s largest real estate bubble,” wrote William A. Fleckenstein, the president of a Seattle-based money management firm.  Ben Bernanke and Alan Greenspan disagree. Both the current and former Fed chairman argue that deciding to purchase a home depends on long-term interest rates on mortgages, not the short-term rates controlled by the Fed, and that short- term and long-term rates had become de-linked. “Between  and , the fed funds rate and the mortgage rate moved in lock-step,” Greenspan said.  When the Fed started to raise rates in , officials expected mortgage rates to rise, too, slow- ing growth. Instead, mortgage rates continued to fall for another year. The construc- tion industry continued to build houses, peaking at an annualized rate of . million starts in January —more than a -year high. As Greenspan told Congress in , this was a “conundrum.”  One theory pointed to foreign money. Developing countries were booming and—vulnerable to financial problems in the past—encouraged strong saving. Investors in these coun- tries placed their savings in apparently safe and high-yield securities in the United States. Fed Chairman Bernanke called it a “global savings glut.”  CHRG-111shrg57923--25 Mr. Liechty," I would be happy to. I will echo what Allan has said, what Dr. Mendelowitz has said, about in the importance in terms of political pressures that the institute is able to act in a way that it feels is in the best interest for the country. I have five reasons for being here: Joseph, Jacob, Sam, Matt, and Tom, my five boys. I want them to have a safe, secure financial system that gives them the same opportunity as I had when they grow up and get into the real world and start providing for a family. I think you need to have somebody who has the ability to speak the truth in the middle of a crisis or in the buildup to a crisis and can have the protection. There are really two roles that you think about in terms of systemic regulation. One is advisory, seeing and understanding the risks, and then speaking about them. The second one is the actual regulatory implementation, the different actions you might take in terms of how capital requirements--or how the institutions themselves are regulated. And I think it is very important to separate those two, and making the National Institute of Finance independent would do that. A second point that you want to consider in terms of why you want to keep the National Institute of Finance independent and why you want to also have somebody of high stature involved who is a Presidential appointee, who is going to be able to serve not at the will of the President but for a fixed term, is that if there is a crisis, again, that does happen and the National Institute of Finance is in place, all eyes will turn to the National Institute of Finance. And it needs to have absolute credibility. It needs in some sense to be like the National Oceanic and Atmospheric Administration. When it speaks, it is not speaking because it has some political agenda or because it has to worry about whether its budget is going to be cut or not cut. It is speaking because it is trying to serve the best interests of the Nation. Senator Reed. I want to invite the other panelists to comment also, but one other factor that I think strikes me is that it goes to your point about surprise, and I thought the analogy with the hurricane of 1938 was--I will borrow it. It seems very compelling. But part of this was this was never seriously discussed at a national level--``this'' meaning the growing housing bubble, the national characteristics of it, the growing derivatives trade from a notional value of X to 200X. And as a result, it sort of got lost in the shuffle, and I think one of the purposes of having an agency like this is to get critical topics on the agenda of Congress and the regulators. Then it is our responsibility. But if you do not have an authoritative institution supported by data doing that, then the problem I think you will have is that the next time it will be something different. It will not be a housing bubble and subprime mortgages. It will be something we are not even thinking about, and it will come up. Regulators will talk about it. I am sure the Fed debated internally about the housing bubble. I am sure that the OCC and everybody did. But it never broke through because there was no one tasked with saying this is a serious systemic risk or should be considered at least at this juncture as such. So that is my two bits on the point. Dr. Engle, please, and then Mr. Horne. " CHRG-111shrg57319--523 Mr. Killinger," I do not recall my exact timing. I do remember making public comments beginning in the middle part of 2005. I remember talking to the board from time to time about that there was growing risk because housing prices are growing faster than the rate of inflation. But also at the same time, I can remember everybody arguing of why that is going to be OK and it is unlikely to be a significant downturn in housing. We were kind of the front edge of trying to assess that there was a concern here. Senator Coburn. Well, that follows into my second question because in January 2005 is when you pushed forward a high-risk lending strategy for board approval. Only 2 months earlier, if you saw that prices would decline in the near future, why would you be pushing through a high-risk strategy on a market that you thought was a bubble? " CHRG-111hhrg53245--122 Mr. Garrett," It is not in their rules that they should be weighing in with regard to asset bubbles? " CHRG-109hhrg22160--148 Mr. Garrett," The bubble is about to burst as soon as I buy my house down here in the Washington, D.C., area. I assume it is going to--that is when the market price will start going down again. But going back to the GSEs. Assuming we take some action with regard to the regulatory nature of them, along the lines that have been suggested, is there some other method that we could also be looking into, a more efficient way to finance mortgages back into the private sector, to open up the private sector to allow them to have a more, if you will, competitive on a same playing field, that they can compete with the GSEs and open up that market so that they--if we are not just purely through the regulatory climate, we are actually allowing them to bring down that effect as well. " CHRG-111hhrg56776--57 Mr. Bernanke," If interest rates are below their normal levels, it is because the economy is operating at a very low level. Currently, we are not in anything an economist would call optimum equilibrium or anything like that. We certainly are in a situation where a lot of people are out of work and consumption is well below its normal levels and low interest rates serve the function of increasing demand and putting people back to work. Dr. Paul. You do not think that if interest rates are 2 and 3 percent instead of 6 percent, without artificially low interest rates, there would not be a temptation for people to build too many houses or people to try to capitalize on the fact they are anticipating price inflation and in the bubble? " FinancialCrisisReport--259 C. Mass Credit Rating Downgrades In the years leading up to the financial crisis, Moody’s and S&P together issued investment grade ratings for tens of thousands of RMBS and CDO securities, earning substantial sums for issuing these ratings. In mid-2007, however, both credit rating agencies suddenly reversed course and began downgrading hundreds, then thousands of RMBS and CDO ratings. These mass downgrades shocked the financial markets, contributed to the collapse of the subprime RMBS and CDO secondary markets, triggered sales of assets that had lost investment grade status, and damaged holdings of financial firms worldwide. Perhaps more than any other single event, the sudden mass downgrades of RMBS and CDO ratings were the immediate trigger for the financial crisis. To understand why the credit rating agencies suddenly reversed course and how their RMBS and CDO ratings downgrades impacted the financial markets, it is useful to review trends in the housing and mortgage backed security markets in the years leading up to the crisis. (1) Increasing High Risk Loans and Unaffordable Housing The years prior to the financial crisis saw increasing numbers of borrowers buying not only more homes than usual, but higher priced homes, requiring larger and more frequent loans that were constantly refinanced. By 2005, about 69% of Americans had purchased homes, the largest percentage in American history. 1005 In the five-year period running up to 2006, the median home price, adjusted for inflation, increased 50 percent. 1006 The pace of home price appreciation was on an unsustainable trajectory, as is illustrated by the chart below. 1007 1003 4/27/2007 email from Yuri Yoshizawa to Noel Kirnon, PSI-MOODYS-RFN-000044 (Attachment, PSI- MOODYS-RFN-000045). 1004 See S&P’s “Global Compensation Guidelines 2007/2008,” S&P-SEC 067708, 067733, 067740, and 067747. 1005 See 3/1/2006 “Housing Vacancies and Homeownership Annual Statistics: 2005,” U.S. Census Bureau. 1006 “Housing Bubble Trouble,” The Weekly Standard (4/10/2006). 1007 1/25/2010, “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/23-1j. CHRG-111shrg51290--65 Many of these risky mortgage instruments were made in areas where housing was least affordable, such as California, Florida and Arizona, leading to concentrated areas of unsustainable housing values. (See Figures 3 and 4). This concentration of risky loans put the entire local markets at risk, due to the sudden and extreme withdrawal of credit in the aftermath of a bubble.\10\ \10\ See Susan M. Wachter, Andrey D. Pavlov & Zoltan Pozsar, Subprime Lending and Real Estate Markets, in Mortgage and Real Estate Finance__(Stefania Perrucci, ed., Risk Books 2008).--------------------------------------------------------------------------- Figure 3. Geographic Distribution of Interest-Only Loans, 2006.\11\--------------------------------------------------------------------------- \11\ Anthony Pennington-Cross, Mortgage Product Substitution and State Predatory Lending Laws, Presentation at the 2008 Mid-Year Meeting of the American Real Estate and Urban Economics Association, Washington, D.C., May 27, 2008. Figure 4. Geographic Distribution of Low-Documentation Loans, 2006\12\--------------------------------------------------------------------------- \12\ Id. fcic_final_report_full--403 H o u se h o l d Net W ort h The crisis wiped out much more wealth than other recent events such as the bursting of the dot-com bubble in 2000. IN TRILLIONS OF DOLLARS $ 7 0 60 50 $54.9 4 0 30 20 10 0 1952 1960 19 7 0 1980 1990 2000 2010 NO TE: Net worth i s assets m i nus li ab ili t i es for U . S . househo l ds . SOURC E: F edera l Reserve Fl ow of F unds Report Figure . early in . The homeownership rate declined from its peak of . in  to . as of the fall of . Because so many American households own homes, and because for most homeowners their housing represents their single most important asset, these declines have been especially debilitating. Borrowing via home equity loans or cash-out refinancing has fallen sharply. At an FCIC hearing in Bakersfield, California, Marie Vasile explained how her family had relocated  miles into the mountains to a rental house to help her hus- band’s fragile health.  Their old home was put up for sale and languished on the mar- ket, losing value. Eventually, she and her husband found buyers willing to take their house in a “short sale”—that is, a sale at a price less than the balance of the mortgage. But because the lender was acting slowly to approve that deal, they risked losing the sale and then going into foreclosure. “To top this all off,” Vasile told commissioners, “my husband is in the position of possibly losing his job. . . . So not only do I have a house that I don’t know what’s happening to, I don’t know if he’s going to have a job come December. This is more than I can handle. I’m not eating. I’m not sleeping.” Serious mortgage delinquencies—payments that are late  days or more or homes in the foreclosure process—have spread since the crisis. Among regions, the eastern states in the Midwest (Ohio, Indiana, Illinois, Wisconsin, and Michigan) had the highest delinquency rate, topping  in .  By fall , this rate had risen to .. Other regions also endured high rates—especially the so-called sand states, where the housing crisis was the worst. The third quarter  serious delinquency rate for Florida was .; Nevada, .; Arizona, .; and California, .. The data company CoreLogic identified the  housing markets with the worst records of “distressed” sales, which include short sales and sales of foreclosed proper- ties. Las Vegas led the list in mid-, with distressed sales accounting for more than  of all home sales.  “The state was overbuilt and some , jobs were predicated on a level of growth and consumer spending that seemed to evaporate al- most overnight,” Jeremy Aguero, an economic and marketing analyst who follows the Nevada economy, testified to the Commission.  fcic_final_report_full--448 The inability to find funding, financial firm deleveraging, and macroeconomic weakness translated into tighter credit for consumers and businesses. Securitization markets for other kinds of debt collapsed rapidly in  and still have not recovered fully, cutting off a substantial source of financing for credit cards, car loans, student loans, and small business loans. Decreased credit availability, the collapse of the housing bubble, and additional wealth losses from a declining stock market led to a sharp contraction in consump- tion and output and an increase in unemployment. Real GDP contracted at an annual rate of . percent in the third quarter of , . percent in the fourth quarter, and . percent in the first quarter of . The eco- nomic contraction in the fourth quarter of  was the worst in nearly three decades. Firms and households that had not previously been directly affected by the financial crisis suddenly pulled back–businesses stopped hiring and halted new in- vestments, while families put spending plans on hold. After the panic began, the rate at which the economy shed jobs jumped, going from an average of , jobs lost per month in the first three quarters of , to an average of over , jobs lost per month in the fourth quarter of  and the first quarter of . The economy continued to lose jobs through most of , with the unemployment rate peaking at . percent in October  and remaining above . percent for the rest of  and the first eleven months of . While the shock and panic therefore appear to have ended in early , the harm to the real economy continues through today. Firms and families are still deleverag- ing and are uncertain about both future economic growth and the direction of future policy. The final tragedy of the financial and economic crisis is that the needed recov- ery is slow and looks to be so for a while longer. NOTES 1. A vote of the Commission on December 6, 2010, limited dissenters to nine pages each in the approximately 550-page commercially published book. No limits apply to the official version sub- mitted to the President and the Congress. 2. Ben S. Bernanke, “Monetary Policy and the Housing Bubble,” Speech at the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010 (www.federalreserve.gov/ newsevents/speech/bernanke20100103a.htm). 3. Ibid. 4. “Risky borrowers” does not mean poor. While many risky borrowers were low-income, a borrower with unproven income applying for a no-documentation mortgage for a vacation home was also risky. 5. Bernanke, “Monetary Policy and the Housing Bubble.” 6. The Commission vigorously debated the relative importance and the motivations of the dif- ferent types of securitizers in lowering credit quality. We think that both types of securitizers were in part responsible and that these debates are less important than the existence of lower standards and how this problem fits into the broader context. 7. While bad information created by credit rating agencies was an essential cause of the crisis, it is less clear why they did this. Important hypotheses include: (1) bad analytic models that failed to account for correlated housing price declines across wide geographies, (2) an industry model that encouraged the rating agencies to skew their ratings upward to generate business, and (3) a lack of market competition due to their government-induced oligopoly. 8. In most cases during the crisis, the three key policymakers were Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and Federal Reserve Bank of New York Presi- dent Timothy Geithner. Other officials were key in particular cases, such as FHFA Director Jim Lockhart’s GSE actions and FDIC Chairman Sheila Bair’s extension of temporary loan guarantees to bank borrowing in the fall of 2008. During the financial recovery and rebuilding stage that be- gan in early 2009, the three key policymakers were Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke, and White House National Economic Council Director Larry Summers. 9. Ben S. Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, session 1: The Federal Reserve, September 2, transcript, p. 78.  FOMC20050630meeting--118 116,VICE CHAIRMAN GEITHNER.," I remember that bubble! [Laughter] I have two questions. My first is for John Williams or perhaps for Dave Stockton. What is the right way to think about dealing with uncertainty in considering the policy question? Put aside Glenn’s question about whether you know anything ever about the relationship between prices and fundamentals at a given point. What if what you don’t know is simply the likely path of home prices going forward? You could take the group here around the table and assume some path, but there would be a fairly fat band of uncertainty around that path. What does your regime imply, John, for policy in that particular circumstance? Do you basically ignore housing prices and look at all the other things we look at?" fcic_final_report_full--226 THE BUST CONTENTS Delinquencies: “The turn of the housing market” .............................................  Rating downgrades: “Never before” ...................................................................  CDOs: “Climbing the wall of subprime worry” .................................................  Legal remedies: “On the basis of the information” .............................................  Losses: “Who owns residential credit risk?” ......................................................  What happens when a bubble bursts? In early , it became obvious that home prices were falling in regions that had once boomed, that mortgage originators were floundering, and that more and more families, especially those with subprime and Alt-A loans, would be unable to make their mortgage payments. What was not immediately clear was how the housing crisis would affect the fi- nancial system that had helped inflate the bubble. Were all those mortgage-backed securities and collateralized debt obligations ticking time bombs on the balance sheets of the world’s largest financial institutions? “The concerns were just that if people . . . couldn’t value the assets, then that created . . . questions about the solvency of the firms,” William C. Dudley, now president of the Federal Reserve Bank of New York, told the FCIC.  In theory, securitization, over-the-counter derivatives and the many byways of the shadow banking system were supposed to distribute risk efficiently among investors. The theory would prove to be wrong. Much of the risk from mortgage-backed securi- ties had actually been taken by a small group of systemically important companies with outsized holdings of, or exposure to, the super-senior and triple-A tranches of CDOs. These companies would ultimately bear great losses, even though those in- vestments were supposed to be super-safe. As  went on, increasing mortgage delinquencies and defaults compelled the ratings agencies to downgrade first mortgage-backed securities, then CDOs. Alarmed investors sent prices plummeting. Hedge funds faced with margin calls from their repo lenders were forced to sell at distressed prices; many would shut down. Banks wrote down the value of their holdings by tens of billions of dollars.  fcic_final_report_full--208 Credit default swaps greased the CDO machine in several ways. First, they al- lowed CDO managers to create synthetic and hybrid CDOs more quickly than they could create cash CDOs. Second, they enabled investors in the CDOs (including the originating banks, such as Citigroup and Merrill) to transfer the risk of default to the issuer of the credit default swap (such as AIG and other insurance companies). Third, they made correlation trading possible. As the FCIC survey revealed, most hedge fund purchases of equity and other junior tranches of mortgage-backed securities and CDOs were done as part of complex trading strategies.  As a result, credit de- fault swaps were critical to facilitate demand from hedge funds for the equity or other junior tranches of mortgage-backed securities and CDOs. Finally, they allowed spec- ulators to make bets for or against the housing market without putting up much cash. On the other hand, it can be argued that credit default swaps helped end the hous- ing and mortgage-backed securities bubble. Because CDO arrangers could more eas- ily buy mortgage exposure for their CDOs through credit default swaps than through actual mortgage-backed securities, demand for credit default swaps may in fact have reduced the need to originate high-yield mortgages. In addition, some market partic- ipants have contended that without the ability to short the housing market via credit default swaps, the bubble would have lasted longer. As we will see, the declines in the ABX index in late  would be one of the first harbingers of market turmoil. “Once [pessimists] can, in effect, sell short via the CDS, prices must reflect their views and not just the views of the leveraged optimists,” John Geanakoplos, a Yale economics professor and a partner in the hedge fund Ellington Capital Management, which both invested in and managed CDOs, told the FCIC.  CITIGROUP: “I DO NOT BELIEVE WE WERE POWERLESS” While the hedge funds were betting against the housing market in  and , Citigroup’s CDO desk was pushing more money to the center of the table. CHRG-111hhrg51591--41 Mr. Harrington," The question about whether the train has left the station, or I guess the horse leaves the barn as well, is a really good one. With AIG and then the life companies asking for TARP money, I have had to ask myself, basically the safety net has now been extended so far and there is really no going back or constraining it. And I don't think so. I think that the AIG situation and the asset bubble, the housing bubble, is unique enough that if we pay close attention to what happened and why and think about patching the places where there was a clear breakdown, whether it is the Office of Thrift Supervision or whatever, that maybe we can then think about the bigger picture, which is if we need to guarantee banks because of the payment system, do we want to have that guarantee spread implicitly or explicitly broadly throughout the financial system? And if we are going to have it spread one way or the other, then we probably should make it formal and regulate accordingly. We will have to have a lot tighter regulation in principle. But I would think as part of that process, maybe we could revisit the whole issue of what activities are fundamentally central to the economy that require a strong guarantee, and maybe revisit whether or not we don't need to wall-off those activities. I was always skeptical with Gramm-Leach-Bliley about how you allegedly can have part of the bank holding company guaranteed, and there is not going to be any spillover on the unguaranteed parts. To me that is fine in theory, but in practice probably doesn't work, so maybe we need to reconsider it. " FinancialCrisisInquiry--731 THOMPSON: So you live in California. And you’ve lived through the hubris of the dot com bubble. CHRG-111hhrg53245--123 Mr. Zandi," No. There is a reluctance to weigh against asset bubbles, yes, at the Federal Reserve. " CHRG-111shrg55278--112 PREPARED STATEMENT OF ALICE M. RIVLIN Senior Fellow, Economic Studies, Brookings Institution July 23, 2009 Mr. Chairman and Members of the Committee, I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. I will focus on changes in our regulatory structure that might prevent another catastrophic financial meltdown and what role the Federal Reserve should play in a new financial regulatory system. It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic well-being and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and overborrowing, excessive risk taking, and outsized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world's economic well-being.Approaches To Reducing Systemic Risk The crisis was a financial ``perfect storm'' with multiple causes. Different explanations of why the system failed--each with some validity--point to at least three different approaches to reducing systemic risk in the future.The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system charged with spotting perverse incentives, regulatory gaps and market pressures that might destabilize the system and taking steps to fix them. The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.The system crashed because large interconnected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms--or even break them up--and to expedited resolution authority for large financial firms (including nonbanks) to lessen the impact of their failure on the rest of the system. Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier 1 Financial Institutions. I believe it would be a mistake to identify specific institutions as too-big-to-fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.The Case for a Macro System Stabilizer One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, antiregulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in. Perverse Incentives. Lax lending standards created the bad mortgages that were securitized into the toxic assets now weighting down the books of financial institutions. Lax lending standards by mortgage originators should have been spotted as a threat to stability by a Macro System Stabilizer--the Fed should have played this role and failed to do so--and corrected by tightening the rules (minimum down payments, documentation, proof that the borrow understands the terms of the loan and other no-brainers). Even more important, a Macro System Stabilizer should have focused on why the lenders had such irresistible incentives to push mortgages on people unlikely to repay. Perverse incentives were inherent in the originate-to-distribute model which left the originator with no incentive to examine the credit worthiness of the borrower. The problem was magnified as mortgage-backed securities were resecuritized into more complex instruments and sold again and again. The Administration proposes fixing that system design flaw by requiring loan originators and securitizers to retain 5 percent of the risk of default. This seems to me too low, especially in a market boom, but it is the right idea. The Macro System Stabilizer should also seek other reasons why securitization of asset-backed loans--long thought to be a benign way to spread the risk of individual loans--became a monster that brought the world financial system to its knees. Was it partly because the immediate fees earned by creating and selling more and more complex collateralized debt instruments were so tempting that this market would have exploded even if the originators retained a significant portion of the risk? If so, we need to change the reward structure for this activity so that fees are paid over a long enough period to reflect actual experience with the securities being created. Other examples, of perverse incentives that contributed to the violence of the recent perfect financial storm include Structured Investment Vehicles (SIV's) that hid risks off balance sheets and had to be either jettisoned or brought back on balance sheet at great cost; incentives of rating agencies to produce excessively high ratings; and compensation structures of corporate executives that incented focus on short-term earnings at the expense the longer run profitability of the company. The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem. The Treasury makes the case for a regulator with a broad mandate to collect information from all financial institutions and ``identify emerging risks.'' It proposes putting that responsibility in a Financial Services Oversight Council, chaired by the Treasury, with its own permanent expert staff. The Council seems to me likely to be cumbersome. Interagency councils are usually rife with turf battles and rarely get much done. I think the Fed should have the clear responsibility for spotting emerging risks and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and possible threats to it. The Fed should consult regularly with the Treasury and other regulators (perhaps in a Financial Services Oversight Council), but should have the lead responsibility. Spotting emerging risks would fit naturally with the Fed's efforts to monitor the State of the economy and the health of the financial sector in order to set and implement monetary policy. Having explicit responsibility for monitoring systemic risk--and more information on which to base judgments would enhance its effectiveness as a central bank. Controlling Leverage. The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the overleveraged superstructure of complex derivatives erected on the shaky foundation of America's housing prices. By itself, the housing boom and bust would have created distress in the residential construction, real estate, and mortgage lending sectors, as well as consumer durables and other housing related markets, but would not have tanked the economy. What did us in was the credit crunch that followed the collapse of the highly leveraged financial superstructure that pumped money into the housing sector and became a bloated monster. One approach to controlling serious asset-price bubbles fueled by leverage would be to give the Fed the responsibility for creating a bubble Threat Warning System that would trigger changes in permissible leverage ratios across financial institutions. The warnings would be public like hurricane or terrorist threat warnings. When the threat was high--as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification--the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level. The Fed already has the power to set margin requirements--the percentage of his own money that an investor is required to put up to buy a stock if he is borrowing the rest from his broker. Policy makers in the 1930s, seeking to avoid repetition of the stock price bubble that preceded the 1929 crash, perceived that much of the stock market bubble of the late 1920s had been financed with money borrowed on margin from broker dealers and that the Fed needed a tool distinct from monetary policy to control such borrowing in the future. During the stock market bubble of the late 1990s, when I was Vice Chair of the Fed's Board of Governors, we talked briefly about raising the margin requirement, but realized that the whole financial system had changed dramatically since the 1920s. Stock market investors in the 1990s had many sources of funds other than borrowing on margin. While raising the margin requirements would have been primarily symbolic, I believe with hindsight that we should have done it anyway in hopes of showing that we were worried about the bubble. The 1930s legislators were correct: monetary policy is a poor instrument for counteracting asset price bubbles; controlling leverage is likely to be more effective. The Fed has been criticized for not raising interest rates in 1998 and the first half of 1999 to discourage the accelerating tech stock bubble. But it would have had to raise rates dramatically to slow the market's upward momentum--a move that conditions in the general economy did not justify. Productivity growth was increasing, inflation was benign and responding to the Asian financial crisis argued for lowering rates, not raising them. Similarly, the Fed might have raised rates from their extremely low levels in 2003 or raised them earlier and more steeply in 2004-5 to discourage the nascent housing price bubble. But such action would have been regarded as a bizarre attempt to abort the economy's still slow recovery. At the time there was little understanding of the extent to which the highly leveraged financial superstructure was building on the collective delusion that U.S. housing prices could not fall. Even with hindsight, controlling leverage (along with stricter regulation of mortgage lending standards) would have been a more effective response to the housing bubble than raising interest rates. But regulators lacked the tools to control excessive leverage across the financial system. In the wake of the current crisis, financial system reformers have approached the leverage control problem in pieces, which is appropriate since financial institutions play diverse roles. However the Federal Reserve--as Macro System Stabilizer--could be given the power to tie the system together so that various kinds of leverage ratios move in the same direction simultaneously as the threat changes. With respect to large commercial banks and other systemically important financial institutions, for example, there is emerging consensus that higher capital ratios would have helped them weather the recent crisis, that capital requirements should be higher for larger, more interconnected institutions than for smaller, less interconnected ones, and that these requirements should rise as the systemic threat level (often associated with asset price bubbles) goes up. With respect to hedge funds and other private investment funds, there is also emerging consensus that they should be more transparent and that financial derivatives should be traded on regulated exchanges or at least cleared on clearinghouses. But such funds might also be subject to leverage limitations that would move with the perceived threat level and could disappear if the threat were low. One could also tie asset securitization into this system. The percent of risk that the originator or securitizer was required to retain could vary with the perceived threat of an asset price bubble. This percentage could be low most of the time, but rise automatically if Macro System Stabilizer deemed the threat of a major asset price bubble was high. One might even apply the system to rating agencies. In addition to requiring rating agencies to be more transparent about their methods and assumptions, they might be subjected to extra scrutiny or requirements when the bubble threat level was high. Designing and coordinating such a leverage control system would not be an easy thing to do. It would require create thinking and care not to introduce new loopholes and perverse incentives. Nevertheless, it holds hope for avoiding the run away asset price exuberance that leads to financial disaster.Systemically Important Institutions The Obama administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier 1 Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go. It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the Federal Government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late. Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks. Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ``too-big-to-fail'' and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures. Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the U.K.'s FSA, but structured to be more effective than the FSA proved in the current crisis. In the U.S. one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies. I don't pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier 1 Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy. Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macroeconomists--Paul Volcker, Alan Greenspan, Ben Bernanke--who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort--including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed's control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown--and the Fed has been more transparent about its objectives. Although respect for the Fed's monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives. If the Fed were to take on the role of consolidated prudential regulator of Tier 1 Financial Holding Companies, it would need strong, committed leadership with regulatory skills--lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan, or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed's budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed's effectiveness and credibility in containing inflation. In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system--again in coordination with the Council. I would not create a special regulator for Tier 1 Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank. Thank you, Mr. Chairman and Members of the Committee. ______ CHRG-111hhrg56776--278 Mr. Nichols," Congressman Foster, I think it was a perfect storm of activities, activities, conditions, behaviors, failures, in a lot of places. So like Chairman Bernanke pointed to two or three different factors, I even think it's broader than that. Certainly, the industry played a role in terms of internal controls and risk management; lack of mortgage origination standards; the role of credit rating agencies; even our trade imbalance, a lot of money coming in for yield, interest rate policy. There was a perfect storm of failures. People were overleveraged. Some Americans bit off more than they could chew. It was really--I don't think you could just point to one thing that led to the housing bubble. There were a lot of accelerates and a lot of contributors to it, but it's a dozen different factors all intertwined, in my humble opinion. " fcic_final_report_full--400 THE ECONOMIC FALLOUT CONTENTS Households : “I’m not eating. I’m not sleeping” ..................................................  Businesses: “Squirrels storing nuts” ...................................................................  Commercial real estate: “Nothing’s moving” ......................................................  Government: “States struggled to close shortfalls” .............................................  The financial sector: “Almost triple the level of three years earlier” ....................  Panic and uncertainty in the financial system plunged the nation into the longest and deepest recession in generations. The credit squeeze in financial markets cascaded throughout the economy. In testifying to the Commission, Bank of America CEO Brian Moynihan described the impact of the financial crisis on the economy: “Over the course of the crisis, we, as an industry, caused a lot of damage. Never has it been clearer how poor business judgments we have made have affected Main Street.”  In- deed, Main Street felt the tremors as the upheaval in the financial system rumbled through the U.S. economy. Seventeen trillion dollars in household wealth evaporated within  months, and reported unemployment hit . at its peak in October . As the housing bubble deflated, families that had counted on rising housing val- ues for cash and retirement security became anchored to mortgages that exceeded the declining value of their homes. They ratcheted back on spending, cumulatively putting the brakes on economic growth—the classic “paradox of thrift,” described al- most a century ago by John Maynard Keynes. In the aftermath of the panic, when credit was severely tightened, if not frozen, for financial institutions, companies found that cheap and easy credit was gone for them, too. It was tougher to borrow to meet payrolls and to expand inventories; businesses that had neither credit nor customers trimmed costs and laid off employees. Still to- day, credit availability is tighter than it was before the crisis. Without jobs, people could no longer afford their house payments. Yet even if moving could improve their job prospects, they were stuck with houses they could not sell. Millions of families entered foreclosure and millions more fell behind on their mortgage payments. Others simply walked away from their devalued proper- ties, returning the keys to the banks—an action that would destroy families’ credit for  years. The surge in foreclosed and abandoned properties dragged home prices down still more, depressing the value of surrounding real estate in neighborhoods across the country. Even those who stayed current on their mortgages found themselves whirled into the storm. CHRG-111hhrg55809--194 Mr. Paulsen," And if I could just switch gears then. Let me ask another question, the Federal Reserve's approach to managing monetary policy in advance of the last two recessions, if you go back in time, seems to be a little bit unstable. In other words, by waiting for an asset bubble to build up and then rescuing the economy after the bubble bursts, you know, it appears that you can create other problems. And just maybe give some comments on, why can't the Federal Reserve show a little bit more restraint in the monetary policy in advance when we are faced with what looks like a risky asset bubble coming down the pike? Would it ultimately be better to protect job loss or inflation down the road if we are able to--it is not often popular, for instance, to do it, but is that going to make more sense than--given the recent experience we have had recently, does that make more sense to look more in advance on that? " CHRG-111hhrg61852--61 Mr. Hinojosa," Madam Chairwoman, I am going to pass. I yield back. Mrs. McCarthy of New York. I recognize the gentleman from North Carolina. Mr. Miller of North Carolina. Thank you, Madam Chairwoman. This morning, Mr. Bernanke said that the housing market remains weak with the overhang of vacant and foreclosed homes weighing on home prices and construction. That seemed to be the kind of understatement that you would have expected from his predecessor. In 2005, housing starts were 2,068,000; last year, there were 554,000. Some have said that 2 million was way too many, that was part of the bubble. But from 1996 through 2002 or so, new housing starts were at 1.5 million to 1.6 million, and the estimate this year is that it is going to come in less than last year. That seems to be an enormous burden on the economy. That is a huge employer. Home building has been 16 percent of our GDP, and if it is a quarter of what it has been, it is hard to imagine how we are going to come out of the recession in a very strong way. And usually it is housing that has led us out of downturns in the past. There is some debate about what the problem is. Some have said we just have too many houses for our population. Others have said that it is really tied to the recession; that demand is down because of recessionary forces, the liquidity trap; that people aren't buying houses because nobody is buying the stuff that their employer is making, so their wages are down, or they are unemployed. And there is also the foreclosure crisis that continues to push down home values, which continues to be a huge disincentive to building new houses. There is a large number of houses that are foreclosed or destined for foreclosure that are either in the inventory or part of the shadow inventory. Mr. Mishel, what is your sense of what the demand is for housing now? If we got the economy functioning halfway normally, how many new housing starts could we expect in a year? And how much of this is because of foreclosure? How much of this is because of recessionary factors? " CHRG-110shrg50418--99 Mr. Morici," Yes. I think it is important to recognize that these three companies in the context of the other major Japanese competitors and Korean competitors, no one of them can decide to sit on the sidelines when there is a credit hysteria and not participate because of the loss of market share, then the consequent impact on their product development budgets and so forth. It isn't like they could get together and say, gee, we are making too much credit. You become part of the economy. It is much like the homebuyer in 2005 saying, gee, there may be a bubble out there. I should sit this out. And they sit it out 2 years and they find out the house costs $100,000 more than before. They have to participate. That said, America is over-car-ed just as it is over-housed. I am a macroeconomist and I know something about this. We can expect to sell fewer cars going forward for a variety of reasons. Credit is going to be more expensive. People are going to be saving more than they have in the past. The cars last longer. They are much more durable. People have been buying cars because they get tired of them, not because they wear out. I drive a Ford truck. " CHRG-110hhrg46591--34 The Chairman," I thank the gentleman. I would just take a second to note that both of them quite correctly pointed out that credit unions bear absolutely no responsibility for the bad lending practices, and I think they are entitled to that recognition. We will now begin with our witnesses. We will begin with Alice Rivlin, who is a senior fellow at the Metropolitan Policy Program, economic studies, and director at the Brookings Institution. Dr. Rivlin. STATEMENT OF THE HONORABLE ALICE M. RIVLIN, SENIOR FELLOW, METROPOLITAN POLICY PROGRAM, ECONOMIC STUDIES, AND DIRECTOR, GREATER WASHINGTON RESEARCH PROJECT, BROOKINGS INSTITUTION Ms. Rivlin. Thank you, Mr. Chairman, and members of the committee. Past weeks have witnessed historic convulsions in financial markets around the world. The freezing of credit markets and the failure of major financial institutions triggered massive interventions by governments and by central banks as they attempted to contain the fallout and to prevent total collapse. We are still in damage control mode. We do not yet know whether these enormous efforts will be successful in averting a meltdown, but this committee is right to begin thinking through how to prevent future financial collapses and how to make markets work more effectively. Now pundits and journalists have been asking apocalyptic questions: Is this the end of market capitalism? Are we headed down the road to socialism? Of course not. Market capitalism is far too powerful a tool for increasing human economic wellbeing to be given away because we used it carelessly. Besides, there is no viable alternative. Hardly anyone thinks we would be permanently better off if the government owned and operated financial institutions and decided how to allocate capital. But market capitalism is a dangerous tool. Like a machine gun or a chain saw or a nuclear reactor, it has to be inspected frequently to see if it is working properly and used with caution according to carefully thought-out rules. The task of this committee is to reexamine the rules. Getting financial market regulation right is a difficult and painstaking job. It is not a job for the lazy, the faint-hearted, or the ideologically rigid. Applicants for this job should check their slogans at the door. Too many attempts to rethink the regulation of financial markets in recent years have been derailed by ideologues shouting that regulation is always bad or, alternatively, that we just need more of it. This less versus more argument is not helpful. We do not need more or less regulation; we need smarter regulation. Moreover, writing the rules for financial markets must be a continuous process of fine-tuning. In recent years, we have failed to modernize the rules as markets globalized, as trading speed accelerated, as volume escalated, and as increasingly complex financial products exploded on the scene. The authors of the financial market rule books have a lot of catching up to do, but they also have to recognize that they will never get it right or will be able to call it quits. Markets evolve rapidly, and smart market participants will always invent new ways to get around the rules. It is tempting in mid-catastrophe to point fingers at a few malefactors or to identify a couple of weak links in a larger system and say those are the culprits and that if we punish them the rest of us will be off the hook, but the breakdown of financial markets had many causes of which malfeasance and even regulatory failure played a relatively small role. Americans have been living beyond their means individually and collectively for a long time. We have been spending too much, have been saving too little, and have been borrowing without concern for the future from whomever would support our overconsumption habit--the mortgage company, the new credit card, the Chinese Government, whatever. We indulged ourselves in the collective delusion that housing prices would continue to rise. The collective delusion affected the judgment of buyers and sellers, of lenders and borrowers and of builders and developers. For a while, the collective delusion was a self-fulfilling prophesy. House prices kept rising, and all of the building and borrowing looked justifiable and profitable. Then, like all bubbles, it collapsed as housing prices leveled off and started down. Now bubbles are an ancient phenomenon and will recur no matter what regulatory rules are put in place. A housing bubble has particularly disastrous consequences because housing is such a fundamental part of our everyday life with more pervasive consequences than a bubble in, say, dot com stocks. More importantly, the explosion of securitization and increasingly complex derivatives had erected a huge new superstructure on top of the values of the underlying housing assets. Interrelations among those products, institutions, and markets were not well-understood even by the participants. But it is too easy to blame complexity, as in risk models failed in the face of new complexity. Actually, people failed to ask commonsense questions: What will happen to the value of these mortgage-backed securities when housing prices stop rising? They did not ask because they were profiting hugely from the collective delusion and did not want to hear the answers. Nevertheless, the bubbles and the crash were exacerbated by clear regulatory lapses. Perverse incentives had crept into the system, and there were instances where regulated entities, even the Federal Reserve, were being asked to pursue conflicting objectives at the same time. These failures present a formidable list of questions that the committee needs to think through before it rewrites the rule book. Here are my offers for that list: We did have regulatory gaps. The most obvious regulatory gap is the easiest to fill. We failed to regulate new types of mortgages--not just subprime but Alt-A and no doc and all the rest of it--and the lax, sometimes predatory lending standards that went with them. Giving people with less than sterling credit access to homeownership at higher interest rates is actually, basically, a good idea, but it got out of control. Most of the excesses were not perpetrated by federally regulated banks, but the Federal authorities should have gotten on the case, as the chairman has pointed out, and should have imposed a set of minimum standards that applied to all mortgage lending. We could argue what those standards should be. They certainly should include minimum downpayments, the proof of ability to pay, and evidence that the borrower understands the terms of the loan. Personally, I would get rid of teaser rates, of penalties for prepayment and interest-only mortgages. We may not need a national mortgage lender regulator, but we need to be sure that all mortgage lenders have the same minimum standards and that these are enforced. Another obvious gap is how to regulate derivatives. We can come back to that. But much of the crisis stemmed from complex derivatives, and we have a choice going forward. Do we regulate the leverage with which those products are traded or the products themselves? " CHRG-111hhrg53244--200 Mr. Foster," And the second point is, do you think that the Fed is necessarily helpless to mitigate future real estate bubbles? For example, in this week's Economist Magazine, they discuss China's response. And of course, as you know, they are pushing very heavily on monetary policy and credit availability and so on, but at the same time, to avoid reinflating a real estate bubble they are turning up the mortgage origination requirements. You now have to put 40 percent down and so on, and so that they are independently operating both of those. Do you think that actually there is a reasonable role for the Fed or some other regulator to try to make this happen? " CHRG-111shrg54533--61 Secretary Geithner," I don't think you need to wait for the Fed on that to proceed with the legislative process on design. There is the specific set of questions around how to deal with some of the concerns Senator Shelby and others raised about the role of the Reserve Bank Boards, the set of firewalls and constraints that prevent involvement of Federal Reserve Bank Boards in supervision, a range of things like that where we think it would be appropriate for the Fed to try to clarify, bring recommendations for how to tighten up those kind of safeguards and constraints, and I think that can happen on that path without getting in the way of your efforts to consider legislation. I know the Chairman is considering coming together, and will be happy, I am sure, to come before the Committee and talk about what role they think the Fed should play in looking at systemic risk and how to respond to the concerns many of you raised that that not distract them from their core responsibilities for monetary policy. Senator Reed. You know, my sense is that with these new responsibilities, there has to come not only new organizational arrangements, which we would like to, I guess, have them suggest what their recommendations are, and then second, I think, is even the issue of culture. That is this issue of is it safety and soundness trumps everything else? I think also, too, in terms of transparency, one of the--my sense from talking in hearings and just generally is that, you know, there were rather vigorous debates in the Fed about is there a housing bubble, is there not a housing bubble, were savings rates too low, et cetera. That never got out. How do we have an agency that is going to be transparent in terms of these issues? Similarly, will there be an independent analytical staff? Will there be someone charged, not just at the Board, but a Deputy for Systemic Regulation that may or may not be subject to the confirmation process? And then this raises the bigger issue which many of my colleagues have talked about is just oversight. Ultimately, they are imposing legislation. I can recall, along with many others, writing several letters, I think, to the Fed about one of these HOEPA regulations coming out. So these are critical issues and I wonder if you could just comment briefly. " CHRG-111hhrg55814--361 Mr. Foster," So you contemplate using it in concert with monetary policy? For example, to cool off a real estate bubble? " FOMC20050503meeting--172 170,MR. STOCKTON.," Just briefly, the special topic at the June meeting will be the question of May 3, 2005 103 of 116 has developed. The lineup is Josh Gallin and Andreas Lehnert here at the Board. They are going to present our views on the probability and potential magnitude of an asset price misalignment in residential real estate markets. And they’re also going to talk about how that might unwind if, in fact, there is some overvaluation. They will address the issues of whose balance sheet the risks reside on and what the consequences might be for household and financial institutions should we get a more serious retrenchment in house prices. Dick Peach from the New York Fed is going to offer a more skeptical assessment of those bubble concerns, and Glenn Rudebusch and John Williams of the San Francisco Fed have agreed to discuss what, if any, consequences there might be from conditions in the housing market for your monetary policy. We’re going to post the presentations at least a week in advance, and we’ll also post any supporting materials as they become available." FOMC20060131meeting--116 114,MR. KOHN.," Thank you, Mr. Chairman. The projections I submitted for this meeting reflected expectations of an economy that probably is operating in level terms somewhere in the neighborhood of its long-run, sustainable potential and will continue to do so over the next two years with growth broadly in line with the growth of potential and inflation basically stable. My forecasts for 2006 are very close to those I submitted last January and June. That’s partly a product of innate stubbornness. [Laughter] But it also reflects the fact that 2005 came in largely as expected—after allowance for hurricanes and an energy shock last year that elevated core inflation and damped growth somewhat compared with our forecasts last January. This is encouraging in that it suggests that we are not looking at major unexplained and unanticipated forces acting on the economy. At this point, our focus appropriately is on keeping inflation contained. I see several reasons for optimism in this regard. One is the performance of core consumer prices and price measures, which continue to suggest that the pass-through of higher energy prices will be limited. Core inflation was roughly stable last year. It picked up a bit in the fourth quarter, but that was from unusually low readings in the third quarter. Declining consumer inflation expectations in the most recent Michigan survey, along with the failure of market-based inflation compensation readings to respond significantly to the substantial run-up in oil prices and higher core readings over the intermeeting period, just reinforce my assessment that any pass-through should be small and limited in duration. As we noted at the last meeting, perhaps the greater threat to sustained good inflation performance comes from possible increases in pressures on resources. The critical question is whether growth in output close to trend is a reasonable expectation with only modest further policy firming, given the low level of long-term rates, reduced drag from energy prices, and a boost from rebuilding. I thought it was a reasonable expectation, for a number of reasons. First, after smoothing through the fluctuations caused by auto incentives and hurricanes, private domestic final demand already showed signs of moderation last year. Growth in private domestic final sales slowed from 4¼ percent in the first half of the year to 3 percent in the second half of the year, with every element—consumption, business fixed investment, residential housing investment— moderating. The staff estimates that about 0.3 of this was due to hurricane effects, but that still leaves underlying private demand slowing to an annual rate of about 3¼ or 3½ percent. This moderation did not reflect the full effects of our policy tightening, especially on the housing market. Even well-anticipated increases in the short-term rates seem to be having a significant effect on housing markets, which have become more dependent on adjustable rate mortgages to maintain affordability. We are just beginning to see the anticipated slowdown in this sector. With growth in consumption and sales constrained by a leveling-out of housing wealth, businesses are unlikely to see the need to step up the pace at which they are adding to their capital stock. As a consequence, investment growth could slow, at least slightly, over the next few years, reflecting reduced impetus from the accelerator. Finally, although foreign economies are strengthening some, foreign investment and consumption remain subdued relative to income. And given our continuing outsized appetite for imports, net exports are unlikely to be putting added impetus to demands on domestic production. I think there are several upside and downside risks around this picture of growth near potential, as a number of you pointed out. I agree that the housing market is the most likely source of a shortfall in demand. I don’t think we can have much confidence about how the dynamics of this market will play out now that it has begun to soften. My suspicion is that, as little bubbles in the froth are popped, the risks are tilted more toward quite a sharp cooling off than toward a very gradual ebbing of price increases and building activity. On the other side, it seems to me global demand would be a major upside risk to growth and to price stability. The extraordinarily rapid rise in commodity prices and upward movement in global equity prices may indicate a very fundamental turnaround in foreign demand and attitudes beyond just a stepwise strengthening of growth. For now, these remain risks that we’ll need to monitor. In making my forecast, I assumed we would tighten at this meeting, and likely at the next as well, to gain greater assurance that inflation will remain contained over time, consistent with my forecast of a 1¾ percent increase in core prices in 2007. However, I do see action in March as dependent on the readings we get in coming months. There is, as usual, considerable uncertainty about the precise nature and magnitude of the risk to the outlook, but we’re dealing with an economic picture that overall is remarkably good and expected to remain that way for the foreseeable future. Reflecting on this situation, among many, many aspects of the past, I end my remarks as I began them: Thank you, Mr. Chairman." CHRG-111hhrg56766--267 Mr. Bernanke," We are monitoring that very carefully. It is obviously very difficult to know if there is a bubble, particularly in the early stages. Our best assessment right now is there is not any obvious level in U.S. economy. If there was a bubble, then the response probably would depend on which asset it was, what part of the economy it was. My view is that in the longer term, when possible, you want to address those kinds of systemic risks through regulation and supervision rather than through monetary policy, but if there were not appropriate tools, and you are right, there are some countries where they can vary the loan to value ratio as a policy tool, which I think-- " CHRG-109hhrg22160--147 Mr. Greenspan," I think we are running into certain problems in certain localized areas. We do have characteristics of bubbles in certain areas but not, as best I can judge, nationwide. And I don't expect that we will run into anything resembling a collapsing bubble. I do believe that it is conceivable that we will get some reduction in overall prices, as we have had in the past, but that is not a particular problem. Remember that there is a very significant buffer in home equity at this stage because with most of mortgages being of conforming type with a 20 percent down payment, and even when it is less, prices since the homes were bought have gone up on average very considerably, so we have a fairly large buffer against price declines and therefore difficulties which would emerge with homeowners. " CHRG-111shrg57319--91 Mr. Cathcart," I would say the Board was responsive. The Board would continually ask management why progress hadn't been made on certain chronic issues which were repeat items from both internal audit, credit review, and from the regulators. But it appeared as if there was little consequence to these problems not being fixed. Senator Coburn. OK. Thank you. Mr. Vanasek, on Exhibit 78a,\1\ there is an email exchange between you and Mr. Killinger where he said, ``I have never seen such a high-risk housing market. . . . This typically signifies a bubble.'' You responded, ``All the classic signs are there.'' Wasn't this email written just months after WaMu made a strategic decision to shift to riskier lending?--------------------------------------------------------------------------- \1\ See Exhibit No. 78a, which appears in the Appendix on page 790.--------------------------------------------------------------------------- " FOMC20050630meeting--193 191,MR. STOCKTON.," That certainly seems possible. When I look at Josh’s exhibit 3 on page 5, I see the Miami price-rent ratio at 64 percent above its trend. Now, it’s possible that everybody just woke up and decided, boy, there are people in Miami who are just really terrific to be around—it’s an exciting city and fascinating people live there. [Laughter] But it’s also possible that that statistic could be an indication that people have unrealistic expectations about the rate of increase in house prices expected in Miami. And there is certainly a lot of anecdotal evidence that in that particular city there is a lot of flipping of properties going on as well as other developments that might not be reflective of a purely equilibrium move in house prices or of agglomeration economies. So I’m still a little nervous about this. There are a lot of good reasons why prices ought to be high relative to rents and relative to incomes. And I think even President Poole’s suggestion that maybe housing is undervalued can’t be ruled out. We’ve done simple dividend discount-type calculations on rents and interest rates. And if you make a certain assumption about the growth rate of real rents going forward and the persistence of low interest rates, you can get figures showing further appreciation of maybe not 40 percent but rates that are pretty high. So we think that’s within June 29-30, 2005 65 of 234 nation as a whole a run-up in prices that certainly looks very unusual by historical standards. It could very well be that this time is different and it’s all being driven by fundamentals. But we don’t think you should rule out the possibility that you could be facing a period in which prices could be declining or just be softer. One point that has been made is that we obviously don’t know how the end will look—if there is an end. The end could come through a long period of just relatively subdued growth in nominal house prices. It wouldn’t have to be associated with a 20 percent decline. As we noted in the Greenbook, that is an extreme drop. In fact, to get to John’s scenario 3, a lot of extreme things have to happen. It takes an unusually large drop in house prices and a lot of spillover effects. As you recall, the first scenario was pretty tame; if you move down 50 basis points on interest rates, it offsets that. But if you layer on top of the decline in house prices a big drop in consumer confidence, a big equity extraction effect, or a much bigger wealth effect from housing—which looks to us to be pretty much on the edge—and throw in some covariance with a bond market event, the situation worsens substantially. But it takes a lot to get to a real disaster type of scenario. So even though we feel that house prices have moved out of alignment with the fundamentals, we don’t necessarily think the implications of that are that you’re going to be confronted immediately with some large problem. In fact, our best guess would be that the misalignment would unwind in ways that would be quite feasible for you to offset and insulate. There are questions on the supervisory side. There I don’t think the historical evidence suggests that supervisory policy has been used effectively to head off asset bubbles or to elegantly deflate them when they occur. What you might hope to do is to have in place policies that will prevent the kind of spillover effects of John’s scenario 2 so that you just have a wealth effect. In June 29-30, 2005 66 of 234 sheets as a reduction in wealth. One might hope that they respond accordingly and that we won’t have the complications with intermediation or other kinds of things that would add to that effect. So our story basically is that we’re worried about valuations in the housing market, but we don’t necessarily see that as having profound consequences for your policy going forward." fcic_final_report_full--427 STAGES OF THE CRISIS As of December , the United States is still in an economic slump caused by a fi- nancial crisis that first manifested itself in August  and ended in early . The primary features of that financial crisis were a financial shock in September  and a concomitant financial panic . The financial shock and panic triggered a severe con- traction in lending and hiring beginning in the fourth quarter of . Some observers describe recent economic history as a recession that began in December  and continued until June , and from which we are only now be- ginning to recover. While this definition of the recession is technically accurate, it ob- scures a more important chronology that connects financial market developments with the broader economy. We describe recent U.S. macroeconomic history in five stages: • A series of foreshocks beginning in August , followed by an economic slowdown and then a mild recession through August , as liquidity prob- lems emerged and three large U.S. financial institutions failed; • A severe financial shock in September , in which ten large financial institu- tions failed, nearly failed, or changed their institutional structure; triggering • A financial panic and the beginning of a large contraction in the real economy in the last few months of ; followed by • The end of the financial shock, panic, and rescue at the beginning of ; followed by • A continued and deepening contraction in the real economy and the beginning of the financial recovery and rebuilding period. As of December , the United States is still in the last stage. The financial sys- tem is still recovering and being restructured, and the U.S. economy struggles to re- turn to sustained strong growth. The remainder of our comments focuses on the financial crisis in the first three stages by examining its ten essential causes. THE TEN ESSENTIAL CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS The following ten causes, global and domestic, are essential to explaining the finan- cial and economic crisis. I. Credit bubble. Starting in the late s, China, other large developing countries, and the big oil-producing nations built up large capital surpluses. They loaned these savings to the United States and Europe, causing interest rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to finance risky investments declined. A credit bubble formed in the United States and Europe, the most notable manifestation of which was increased investment in high-risk mortgages. U.S. monetary policy may have con- tributed to the credit bubble but did not cause it. CHRG-111hhrg53245--114 Mr. Garrett," You need someone to address situations, future asset bubbles, for dealing with being countercyclical as opposed to being procyclical? " fcic_final_report_full--424 HOW OUR APPROACH DIFFERS FROM OTHERS’ During the course of the Commission’s hearings and investigations, we heard fre- quent arguments that there was a single cause of the crisis. For some it was interna- tional capital flows or monetary policy; for others, housing policy; and for still others, it was insufficient regulation of an ambiguously defined shadow banking sec- tor, or unregulated over-the-counter derivatives, or the greed of those in the financial sector and the political influence they had in Washington. In each case, these arguments, when used as single-cause explanations, are too simplistic because they are incomplete. While some of these factors were essential contributors to the crisis, each is insufficient as a standalone explanation. The majority’s approach to explaining the crisis suffers from the opposite prob- lem–it is too broad. Not everything that went wrong during the financial crisis caused the crisis, and while some causes were essential, others had only a minor im- pact. Not every regulatory change related to housing or the financial system prior to the crisis was a cause. The majority’s almost -page report is more an account of bad events than a focused explanation of what happened and why. When everything is important, nothing is. As an example, non-credit derivatives did not in any meaningful way cause or contribute to the financial crisis. Neither the Community Reinvestment Act nor re- moval of the Glass-Steagall firewall was a significant cause. The crisis can be ex- plained without resorting to these factors. We also reject as too simplistic the hypothesis that too little regulation caused the crisis, as well as its opposite, that too much regulation caused the crisis. We question this metric for determining the effectiveness of regulation. The amount of financial regulation should reflect the need to address particular failures in the financial sys- tem. For example, high-risk, nontraditional mortgage lending by nonbank lenders flourished in the s and did tremendous damage in an ineffectively regulated en- vironment, contributing to the financial crisis. Poorly designed government housing policies distorted market outcomes and contributed to the creation of unsound mortgages as well. Countrywide’s irresponsible lending and AIG’s failure were in part attributable to ineffective regulation and supervision, while Fannie Mae and Freddie Mac’s failures were the result of policymakers using the power of government to blend public purpose with private gains and then socializing the losses. Both the “too little government” and “too much government” approaches are too broad-brush to explain the crisis. The majority says the crisis was avoidable if only the United States had adopted across-the-board more restrictive regulations, in conjunction with more aggressive regulators and supervisors. This conclusion by the majority largely ignores the global nature of the crisis. For example: • A credit bubble appeared in both the United States and Europe. This tells us that our primary explanation for the credit bubble should focus on factors common to both regions. FOMC20070321meeting--73 71,MS. YELLEN.," Thank you, Mr. Chairman. Recent data on economic activity have been downbeat in many sectors, and I agree with the general tenor of the Greenbook that the near-term outlook is weaker than before. Indeed, we have cut expected growth this year almost ½ percentage point, to 2¼ percent. This pace of growth is substantially below potential, and we expect the unemployment rate to start to edge up fairly quickly. Even relative to this lower baseline, I think the downside risks to the prospects for output growth have sharpened in the intermeeting period. I’m especially concerned about two risks—broader retrenchment in financial markets along the lines that we’re seeing in the subprime mortgage market and a further hesitation and faltering of capital spending. As we discussed in detail two years ago, an asset price bubble inevitably leads to unsustainable imbalances in the economy and a misallocation of resources. The extraordinary run-up in house prices in recent years led to construction and sales booms that couldn’t last. So far the adjustments to more-sustainable levels of housing starts and sales have been relatively orderly. However, there is still an overhang of precarious financing from the past relaxed mortgage-lending standards that has to be eliminated. For example, in 2005 and 2006 something like 40 percent of first-time homebuyers put no money down with their purchase. The market is beginning to recognize the size of this overhang and, with the recent deterioration in the performance of subprime mortgages, is dramatically reassessing mortgage risk. Going forward, we will have to closely monitor increases in mortgage-risk compensation and tightening of credit standards. Such changes, especially if they go too fast or too far, could amplify the housing- sector decline as has been recognized, pushing housing prices and activity down, and with spillovers to consumer spending, they could prove to be a substantial drag on the overall economy. Despite the recent turmoil in equity and mortgage markets, a reassessment of overall risk has yet to occur. We are still in an environment of low long-term yields, ample liquidity, and what appears to be a generally low level of compensation for risk. For example, I recently talked with the principals of several major private-equity funds, who were not just amazed but also appalled about the amount of money their industry has attracted. [Laughter] One partner said that he would have no difficulty immediately raising $1 billion. Indeed, one of his biggest problems is would-be investors who get angry at him because he is unwilling to take their money. This unwillingness reflects his difficulty in identifying deals that are likely to yield adequate returns even though, for the buyout firms, debt also is available in what they depict as very attractive so-called covenant-lite terms—perhaps too attractive given the vulnerability of some of the highly leveraged yields. My contacts suggest that some private-equity firms with similar assessments of the shortage of profit opportunities are less restrained and do take additional money, partly because of the large upfront fees that are generated by these deals. So just as we have seen in mortgage markets, the bubble in private equity, as my sources characterize it, and the overabundance of liquidity more generally raise the risk of a sharp retrenchment in credit and higher risk spreads with associated risks to economic growth and, conceivably, even financial stability. A second, related risk concerns investment spending. It’s surprising that, despite the ample financing available, firms have still been reluctant to ramp up their capital spending. Certainly, any precipitous tightening of financing could curtail investment. However, as noted in one of the Greenbook alternative simulations, greater business pessimism about future returns to new capital is also a significant risk. The recent pullback in orders and shipments for capital goods has persisted and deepened more than any of us had anticipated. Even for high-tech spending, which continues to expand, my contacts on the manufacturing side are not very optimistic. Sales of PCs and related equipment were mildly disappointing in 2006, and our contacts don’t see the introduction of the Microsoft Vista operating system in January as having generated much enthusiasm among businesses. Turning to inflation, our outlook for core inflation, like that of the Greenbook, has changed little since January. I continue to anticipate gradually moderating inflation with core PCE price inflation edging down from 2¼ percent in 2006 to 2 percent this year. There are certainly clear upside risks to this forecast, especially given the resumption of increases in energy prices. These risks remain despite some weakening in the outlook for real activity. In principle, the anticipated subpar growth should help relieve inflationary pressures. However, we remain very uncertain about what par is. The continued low unemployment rate, coupled with recent sluggish output growth, suggests via Okun’s law that potential output could be growing in the vicinity of 2¼ percent. If, contrary to our assumption, that were the case, any labor market tightness now boosting inflation might not diminish this year. More-favorable news is found in recent survey evidence on inflation expectations. As many of you have commented in past meetings, inflation expectations are perhaps more influential to the inflation outlook than is the unemployment rate. Their relative stability over the past several years has probably been a key factor restraining the rise in inflation over the past two years. However, what has not generally been noted is the importance of near-term inflation expectations, those with a forecast horizon of a year or two. Both economic theory and empirical evidence suggest that these near-term inflation expectations are as important as long-run expectations for determining inflation dynamics. The latest Blue Chip and Professional Forecasters surveys both show expectations of core inflation edging down next year. For example, the SPF shows core PCE inflation dropping to 2 percent next year, exactly in line with our own forecast. I also see the general downward tilt in inflation expectations over the next couple of years as contributing to a favorable inflation prognosis." CHRG-111hhrg61852--90 Mr. Koo," At this juncture, I must say government has to be involved and in a sustainable way with a substantial amount until private sector balance sheets are repaired. I am not always for fiscal stimulus. I started my career at the New York Fed. I believe the monetary policy, all the market stuff. Occasionally, once in every several decades, the private sector does go crazy, and that is called a bubble. And once the bubble bursts, I am afraid there is this long period where they will have to do their balance sheets repair. And when the private sector is in that mode, the public sector must come in. " FOMC20050630meeting--170 168,MR. WILLIAMS.," In fact, the third scenario that I considered involved trying to emphasize that point—namely that, at least by some measures that people have come up with, there is a big difference in where bond rates are relative to standard estimates of fundamentals. It’s actually a much bigger problem for the economy than just the house-price effect directly, at least according to the FRB/US model. More importantly, it could be one of the factors driving a big part of the house- price appreciation. In terms of needing strong house prices to keep the economy moving, the way I view your third question is that if it weren’t for the house-price run-up, monetary policy would need to be easier, given current economic conditions. And I think that’s absolutely right. One way to think about my scenarios is just to reverse the signs, especially in scenarios 1 and 2, and think about it as this as the positive stimulus we’ve gotten from a 20 percent appreciation of housing prices and this is the positive effect we’ve gotten from some other factors. Especially scenario 1, I think you can see that way. The reason I mentioned the misallocation of resources toward housing-related activities in June 29-30, 2005 57 of 234 is that they actually lead to, as Glenn mentioned, a misallocation of resources. Therefore, these gaps between fundamental prices and actual prices should appear in the policymaker’s objective function, in addition to inflation, output and employment. So there is a notion here that that’s just another problem that you would want to balance off if you could. Now, I’d like to emphasize in my closing remarks that the assumption that you could affect the bubble is very problematic. As Josh himself mentioned, these relationships between housing prices and interest rates are just not as strong as one would think and not as strong as economic theory would suggest." CHRG-110shrg50418--88 Mr. Wagoner," Sure. " Chairman Dodd," ----that what you were doing here was actually going to end up in a bubble kind of situation, that could only end up in the situation we are now facing? " CHRG-111shrg57322--312 Mr. Tourre," I would echo some of my colleagues' comments that the compensation structure which is based on the firm's performance, the business' performance, and, the personal performance, at least at Goldman Sachs, I think were aligning incentives correctly. Senator Ensign. OK. Thank you, Mr. Chairman. Senator Levin. Thank you, Senator Ensign. I think as all the questions have gone today, I think that we are seeing some of the problems. Thank you, Senator Ensign. Senator Tester. Senator Tester. Thank you, Mr. Chairman. I appreciate your holding this hearing. It has been a pretty long morning. I do not know if there is going to be anybody coming after me or not, but I want to thank you folks for being here today. I appreciate it very much. I think we will head in a couple different directions here. Mr. Birnbaum, why, how, and when did you become convinced that there was a housing bubble on the verge of collapse? " CHRG-111hhrg53245--78 Mr. Kanjorski," I agree with you, but I wanted to perhaps attack part of your premise there. I recall very clearly in 2005, the Chairman of the Federal Reserve was testifying before this committee. I specifically asked him a question, whether or not there was a real estate bubble in his opinion, and he said he thought there was, and that the price of real estate was ever increasing, but it was perfectly manageable and it did not constitute a risk to the system. If he in fact were the gatherer of that information and the analyzer of that information, we would have missed the opportunity to have found systemic risk. What is your answer to Mr. Greenspan's lack of perceiving that difficulty? Ms. Rivlin. I think he was just wrong. He said that himself. He did not see this one. I think we have learned a lot about bubbles. One thing we have learned is that interest rates is not a perfect tool for controlling them, which is why I would give them more leverage control as well. " CHRG-110hhrg44901--33 Mr. Manzullo," Thank you, Mr. Chairman. Chairman Bernanke, earlier this week you took an action to crack down on a range of shady lending practices that have hurt the Nation's riskiest subprime borrowers and also have caused a tremendous amount of economic distress in this country. Among other things, the Fed issued regulations that would prohibit lenders from lending without considering the borrower's ability to repay and also would require creditors to verify their income and assets at the time of the borrowing. These are pretty basic. Although hindsight is a 20/20 issue, and it is easy to sit here and say the Fed should have done this a long time ago, the evidence of this housing bubble has been going on for some time. And my question is, what took the Fed so long to act? And then the regulation you are coming out with is not going to be effective until October 1st of next year. Those are the issues just involving in the subprime borrowers. As to the regular borrowers, you came up with another landmark regulation that says, whenever a borrower gives a check to the bank that the bank has to credit it that day to the borrower's account. I mean, this shows knowledge of some very basic problems that have been wrong in the housing industry. But what took the Fed so long to act? And why wait 15 months before the regulations go into effect? " FOMC20060808meeting--58 56,MS. PIANALTO.," Thank you, Mr. Chairman. My outlook hasn’t changed very much since last spring, when I was contemplating the not-so-welcome cycle of slowdown in economic activity and some persistence in both headline and core inflation due to the lingering effects of large energy-price increases. In fact, the Greenbook projections for real GDP now reflect something close to the pessimistic end of where I thought things could be heading. The difference is that I have been thinking more of a cyclical slowdown and not so much of a slowdown in demand and supply, as reflected in the Greenbook baseline. The possibility that slack might not be widening as economic growth moves down puts the recent inflation numbers in a particularly bad light. I have been especially concerned about how broadly based the inflationary pressures appear to be. When you take energy components out of the CPI and you look at the median that Richard was referring to earlier, about 67 percent of the expenditure-weighted items in the CPI increased at an annual rate of 3 percent or more in June, which is about the same share that we have seen since March. As Richard mentioned, the PCE statistics yield basically the same results. In Procter & Gamble’s most recent earnings report, the company attributed its good earnings performance partly to the ability to pass on higher costs through to product prices, and I am hearing similar remarks about pricing power from our directors and District business contacts. Although my business contacts have been reporting some ability to pass on price increases now at the retail level, where in the past they were saying that it was very difficult to go beyond intermediate goods, they’re not so sure that they will get more than one-time catch-up adjustments. Most of my business contacts have not expressed concerns about an elevation in the long-term inflation trend. Nevertheless, I think there are clearly reasons to be worried about the risk of inflationary pressures intensifying over the balance of the projection period. I also think that there is a risk that we’re not going to see as much slack as is embedded in the Greenbook baseline. As in many other parts of the country, activity in the housing sector is slowing in the Midwest, particularly in the Fourth District, and the housing situation in the Fourth District could never be characterized as bubbly or frothy. Some of the veteran Realtors in my District with whom I have been talking are saying that this housing market is the worst that they can recall. Comments like these, although they are selected, do suggest some more uncertain prospects for the housing sector. My directors and business contacts have also been sounding a bit more cautious about the outlook for their sales, but at the same time their capital spending plans appear to be intact. They remain vocal about the ability to get productivity gains, and they remain disciplined about their hiring plans. So as I contemplate the weaker spending track that’s forecast in the Greenbook, I’m inclined to attribute more of it to the demand side of the economy than to the supply side. That is, I am expecting the Greenbook’s call for moderation in economic growth to result in a little more slack than appears in the Greenbook’s baseline. In a qualitative sense, my outlook carries lower inflationary pressure than the Greenbook baseline and thus is similar in spirit to the “lower NAIRU” alternative scenario. Separating the cyclical and structural performance of the economy, of course, is a real challenge, and it is natural, I think, to feel unsure about the real-time estimates and projection of slack. If the slower growth of potential output in the Greenbook baseline is accurate, it raises the possibility that the equilibrium real interest rate may be lower than it was in the last half of the 1990s. In summary, Mr. Chairman, I still think there are risks to both of our objectives. Thank you." fcic_final_report_full--469 One of the many myths about the financial crisis is that Wall Street banks led the way into subprime lending and the GSEs followed. The Commission majority’s report adopts this idea as a way of explaining why Fannie and Freddie acquired so many NTMs. This notion simply does not align with the facts. Not only were Wall Street institutions small factors in the subprime PMBS market, but well before 2002 Fannie and Freddie were much bigger players than the entire PMBS market in the business of acquiring NTM and other subprime loans. Table 7, page 504, shows that Fannie and Freddie had already acquired at least $701 billion in NTMs by 2001. Obviously, the GSEs did not have to follow anyone into NTM or subprime lending; they were already the dominant players in that market before 2002. Table 7 also shows that in 2002, when the entire PMBS market was $134 billion, Fannie and Freddie acquired $206 billion in whole subprime mortgages and $368 billion in other NTMs, demonstrating again that the GSEs were no strangers to risky lending well before the PMBS market began to develop. Further evidence about which firms were first into subprime or NTM lending is provided by Fannie’s 2002 10-K. This disclosure document reports that 14 percent of Fannie’s credit obligations (either in portfolio or guaranteed) had FICO credit scores below 660 as of December 31, 2000, 16 percent at the end of 2001 and 17 percent at the end of 2002. 31 So Fannie and Freddie were active and major buyers of subprime loans in years when the PMBS market had total issuances of only $55 billion (2000) and $94 billion (2001). In other words, it would be more accurate to say that Wall Street followed Fannie and Freddie into subprime lending rather than vice versa. At the same time, the GSEs’ purchases of subprime whole loans throughout the 1990s stimulated the growth of the subprime lending industry, which ultimately became the mainstay of the subprime PMBS market in the 2000s. 2005 was the biggest year for PMBS subprime issuances, and Ameriquest ($54 billion) and Countrywide ($38 billion) were the two largest issuers in the top 25. These numbers were still small in relation to what Fannie and Freddie had been buying since data became available in 1997. The total in Table 7 for Fannie and Freddie between 1997 and 2007 is approximately $1.5 trillion for subprime loans and over $4 trillion for all NTMs as a group. Because subprime PMBS were rich in NTM loans eligible for credit under HUD’s AH goals, Fannie and Freddie were also the largest individual purchasers of subprime PMBS from 2002 to 2006, acquiring 33 percent of the total issuances, or $579 billion. 32 In Table 3 above, which organizes mortgages by delinquency rate, these purchases are included in line 1, which had the highest rate of delinquency. These were self-denominated subprime—designated as subprime by the lender when originated—and thus had low FICO scores and usually a higher interest rate than prime loans; many also had low downpayments and were subject to other deficiencies. Ultimately, HUD’s policies were responsible for both the poor quality of the subprime and Alt-A mortgages that backed the PMBS and for the enormous size to which this market grew. This was true not only because Fannie and Freddie 31 2003 10-K, Table 33, p.84 http://www.sec.gov/Archives/edgar/data/310522/000095013303001151/ w84239e10vk.htm#031. 32 See Table 3 of “High LTV, Subprime and Alt-A Originations Over the Period 1992-2007 and Fannie, Freddie, FHA and VA’s Role” found at http://www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf . stimulated the growth of that market through their purchases of PMBS, but also because the huge inflow of government or government-directed funds into the housing market turned what would have been a normal housing bubble into a bubble of unprecedented size and duration. This encouraged and enabled unprecedented growth in the PMBS market in two ways. FinancialCrisisInquiry--11 Finally, our shareholders will have an advisory vote on the firm’s compensation principles and the compensations of its named executive officers at the firm’s annual meeting of shareholders in 2010. Once again, we appreciate the opportunity to assist the commission in your critical role. And I look forward to your questions. Thank you. CHAIRMAN ANGELIDES: Thank you very much. Thank you so much. Mr. Dimon? DIMON: Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Jamie Dimon and I am chairman and chief executive officer of JPMorgan Chase and Company. I appreciate the invitation to appear before you today. If we are to learn from this crisis moving forward, we must be brutally honest about the causes and develop a realistic understanding of them that is not overly simplistic. The FCIC’s contribution to this debate is critical, and I hope my participation will further the commission’s goals. I’d like to start by touching on some of the factors I believe led to the financial crisis. Of course, much has been said and much more will be written on the topic, so my comments are summary in nature. As we know all too well, new and poorly underwritten mortgage products helped fuel housing price appreciation, excessive speculation and far higher credit losses. When the housing bubble burst, it exposed serious flaws in mortgage underwriting, and losses flowed from the chain from mortgages to securitizations to derivatives based on these products. CHRG-111hhrg48875--142 Secretary Geithner," More generally, I would say that, again, this country, our Nation, did not have effective means to prevent the buildup of risk that would be threatening to the system nor to protect the economy from the consequences of the unwinding of those big bubbles. " CHRG-111shrg57923--38 Mr. Horne," I have known that there has been a national housing problem since the first time that our partners--we have over 900 data partners that we work with. One of our largest data partners is First American CoreLogic, which is the largest collector of deed, tax, and mortgage roll property information in the country. So when I started analyzing their data and combining it with Dow Jones information about the individual market segments and the tremendous volumes--I mean, we collect terabytes and terabytes of information--and start looking at the various factors that we call trigger events--these are things that occur that show an action taking place that is either positive or potentially adverse actions--we saw this occurring, frankly, before 2007. We actually saw the bubble before the bubble and could tell some of these things were starting to happen. The problem, again, is this is macro data. When they roll it up and look at it, they usually look at it within the housing market, within the specific segment of the database that they have, and we haven't brought it together with our unemployment findings, with our bankruptcy findings, with our commercial real estate information to separate it from the residential real estate information. And this disaggregation of information in these individual silos prevent us from being able to do, except through very extensive manual efforts, the ability to bring this data together in a way so we actually can build real models on the symbiosis, the systemic issues that are occurring between all these different factors in the marketplace. The systemic issues that occur within an institution and institutions, which I think we are talking about here, between the majors, the Citicorps, the JPMorgans, the AIGs, are extensive and we understand that they are very complex and the counterparty risks there are very difficult to track, particularly if you don't have access to all of the other pieces of information. Now, we have large amounts of information regarding derivative data, regarding all sorts of different kinds of financial instruments, but it is only segments of the market. We don't have all of it because not all of it is available, even in public or private data. So part of the issue here is the investment that needs to be done to actually build the database. Senator Reed. Well, I don't--we have taken a great deal of your time and it has been extremely valuable, so thank you. But I don't sense there is a mutually exclusive sort of agenda here. I think we are talking about the same thing, which is building in the short term an information gathering and an analytical capability that will help us, but in the longer term, getting to the point where it is just not prediction, there might be even some treatment involved, which is the point you made. Dr. Mendelowitz, a final point. " FOMC20050630meeting--12 10,MR. WILLIAMS.," I’ll be referring to the exhibits beginning on page 26. In my presentation today, I’ll lay out a few scenarios that illustrate the potential macroeconomic fallout resulting from a significant decline in house prices, and I will examine policy responses that minimize it. I’ll start by describing the possible size of the current problem—assuming there is one. As pointed out in Dick Peach’s presentation, there are serious difficulties in accurately measuring both actual and “fundamental” house prices. But, for the purposes of my presentation, I will take as a working hypothesis that house prices are high relative to fundamentals—or, in terms of the decision tree that Glenn just laid out, I assume that the answer to his question 1 is “Yes, the asset price appears misaligned.” As Josh Gallin indicated, it would take up to a 20 percent decline in house prices to bring the price-to-rent ratio back in line with fundamentals. With housing wealth standing at around $18 trillion today, such a drop in house prices would extinguish $3.6 trillion of household wealth. That’s equal to about 30 percent of GDP. Based on a marginal propensity to consume from housing wealth of 3½ cents on the dollar, this decline in wealth would entail a nearly 1½ percentage point increase in the personal saving rate. And, according to estimates from the FRB/US model, it implies a 40 basis point reduction in the long-run neutral real funds rate. June 29-30, 2005 18 of 234 at that time were arguably some 50 to 70 percent overvalued. Correction of prices to fundamentals at that time would have implied a reduction in household wealth of $6.7 trillion, equal to about 70 percent of contemporaneous GDP. In the event, stock market wealth fell by $4.6 trillion between March 2000 and March 2001, and at its lowest point was down $8.5 trillion. There is considerable uncertainty regarding the magnitude of the effects of changes in stock market and housing wealth on household spending; nonetheless, it seems clear the magnitude of the current potential problem is much smaller than, and perhaps only half as large as, that of the stock market bubble. Of course, if house prices continue to soar—and in the San Francisco Bay Area, at least, they show no signs of slowing—the magnitude of the housing overvaluation problem will rise as well. A cautionary note worth emphasizing is that the monetary policy cushion available today, as measured by the prevailing federal funds rate, is noticeably smaller than it was in early 2000 at the peak of the stock market. The first question that comes to mind is: What should monetary policy do, if anything, about the apparent overvaluation in house prices? The answer to that depends crucially on the answer to Glenn’s second question: “Do bubble fluctuations result in large macroeconomic consequences that monetary policy cannot readily offset?” Therefore, I now explore the effects of a bubble collapse and the ability of policy to respond effectively to them. I consider three scenarios in which a housing bubble deflates relatively quickly. I use the FRB/US model to quantify these effects. Note that for the materials posted last Wednesday, I based my simulations on the April Greenbook projection. I have since updated the simulations, and the ones that I will be showing today are based on the extended June Greenbook projection. In each scenario, I assume that house prices fall by 20 percent relative to the baseline over the next 2½ years. June 29-30, 2005 19 of 234 gap, and with the long-run natural rate of interest that appears in the rule varying in accord with sustained changes in housing wealth and bond premiums. The second page of my exhibit shows the results from model simulations of a 20 percent decline in house prices, where only the standard channels included in the FRB/US model are in play. For comparison, I have also plotted the baseline paths, based on the June extended Greenbook projection but modified under the assumption that monetary policy is set optimally in the way I just described. Because a decline in house prices primarily influences demand, not supply, it does not pose a difficult tradeoff between policy goals. In addition, according to the model, the macroeconomic effects play out gradually and are moderate in magnitude, giving policy time to respond. The optimal policy calls for a path for the funds rate that averages about 3¼ percent during 2007 and 2008—about 40 basis points below the baseline path. Under this policy, the unemployment and inflation rates are nearly the same as in the baseline. The very small rise in inflation reflects the effects of the depreciation of the dollar resulting from the reduction in domestic interest rates. The modified Taylor rule is able to mimic the outcomes under the optimal policy reasonably well, indicating that policy need not fully anticipate future house- price declines to be effective, but can simply respond to events as they unfold. Note that if the house-price decline were larger (or the marginal propensity to consume out of housing wealth bigger), then the policy implication would simply be to cut rates by proportionally more. In summary, assuming that the FRB/US model does a good job of capturing the macroeconomic implications of declining house prices, such an event does not pose a particularly difficult challenge for monetary policy. One lingering concern, however, is that the model may be missing other important avenues by which large movements in house prices affect the economy. I now consider a scenario that entertains that possibility. June 29-30, 2005 20 of 234 The Taylor rule, however, is not as successful. It fails to anticipate the spillover effects and responds too timidly once they occur. Still, it contains the rise in unemployment to only about ½ percentage point above baseline and moves inflation slightly more rapidly toward the assumed inflation objective. I should note that, given the uncertainty regarding the size and timing of such spillovers, the ideal outcome in the optimal policy simulation exaggerates the real-world ability of monetary policy to offset the effects of such shocks. As I noted before, the thought experiment behind these first two sets of simulations is that house prices fall in a kind of vacuum, without any relationship to other events. Some commentators have argued that the current high level of house prices is the outcome of a history of very low interest rates and past house-price appreciation that has given rise to irrationally optimistic expectations of future appreciation. Indeed, a simple estimated equation relating the current price-to-rent ratio to the user cost of housing and past house-price appreciation does a reasonably good job of explaining much of the run-up in house prices over the past several years. If this explanation holds water, a potential risk to housing prices and the outlook in general lies in the path of longer-term interest rates—which have been surprisingly low, given prevailing economic conditions—and the usual behavior of term premiums. Bond yields could return to more normal levels and in so doing contribute to a downward trajectory in house prices. I explore such a possibility in the final scenario, which builds on Scenario 2, and is the subject of the next page of my exhibit. I now add the assumption that the term premiums on long-term bonds rise by 75 basis points, relative to baseline, over the second half of this year and remain at these levels. This aspect of the scenario is similar to an alternative scenario reported in the June Greenbook. This shock to bond premiums by itself reduces the long-term equilibrium real funds rate by about 70 basis points. Optimal policy calls for the funds rate to fall below 1 percent by the middle of next year and for the funds rate to remain below 3 percent through 2008. The optimal policy is just able to contain the rise in unemployment without confronting the zero bound. The Taylor rule, on the other hand, responds too gradually to events, and, as a result, the unemployment rate reaches 6 percent in early 2007. This scenario presents a difficult challenge for monetary policy, especially in light of the looming zero lower bound on interest rates under the optimal policy. More generally, it highlights that the risks posed by a house-price decline are magnified if they occur in tandem with other events that damp economic activity. June 29-30, 2005 21 of 234 other factors, upon which such a policy necessarily would rely, is imperfectly understood and may have changed over time. Moreover, as seen in the earlier presentations, there remains considerable uncertainty over the degree of overvaluation. Thus, the successful use of monetary policy to reduce the magnitude of a misalignment of house prices would be a daunting task, even assuming that such a goal were deemed desirable. This concludes our prepared remarks." fcic_final_report_full--101 U .S. Home P ri c es INDEX VALUE: JANUARY 2000 = 100 300 250 200 150 100 50 0 Sand states U.S. total Non-sand states U. S . A pr il 2006 201 U. S . A ugust 2010 145 1976 1980 1985 1990 1995 2000 2010 NOTE: Sand states are A rizona, California, Florida, and Nevada. SOURCE: CoreLo g ic and U.S. Census B ureau: 2007 A merican Community Survey, FCIC calculations Figure . ings netted these households an estimated  billion; homeowners accessed an- other  billion via home equity loans.  Some were typical second liens; others were a newer invention, the home equity line of credit. These operated much like a credit card, letting the borrower borrow and repay as needed, often with the conven- ience of an actual plastic card. According to the Fed’s  Survey of Consumer Finances, . of homeowners who tapped their equity used that money for expenses such as medical bills, taxes, elec- tronics, and vacations, or to consolidate debt; another . used it for home improve- ments; and the rest purchased more real estate, cars, investments, clothing, or jewelry. A Congressional Budget Office paper from  reported on the recent history: “As housing prices surged in the late s and early s, consumers boosted their spending faster than their income rose. That was reflected in a sharp drop in the per- sonal savings rate.”  Between  and , increased consumer spending ac- counted for between  and  of GDP growth in any year—rising above  in years when spending growth offset declines elsewhere in the economy. Meanwhile, the personal saving rate dropped from . to .. Some components of spending grew remarkably fast: home furnishings and other household durables, recreational goods and vehicles, spending at restaurants, and health care. Overall consumer spending grew faster than the economy, and in some years it grew faster than real disposable income. Nonetheless, the economy looked stable. By , it had weathered the brief re- cession of  and the dot-com bust, which had caused the largest loss of wealth in decades. With new financial products like the home equity line of credit, households could borrow against their homes to compensate for investment losses or unemploy- ment. Deflation, against which the Fed had struck preemptively, did not materialize. At a congressional hearing in November , Greenspan acknowledged—at least implicitly—that after the dot-com bubble burst, the Fed cut interest rates in part to promote housing. Greenspan argued that the Fed’s low-interest-rate policy had stim- ulated the economy by encouraging home sales and housing starts with “mortgage interest rates that are at lows not seen in decades.” As Greenspan explained, “Mort- gage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that home- owners had built up.”  In February , he reiterated his point, referring to “a large extraction of cash from home equity.”  CHRG-111hhrg53245--11 INSTITUTION Ms. Rivlin. Thank you, Mr. Chairman. I am really glad you're holding this hearing to focus on the question of systemic risk and how do we avoid getting into this situation again; and, as you pointed out, I don't think anybody wants more bailouts ever if we can avoid it. I think that requires focusing on prevention. How do we fix the financial system so that we don't have these perfect storms of a huge bubble that makes our system very prone to collapse? And then if this does happen, how do we make it less likely that we would have to resort to bailing out institutions? So I think the task before this committee is first to repair the regulatory gaps and change the perverse incentives and reduce the chances that we will get another pervasive bubble. But, however, hard we try to do this, we have to recognize that there's no permanent fix. And I think one concept of systemic risk, what I call a macro system stabilizer that we need is an institution charged with looking continuously at the regulatory system at the markets and at perverse incentives that have crept into our system. Because whatever rules we adopt will become obsolete as financial innovation progresses, and market participants find around the rules. This macro system stabilizer, I think, should be constantly searching for gaps, weak links, perverse incentives, and so forth and should make views public and work with other regulators and Congress to mitigate the problem. Now, the Obama Administration makes a case for such an institution, for a regulator with a broad mandate to collect information from all financial institutions and identify emerging risk. It proposes putting this responsibility in a financial services oversight counsel, chaired by the Treasury with its own expert staff. That seems to me likely to be a cumbersome mechanism, and I would actually give this kind of responsibility to the Federal Reserve. I think the Fed should have the clear responsibility for spotting emerging risks, and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and the possible threats to it, similar to the report you heard from Mr. Bernanke this morning about the economy. It should consult regularly with the Treasury and other regulators, but it should have the lead responsibility for monitoring systemic risk. Spotting emerging risk would fit naturally with the Fed's efforts to monitor the state of the economy and the health of the financial sector in order to set and implement monetary policy. Having that explicit responsibility and more information on which to base it would enhance its effectiveness as a central bank. I would also suggest giving the Fed a new tool to control leverage across the financial system. While lower interest rates may have contributed to the bubble, monetary policy has multiple objectives, and the short-term interest rate is a poor tool for controlling bubbles. The Fed needs a stronger tool, a control of leverage more generally. But the second task is one you have emphasized in your title, how to make the system less vulnerable to cascading failures, domino effects, due to the presence of large interconnected financial firms whose failure could bring down other firms and markets. This view of what happened could lead to policies to restrain the growth of large interconnected financial firms or even break them up. " fcic_final_report_full--482 However, some of the benefits of securitized mortgages are also detriments when certain mortgage market conditions prevail. If housing values are declining, losses on whole mortgages are recognized only slowly in bank financial statements and will be recognized even more slowly in the larger market. PMBS, however, are far more vulnerable to swings in sentiment than whole mortgages held on bank balance sheets. First, because they are more easily traded, PMBS values can be more quickly and adversely affected by negative information about the underlying mortgages than whole mortgages in the same principal amount. PMBS markets tend to be thin, because PMBS pools differ from one another. If investors believe that mortgages in general are declining in value, or they learn of a substantial and unexpected number of defaults and delinquencies, they may abandon the market for all PMBS, causing the general PMBS price level to fall precipitously. For example, in his book Slapped by the Invisible Hand , Professor Gary Gorton of Yale notes that the ABX index, initially published in late 2006, for the first time gave investors a picture of how others saw the value of a selected group of PMBS pools. The index showed steeply declining values, which caused many investors to withdraw from the market. Gorton observed: “I view the ABX indices as revealing hitherto unknown information, namely, the aggregated view that subprime was worth significantly less…It is not clear whether the housing bubble was burst by the ability to short the subprime housing market or whether house prices were going down and the implications of this were aggregated and revealed by the ABX indices” 49 Whatever the underlying reason, as shown in Figure 3, this seems to be exactly what happened in the financial crisis. The result was a crash in the MBS market as investors fled what looked like major oncoming losses. 49 Gorton, Slapped by the Invisible Hand , note 41, pp.121-123. FinancialCrisisInquiry--652 GORDON: January 13, 2010 Yes. You know, what we’ve observed over time with traditionally underserved borrowers or people with lower or nontraditional credit histories is that we always had higher delinquency rates than was typical in the prime markets but our actual loss rates always ran under 1 percent. And part of that was because—part of how to run a successful operation, lending to these communities, includes understanding that there can be different kinds of income interruptions and vicissitudes of life and working with borrowers through those periods to keep the loan performing. And so, really, we—you know, now, of course, we’ve been impacted by the larger crisis. But just—then what’s become what we now talk about as subprime lending is loan products that had risky features and, as Professor Rosen’s discussed, lots of layers of risk. And these were not products, for the most part, except in the narrowest, narrowest sense—for the most part, these were never products that provided particular benefits to the consumers. They were products that were push-marketed to, you know, more vulnerable populations and then spread out as the bubble grew and housing became more unaffordable for most families. fcic_final_report_full--14 Finally, when the housing bubble popped and crisis followed, derivatives were in the center of the storm. AIG, which had not been required to put aside capital re- serves as a cushion for the protection it was selling, was bailed out when it could not meet its obligations. The government ultimately committed more than  billion because of concerns that AIG’s collapse would trigger cascading losses throughout the global financial system. In addition, the existence of millions of derivatives con- tracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic, helping to precipitate government assistance to those institutions. • We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors re- lied on them, often blindly. In some cases, they were obligated to use them, or regula- tory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their down- grades through 2007 and 2008 wreaked havoc across markets and firms. In our report, you will read about the breakdowns at Moody’s, examined by the Commission as a case study. From  to , Moody’s rated nearly , mortgage-related securities as triple-A. This compares with six private-sector com- panies in the United States that carried this coveted rating in early . In  alone, Moody’s put its triple-A stamp of approval on  mortgage-related securities every working day. The results were disastrous:  of the mortgage securities rated triple-A that year ultimately were downgraded. You will also read about the forces at work behind the breakdowns at Moody’s, in- cluding the flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight. And you will see that without the active participation of the rating agencies, the market for mort- gage-related securities could not have been what it became. * * * T HERE ARE MANY COMPETING VIEWS as to the causes of this crisis. In this regard, the Commission has endeavored to address key questions posed to us. Here we discuss three: capital availability and excess liquidity, the role of Fannie Mae and Freddie Mac (the GSEs), and government housing policy. First, as to the matter of excess liquidity: in our report, we outline monetary poli- cies and capital flows during the years leading up to the crisis. Low interest rates, widely available capital, and international investors seeking to put their money in real estate assets in the United States were prerequisites for the creation of a credit bubble. Those conditions created increased risks, which should have been recognized by market participants, policy makers, and regulators. However, it is the Commission’s conclusion that excess liquidity did not need to cause a crisis. It was the failures out- lined above—including the failure to effectively rein in excesses in the mortgage and financial markets—that were the principal causes of this crisis. Indeed, the availabil- ity of well-priced capital—both foreign and domestic—is an opportunity for eco- nomic expansion and growth if encouraged to flow in productive directions. Second, we examined the role of the GSEs, with Fannie Mae serving as the Com- mission’s case study in this area. These government-sponsored enterprises had a deeply flawed business model as publicly traded corporations with the implicit back- ing of and subsidies from the federal government and with a public mission. Their  trillion mortgage exposure and market position were significant. In  and , they decided to ramp up their purchase and guarantee of risky mortgages, just as the housing market was peaking. They used their political power for decades to ward off effective regulation and oversight—spending  million on lobbying from  to . They suffered from many of the same failures of corporate governance and risk management as the Commission discovered in other financial firms. Through the third quarter of , the Treasury Department had provided  bil- lion in financial support to keep them afloat. FOMC20060808meeting--74 72,MS. BIES.," Thank you, Mr. Chairman. I think our decision today is going to be a close call because of the recent information we’ve gotten both on inflation and on the growth of the economy. We know that, as President Poole and others have mentioned, wage and price inflation has been accelerating and is fairly broadly based. The recent NIPA revisions also concern me because of the faster growth in core PCE prices that those data show. The business surveys, in fact, show that companies feel they have more pricing power than they have had in the past. We know that we are going to have some continuing feed-through of the higher prices of oil. After talking to some folks in the oil industry, I am concerned about the recent Alaska situation. It clearly shows that maintenance of equipment and the efficiency of the operations of some of these companies may be under stress with the high volumes of capacity at which they have been running. We pray that it doesn’t extend much further in additional surprises. What also concerns me about the NIPA revisions are the changes in the productivity numbers. The fact that with the NIPA revisions we are seeing lower productivity and faster- rising labor costs has implications for our forward expectations on inflation. We also see that business investment in equipment and software was much lower. That downward revision worries me because it implies that less capital deepening has occurred, and that would have been a strong base to support productivity going forward. Now we apparently cannot rely on it as a base as much as we could before the revisions. In terms of the housing markets, the rapid escalation of home sale cancellations clearly has been very surprising. Again, the gross sales figures don’t show this, but the information we’ve got on the cancellations indicates a much more pronounced slowdown than we might have expected. In looking through other housing cycles and in talking to bankers and lenders, one of the good things I find is that the industry learned in the 1980s. Because those in the industry are more sophisticated in the way they manage their land costs and their inventory, I think the length of the cycle is unlikely to be as long. In the 1980s, bankers made plenty of funds available for companies to continue to develop land and to put in infrastructure. When the housing bubble burst, all of a sudden we had unsold housing units. They had to be sold before builders could start building on the developments that had already been laid out, and it took us several years to work through that. This time we don’t have the unfinished inventory of developments that we had in the ’80s. So I think that the cycle is likely to be much shorter than it was then and that it will put some firmness in that market. At the same time, this is the sector, aside from energy and commodities, that had a very rapid rise in prices, and it’s good that we’re seeing some correction in those prices right now. The other good trend that I take comfort in is the one that Dino mentioned earlier—that we’re seeing central banks around the world raising rates. When we started raising our rates a couple of years ago, there weren’t too many moving at the same time we did. We know that today monetary policy has global effects: Excessive accommodation in some countries clearly can affect investments in other countries. So I think we now have support in what we’re doing to remove accommodation. We’re seeing that support more broadly across the world; and in the aggregate, then, it will help to moderate inflation in the period going forward. Finally, I’m reminded that we do have long lags in monetary policy, and we still have to see the full impact of what we have already put in train. Thank you, Mr. Chairman." FOMC20080121confcall--49 47,MR. HOENIG.," Mr. Chairman, I hear you, and I appreciate your concerns. I do understand that there is a psychology in the market that is having its effect. I think if we make this statement as strong as we can about the need to watch inflation, and if we understand among ourselves that, as we take this action today and the follow-up actions that I am certain we are going to take, we will watch these inflation numbers, including broad asset values--I know we don't prick bubbles and that sort of thing, but watching these broad asset-price movements--that would be very, very important, at least to think about. I do not wish to be dissenting on this, as troubled as I am about it. I do understand the psychology of it. For those reasons, I am willing to go along with this. But I worry about our ability to deal with reversal as this takes place, especially given where our projections for growth are right now and my concern that we already have inflation above 4 percent. So I defer to you at this point. I would vote for it because I think the psychology of the marketplace is, of course, rather fragile, and I will leave it at that. Thank you. " fcic_final_report_full--458 Given the likelihood that large numbers of subprime and Alt-A mortgages would default once the housing bubble began to deflate in mid- 2007—with devastating effects for the U.S. economy and financial system—the key question for the FCIC was to determine why, beginning in the early 1990s, mortgage underwriting standards began to deteriorate so significantly that it was possible to create 27 million subprime and Alt-A mortgages. The Commission never made a serious study of this question, although understanding why and how this happened must be viewed as one of the central questions of the financial crisis. From the beginning, the Commission’s investigation was limited to validating the standard narrative about the financial crisis—that it was caused by deregulation or lack of regulation, weak risk management, predatory lending, unregulated derivatives and greed on Wall Street. Other hypotheses were either never considered or were treated only superficially. In criticizing the Commission, this statement is not intended to criticize the staff, which worked diligently and effectively under diffi cult circumstances, and did extraordinarily fine work in the limited areas they were directed to cover. The Commission’s failures were failures of management. 1. Government Policies Resulted in an Unprecedented Number of Risky Mortgages Three specific government programs were primarily responsible for the growth of subprime and Alt-A mortgages in the U.S. economy between 1992 and 2008, and for the decline in mortgage underwriting standards that ensued. The GSEs’ Affordable Housing Mission. The fact that high risk mortgages formed almost half of all U.S. mortgages by the middle of 2007 was not a chance event, nor did it just happen that banks and other mortgage originators decided on their own to offer easy credit terms to potential homebuyers beginning in the 1990s. In 1992, Congress enacted Title XIII of the Housing and Community Development Act of 1992 6 ( the GSE Act), legislation intended to give low and 6 Public Law 102-550, 106 Stat. 3672, H.R. 5334, enacted October 28, 1992. 453 moderate income 7 borrowers better access to mortgage credit through Fannie Mae and Freddie Mac. This effort, probably stimulated by a desire to increase home ownership, ultimately became a set of regulations that required Fannie and Freddie to reduce the mortgage underwriting standards they used when acquiring loans from originators. As the Senate Committee report said at the time, “The purpose of [the affordable housing] goals is to facilitate the development in both Fannie Mae and Freddie Mac of an ongoing business effort that will be fully integrated in their products, cultures and day-to-day operations to service the mortgage finance needs of low-and-moderate-income persons, racial minorities and inner-city residents.” 8 The GSE Act, and its subsequent enforcement by HUD, set in motion a series of changes in the structure of the mortgage market in the U.S. and more particularly the gradual degrading of traditional mortgage underwriting standards. Accordingly, in this dissenting statement, I will refer to the subprime and Alt-A mortgages that were acquired because of the affordable housing AH goals, as well as other subprime and Alt-A mortgages, as non-traditional mortgages, or NTMs FOMC20080318meeting--196 194,MR. HOENIG.," Vice Chairman, we have a bubble developing in some parts of our area. I think they are aware of that, and so I think we have to be mindful of that in our discussion more broadly. That is why I think there are important differences that we should necessarily be able to--and should in fact--acknowledge publicly. " FinancialCrisisInquiry--222 GEORGIOU: And construction, right. ZANDI: Let me just give you a statistic. Of the 8 million jobs lost after revision, almost 20 percent are in the construction trade. GEORGIOU: No, I think I’m fine. Thank you. I’ll yield the rest of my time. ZANDI: Good luck with that home. CHAIRMAN ANGELIDES: Mr. Thompson? THOMPSON: Thank you, Mr. Chairman. Many of the questions I had have been addressed, but I do want to ask a few specifics. Ms. Gordon, to what extent, in your opinion, might CRA have been a contributor in any way to the housing bubble? GORDON: We don’t see CRA as a contributor to the—the crisis that occurred. CRA had been working for several decades to get some more lending to people who were qualified for the loans that they were getting. CRA was not intended to put unqualified people into home loans. It was intended to get lending to otherwise qualified people who weren’t being serviced by the financial institutions. THOMPSON: And you would agree with that, Dr. Rosen? CHRG-111hhrg53245--121 Mr. Zandi," Exactly; right. I do think there was a general philosophy, maybe even to this day, that the Federal Reserve should not weigh against asset bubbles, that is not in their job description, so to speak. I think that is inappropriate. I think that it should be something they should do and the tool that they need to implement that-- " CHRG-110shrg50409--55 Mr. Bernanke," Well, a part of what has been happening--and this goes back to Senator Menendez's question about the role of the subprime crisis and so on--is that there was, if you will, a credit boom or a credit bubble where there was an overextension of credit in a lot of areas. There has been a big reversal of attitudes. Banks and other financial institutions are scaling back on their credit risk. They are deleveraging. They are raising capital. And that adjustment process is part of what is happening now that is creating the drag on economic growth. So it is harder to get a mortgage, it is harder to get a business loan. And until we come to a more stable situation where banks are comfortable with their credit standards and their balance sheets, the leveraging process is going to continue and is part of what we are seeing here. Senator Tester. And very quickly, because my time is over, do you--I mean, we have heard figures of 150 banks potentially going down because, I assume, of this adjustment that you just talked about. Do you guys have any projections on what kind of impact banking institutions going down, how many there potentially could be in the next year or do you not want to comment on that? " FOMC20070131meeting--156 154,MR. BARRON.," Thank you, Mr. Chairman. I thought I’d focus a little more today in my comments on the State of Florida as it relates to the housing sector. We’ve heard a lot more positive comments in just the past few minutes about housing. So let me offer a contrarian view, if you will. Florida accounts for about 41 percent of our District employment and 6 percent of overall U.S. employment. As for housing, Florida represented 8 percent of U.S. home sales in 2005 and 6 percent in 2006 as sales and construction continued to decline. To put these numbers in perspective, single-family existing home sales in Florida have dropped 40 percent since January 2005 versus an 11 percent decline in the United States as a whole. Anecdotal reports are that builders are continuing to work down existing inventory and are not starting new projects. In most areas of the state, starts have fallen even more than sales, which should lessen the run-up in housing inventory over the immediate future. Permit issuance for single-family homes is down 54 percent in Florida since January 2005 compared with 28 percent in the nation as a whole. There are certain encouraging signs from reports noting, as mentioned earlier, that buyer traffic is better in some areas, and several of the building contacts that we spoke with expect or, perhaps I would note more accurately, are hopeful that new home sales will improve by the second quarter of 2007. Home prices have declined modestly but remain well above the levels implied by the pre- 2003 trends in most areas. This places housing affordability at a relatively low level by historical standards. As I noted at previous meetings, the demand in coastal markets is being constrained by the steep rise in homeownership insurance that has caused monthly housing costs to rise sharply, even as house prices moderate. We’ve heard reports that in markets where prices accelerated the most in recent years, such as south Florida, employers are struggling to recruit staff because of the high housing costs, with some firms electing to leave south Florida and others beginning to convert corporate owned land to corporate housing just so that they can recruit employees. As I reported at our last meeting, the decline in housing activity continues to have a negative effect on housing- related sectors specifically in the South because of our concentration in the carpet and other related industries. Housing-related employment is no longer a net contributor to year-over-year employment growth in the United States, even though overall job growth has remained very firm. District banks reported that credit quality has softened but remains at very strong levels. However, banks are beginning to be a bit more vocal in expressing concern with regard to the possibility that builders will face financial problems in the coming months. In addition, banks express concern about the number of speculative condominium projects in south Florida. District banks have lower earnings targets for 2007, and the expectation is that bank merger and acquisition activity and layoffs will increase in the coming year. Some banks are even putting out the “for sale” sign in the hope of cashing out now, noting that things could get ugly over the next two years in some areas. Outside the housing sector, indicators of economic performance in the District were mixed. Reports on holiday-related sales were on the positive side, whereas tourism remains relatively mixed across the District. Reports from the manufacturing sector were also mixed, with a weakness in the housing-related industries offset to some extent by the expanding activity in industries related to defense and energy. For the U.S. economy as a whole, the drag from housing that we experienced over the second half of 2006 does not appear at this time to pose a serious threat to the overall economy, although some forecasters anticipate below-trend real GDP growth for the end of 2006 and the first quarter of 2007. Most would say that this situation is temporary and would anticipate that real GDP growth will rebound and be close to the trend rate of 3 percent for the rest of 2007. Our staff projections of real GDP growth have had about the same tone as those of the external forecasters. Our staff believes real GDP growth will be sustained in 2007 by job creation that should match the experience that we’ve seen in 2006. Measured core inflation was well in excess of 2 percent at the end of 2006. The staff forecast is that core inflation will continue to hover just above 2 percent for all of 2007. The expectation is that price growth in services will continue to dominate core inflation going forward. In my comments I’ve focused a bit more on housing. I would just close by noting that my continued concern would be the lack of impetus to drive down inflation over the long term. Thank you." CHRG-110shrg50369--32 Mr. Bernanke," Senator, I realize my testimony was not the most cheerful thing you will hear today, and I was thinking very much about the short-term challenges that we face in terms of the financial markets and growth and inflation. But I do very much believe that the U.S. economy will return to a strong growth path with price stability. We have enormous resources, resilience, productivity, and I am quite confident in the American economy and the American people that we will have strong economic growth in the next few years. Senator Shelby. Mr. Chairman, a commonly watched measure of inflation, as you well know, is the core CPI. Housing constitutes, I understand, almost a third of the core CPI. To what extent has the recent decline in housing prices moderated recent increases in the core CPI? As housing prices go down, inflation, you know, should play here in a negative way, should it not? " CHRG-111shrg55278--65 BROOKINGS INSTITUTION Ms. Rivlin. We are on a roll here. Thank you, Mr. Chairman and Members of the Committee. Controlling systemic risk breaks into two questions, I think, how to avoid the excesses of a bubble economy that can burst and cause a catastrophic downward spiral, and second, how to make sure that if a large interconnected institution fails, it doesn't start that downward spiral and take others with it. On the first question, how to prevent the excesses of a bubble, we need to fix regulatory gaps. Ineffective regulation contributed to the excesses and allowed lax lending standards and all of the things that we have worried about. And we need to correct the perverse incentives that crept into the system, as with the originate-to-distribute model. That can be done, correcting the gaps and perverse incentives, but however we do that, the job is not over. Participants in the financial system will try to avoid the rules, whatever they are. The system will need constant monitoring to make sure that new gaps and perverse incentives are not creeping in that lead to new excesses and instability. So I think one job is this monitoring function. The Obama Administration would put this function with a Financial Oversight Council chaired by the Treasury but with its own staff. I think it would make more sense to put this function at the Federal Reserve, perhaps consulting with a council. The Fed has the clear overview of the whole economy. It fits with the job that they already have for monitoring the economy and the health of the banking system. I would also give the Fed another tool, broader control of the amount of leverage in the system. Bubbles get out of hand when demand is fueled by big increases in speculation with other people's money. The short-term interest rate is not a sufficient tool for controlling as that price bubbles. So I would recommend working out a system in which not only capital requirements, but other constraints on leverage across the system could be tightened in the face of a serious bubble threat. Then there is the problem of the large interconnected institution. This can be mitigated by making it more expensive to get big, having capital requirements rise as institutions grow, for instance. We need much more effective prudential regulation of all financial institutions, especially as they get big enough to threaten the system. The Obama Administration proposes designating institutions that pose systemic risk and giving the Fed responsibility for consolidated prudential regulation of what they call Tier 1 Financial Holding Companies. I think both parts of that proposition would be a mistake. We should not designate institutions as too-big-to-fail and give them their own regulator. It is hard to make up that list. But we would also be creating a new set of GSEs. There is a danger that the regulator of too-big-to-fail institutions would see its job as keeping them from failing and the result would eventually be expensive bailouts. Second, I would definitely not put additional regulatory responsibility at the Federal Reserve. The Fed is very good at monetary policy. It should be headed and staffed by strong macroeconomists who are charged with keeping on top of economic developments. These are different skills from regulation and I think putting an additional regulatory responsibility which they have historically not been very good at at the Fed would dilute their monetary policy focus. I also fear that adding a new set of regulatory authorities to the Fed's task would threaten the independence of monetary policy, which is very important to preserve. Congress would justifiably want more control over such a powerful agency, appropriations, accountability for policy, and so forth. It might easily threaten the independence of the Federal Reserve in taking unpopular decisions to rein in the bubble economy. Thank you, Mr. Chairman. Senator Warner. Professor Meltzer.STATEMENT OF ALLAN H. MELTZER, PROFESSOR OF POLITICAL ECONOMY, FOMC20080805meeting--60 58,VICE CHAIRMAN GEITHNER.," I have a question similar to President Plosser's. Both the financial shock--the housing adjustment--and the big relative price shock you could say all in different forms could hurt the rate of growth of the economy's productive potential. You could say that they all might, in some dimension, reduce the near-term expected path of potential growth. I guess my question is that you have this ""costly sectoral reallocation"" alternative scenario--do you attribute any effect on potential growth over the forecast period in your baseline to the combined effect of the housing adjustment and the big relative price shock from energy? " CHRG-111hhrg51698--78 Mr. Buis," In a very losing position, and they are locked into these higher costs, whether it is livestock producers or grain producers. Buy fertilizer based on record inputs, and fertilizer prices followed oil, and we all know that was a false bubble as well. " FinancialCrisisInquiry--183 And then we had wide-spread speculation. And I submitted an article to you as a commission, which I wrote in 2006 that was published in 2007. Nearly 30 percent of all home sales in the hot markets were just speculators. And this is not a bad thing, but the speculators put down almost no money. They were flipping houses. And our mortgage system was not able to distinguish between a homeowner and a speculator. And I think we really need to do a much better job of that in the future. We already are trying to. We’re— nothing wrong with speculating, but you’ve got to put down hard money -- 30 percent down. Some big number so they’re not destroying the market for the people who want to own and live in houses. There was a regulatory failure, and everybody knew this was happening. Everybody in the country knew this was happening by the middle of 2006 -- late 2006. One of the unregulated institutions—New Century—a mortgage broker—went bankrupt in early 2007. Everybody knew this, but it kept on going on. I tried very hard and others as well to talk to regulators about this—inform them of this—and within institutions—the Fed in particular. There was a big debate going on. Should they do something about it? And it was decided not to. They didn’t think they had the power. They didn’t really believe it was as bad as it was. But there was a big debate with board members about doing something about this. I think really the whole system of a non-recourse loan in both commercial and residential while desirable by the people borrowing has really created this problem. That there is a belief that it’s a—a put option. Things go well, great. If not, I can give it back. And this misalignment of interest at this level—the consumer level, the borrower level—and the misalignment of—of interest throughout the entire system where risk and rewards are disconnected is really how we’re going to fix this. So if I were to summarize I would say too much leverage, poor underwriting and lax regulation. But I want to take you through some of the charts I have. I know I’ve got about five more minutes, but tell you where we are today. And I think you have these at the end of the testimony. They’re figures. And let’s take the first one, which is the housing bubble. It says, “Figure One—U.S. Housing, Single Family Starts.” CHRG-111hhrg51698--623 Mr. Boswell," You are very welcome. Anyone else? Mr. Marshall? I think that concludes our panel today. We cannot thank you enough for your time, your presence. I also think it is fair and reasonable to say we are going to need to continue the dialogue. As I think you may have heard earlier today, we have to do this right. We are counting on your input. So, again, thank you very much, and we will call this meeting adjourned. [Whereupon, at 3:18 p.m., the Committee was adjourned.] [Material submitted for inclusion in the record follows:] Submitted Statement of Hon. Bart Chilton, Commissioner, U.S. Commodity Futures Trading Commission I commend Chairman Peterson for his continued leadership and support his efforts to restore the public's confidence in U.S. futures markets by ensuring appropriate oversight. The proposal incorporates needed changes to our current regulatory structure that will greatly improve our ability to protect consumers and businesses alike. In a speech last week, I quoted the American folklorist Zora Neale Hurston, who said; ``There are years that ask questions, and there are years that answer.'' This year must be a year of answers. During my remarks, I went on to lay out what I see as necessary steps to healing our fractures in our regulatory system. I'm pleased that the Chairman's proposal also addresses several of these critical components. (1) Require OTC reporting and record-keeping. This will enable the CFTC to examine trading information, particularly information about sizable, look-alike or price discovery transactions that could impact regulated markets--markets that have a bearing on what consumers pay for products like gasoline or food, or even interest rates on loans. (2) Oversee mandatory clearing of OTC Credit Default Swap (CDS) transactions, and encourage clearing for other OTC products as appropriate. The stability and safety of our financial system is significantly improved by enhancing clearing systems for CDSs--in a manner that does not lead to cross-border arbitrage--as well as for other OTC derivatives. Such clearing would not only provide counterparty risk, but a data audit trail for regulators. (3) Regulate OTC transactions if the Commission determines that certain trades are problematic. The CFTC should be given the authority to determine and set position limits (aggregated with exchange positions, and eliminate bona fide hedge exemptions) to protect consumers. Congress should also extend CFTC anti- fraud, anti-manipulation and emergency authorities as appropriate to OTC transactions to allow greater openness, transparency and oversight of our financial markets. These provisions are included in the Chairman's proposal. I am hopeful that the Committee will also consider two other items, one within its jurisdiction--the other an appropriations matter. (4) Public Directors on Investment Industry Boards. Corporate boards would benefit greatly from the inclusion of public directors who bring a diversity of backgrounds and experiences to the boardroom. Such a provision would allow farmers, consumer representatives or other individuals to serve and provide different, yet important perspectives. All too often, these boards look more like an extension of the companies themselves than a group of individuals that are there to spot problems and deliver constructive criticism. Unfortunately, what we witnessed in the securities world is that this had to be mandated rather than simply encouraged. For that reason, I would urge Congress to consider a requirement that a third of board members be considered public directors. (5) Congress should appropriate immediate full funding ($157 million for Fiscal Year 2009) in additional resources, which would allow the CFTC to hire an additional 150 employees, and fund related technology infrastructure so that the agency can properly effectuate our duties under the Commodity Exchange Act, as amended by the farm bill. Many in Congress have joined together to call for increased resources for the Securities and Exchange Commission (SEC). By comparison, the CFTC oversees exchanges with significantly greater market capitalization than the SEC. For example the CME Group alone has a market capitalization of roughly $11 billion, while NYSE/Euronext (largest U.S. securities exchange regulated by the SEC) has a market capitalization of $5.5 billion. The SEC has 3,450 employees, while the CFTC struggles with roughly 450--fully 3,000 less staff. It is not a popular thing to call for more money for Federal employees, but cops on the beat are needed to detect and deter crimes. The CFTC needs these additional resources and we need them now. There are many other provisions in the Chairman's proposal that I support, such as closing the London Loophole and ensuring exclusive jurisdiction over environmental futures market regulation. Simply put, the success of a cap-and-trade system requires an experienced regulator. The Chairman's proposal, if enacted, will bring much needed transparency and accountability to both over-the-counter and certain overseas markets; provide the CFTC the authorities necessary to prevent market disruptions from excessive speculation; and give regulators a window into currently ``dark markets'' by requiring reporting and record-keeping. ______ Supplemental Material Submitted by Michael W. Masters, Founder and Managing Member/Portfolio Manager, Masters Capital Management, LLC Dear Congressman Marshall: Thank you for your insightful questions and your leadership on the issue of excessive speculation. I wanted to respond promptly to your request for written answers to the two questions you posed during the hearing. Your first question pertained to a scenario wherein the commodities derivatives markets are balanced, with an equal number of speculators seeking trading profits on the one hand, and physical producers and consumers hedging their real business on the other. What happens, then, if a large number of ``invesculators'' enter the markets? What problems would that pose and what solutions would we need? I believe the scenario you describe is precisely what has happened to our commodity markets in the last 5 years, culminating with the extreme price movements of the last 18 months. ``Invesculators,'' as you referred to them, are extremely damaging to the commodities derivatives markets, due to their belief that commodities are an ``asset class.'' Commodities are raw materials that are consumed by individuals and corporations. They are not an ``asset'' (like a stock or a bond) that can be bought and held for the long term. As much as institutional investors want to believe that commodities can be considered assets, they simply cannot. Physical hedgers--those who produce and consume actual commodities--never suffer from ``irrational exuberance.'' When prices rise, producers are motivated to produce more (that's their business), and consumers are motivated to consume less. In contrast, the ``Invesculator'' responds to an increase in price by thinking, ``oh, that would be a good investment,'' and jumps on the bandwagon by submitting their own buy orders. This is the dynamic that causes price bubbles to form. Every capital asset category has had its bubbles through history: the Japan bubble, the emerging markets bubble, the Internet bubble, the housing bubble, the credit bubble, etc. Eventually, wherever investors go, price bubbles appear. When physical hedgers dominate the commodities derivatives markets then traditional speculators, because they are outnumbered, will emulate the behavior of the physical hedgers. But when speculators rule these markets then they can drive prices to irrational heights that have nothing to do with supply and demand. In the scenario that you described, wherein five speculators and five physical hedgers are transacting in the derivatives market, and then 45 ``invesculators'' show up, the result is a bubble, just as if you put your house on the market, had an open house, and 45 people showed up with their checkbooks. You're going to get a much higher price than if no one, or even a couple of people, showed up. While bubbles in asset markets can be intoxicating, bubbles in commodities are devastating. Every human being around the globe suffers when we experience bubbles in food and energy prices. So what can Congress do about it? Fortunately, the solution is simple, and Congress has already done it since 1936: put a limit on the size of positions that speculators can hold in order to prevent them from dominating the market. This worked superbly from 1936 until about 1998. It is simple and proven, and carries no unintended consequences. Unfortunately in 1998 the CFTC began to let speculative position limits slide. For them the term ``excessive speculation'' came to mean basically the same as ``manipulation.'' At which point the CFTC decided position limits were only necessary to prevent manipulation. Then, in 2000 the Commodities Futures Modernization Act (CFMA) allowed the formation of the Intercontinental Exchange (ICE), and exempted over-the-counter (OTC) swaps dealers from all regulation. The result was that there were no longer any real speculative position limits in energy. Also, the OTC markets effectively rendered position limits in agricultural commodities meaningless. What ensued was rampant speculation, which led to the bubble that finally burst in the second half of 2008. It's easy to see why it is not only essential to reinstate a system of speculative position limits on the exchanges, but it is also critical for those limits to apply to ICE and other exchanges, as well as the OTC markets. When there is a clearly defined limit placed on the money flowing into a market, then prices cannot expand fast enough to cause a bubble. Your question seemed to also pose a more nuanced scenario: assuming a market in which the speculative position limit is, for example, 1,000 contracts, and further assuming that 50,000 contracts are held by speculators and 100,000 contracts are held by physical producers and consumers, what if 300 new speculators show up and they all stay below the 1,000 contract limit, they can still buy 300,000 contracts combined, what should be done then? The answer is that speculative position limits need to be adjusted as market conditions dictate. This scenario provides an excellent illustration of why we recommend the formation of a physical hedgers' panel that would serve to adjust speculative position limits every 3-12 months. If the ratio of speculators to physical hedgers becomes too high (like 350,000 : 100,000--which, for reference, was the approximate ratio in 2008), then the panel should lower the speculative position limit from 1,000 contracts down to, say, 500 contracts. Similarly, if the ratio of speculators to physical hedgers is too low and the markets need more liquidity, then the panel would have the ability to raise the limit to allow speculators to take larger positions. Think of speculative position limits like a valve that controls the level of speculative money in the markets, as well as the speed with which money flows into the markets. We believe that the optimal ratio of speculators to physical hedgers is one to two (34% speculative). The commodities futures markets operated efficiently with no liquidity issues for decades while open interest stayed generally in the range of one speculator for every four physical hedgers. So if the physical hedgers' panel would target a ratio of one speculator for every two physical hedgers that would give the commodities derivatives markets abundant liquidity. Your second question pertained to the possible challenges of implementing across-the-board speculative position limits. The simplest and most effective way to implement speculative position limits is to enforce an ``aggregate'' speculative position limit that a speculator will face regardless of the transaction venue (e.g., a CFTC-regulated futures exchange like NYMEX, a non-CFTC-regulated futures exchange like ICE, or in the OTC market). Let's say that the physical hedger panel determines that the speculative limit for oil should be 5 million barrels or 5,000 contracts. Speculators would be told that they can buy up to 5 million barrels anywhere they want as long as they do not exceed this limit. Consider the problems that can arise if a system of speculative position limits is not established on an aggregate basis and instead individual trading venues are assigned their own unique limits. No matter what system is used for assigning those limits it will run into problems. As an example, if the aforementioned 5,000 contract speculative position limit for crude oil is apportioned as follows: NYMEX: 1,000 ICE: 1,000 OTC: 1,000 contract equivalent (1 million barrels) IPE: 1,000 (International Petroleum Exchange) DME: 1,000 (Dubai Mercantile Exchange) Then, under this scenario, speculators will be forced to spread their trading around in order to access their entire 5,000 contract speculative position limit. Since the amount of liquidity varies from one exchange/venue to the next, it would not make sense to encourage an equal amount of trading on each venue. For example, ICE has half the volume of NYMEX, so should they have the same limit as NYMEX or half the limit of NYMEX? Different problems arise however if unequal speculative position limits are imposed. If the limits were set to match current liquidity like this: NYMEX: 1,000 ICE: 500 OTC: 2,500 IPE: 800 DME: 200 Then the growth of ICE and other exchanges would be stunted due to their low relative limits. This system has the further effect of forcing speculators to trade OTC in order to reach their 5,000 contract maximum. This is not something that I believe Congress wants to do. If limits are placed on some venues but not others, then trading will flow to the places that offer unlimited speculation (currently the OTC markets). This would fail to safeguard against future speculative bubbles, which is what the speculative limits are designed to do. The best system for implementing aggregate speculative position limits would entail the following: (1) All OTC commodity derivative transactions must clear through an exchange. (2) Each speculator would have a trader identification number which would be associated with every trade, just like a customer account number. (3) Foreign boards of trade would have to supply information to the CFTC on U.S. traders (looking at the parent entity level). Those who oppose exchange clearing will complain about ``chicken fat'' swaps and the like, but in reality, 99% of all commodity swaps are composed of futures contracts and basis trades, which would all clear. Congress should resist attempts by Wall Street to avoid exchange clearing by claiming that their derivatives are too exotic and that therefore large segments of the market need to be exempted from the clearing requirement. Almost all OTC commodity derivatives should clear. As part of the clearing process OTC derivatives are transformed into futures contract equivalents. Therefore the process of applying speculative position limits to OTC derivatives that have exchange cleared is as simple as applying limits to futures contracts. Under this system of speculative position limits and exchange clearing, the aggregate activity for an individual trader can be calculated simply by tracking the trader identification number and adding up how much each trader has bought through each venue in each commodity. A trader who exceeds their limit could face a stiff financial penalty (100% of which can go to the CFTC to fund their operations) and that trader's positions could be liquidated on a last-in, first-out basis. In order for this regulation to capture transactions on foreign boards of trade, they must be required to submit the necessary information to the CFTC on a real-time basis in exchange for the CFTC allowing them to place direct terminals in the United States. The CFTC has many ``hooks'' that would allow them to ensure that aggregate speculative position limits apply to foreign boards of trade as well. In summary, the idea is to give speculators one limit and let them ``spend'' it wherever they see fit. I hope I have clarified why aggregate speculative position limits and exchange clearing are the surest protection against a future commodity bubble. Please let me know if I can be of any further assistance. Best regards,Michael W. Masters,Portfolio Manager,Masters Capital Management, LLC. ______ fcic_final_report_full--574 Register 60, no. 86 (May 4, 1995): 22155–223. 83. Division of Consumer and Community Affairs, memorandum to Board of Governors, August 10, 1998. 84. Federal Reserve Board press release, “Order Approving the Merger of Bank Holding Companies,” August 17, 1998, pp. 63–64. 85. Lloyd Brown, interview by FCIC, February 5, 2010. 86. Andrew Plepler, interview by FCIC, July 14, 2010. 87. Assuming 75% AAA tranche ($1.20), 10% AA tranche ($0.20), 8% A tranche ($0.30), 5% BBB tranche ($0.40), and 2% equity tranche ($2.00). See Goldman Sachs, “Effective Regulation: Part 1, Avoid- ing Another Meltdown,” March 2009, p. 22. 88. David Jones, interview by FCIC, October 19, 2010. See David Jones, “Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues,” Journal of Banking and Finance 24, nos. 1–2 (January 2000): 35–58. 89. Henry Paulson, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 1: Perspective on the Shadow Banking System, May 6, 2010), transcript, p. 34. 90. Jones, interview. Chapter 7 1. For example, an Alt-A loan may have no or limited documentation of the borrower’s income, may have a high loan-to-value ratio (LTV), or may be for an investor-owned property. 2. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Mar- ket (Bethesda, MD: Inside Mortgage Finance, 2009), p. 9, “Mortgage & Asset Securities Issuance” (show- ing Wall St. securitizing a third more than Fannie and Freddie); p. 13, “Non-Agency MBS Issuance by Type.” FCIC staff calculations from 2004 to 2006 (for growth in private label MBS). 3. Charles O. Prince, interview by FCIC, March 17, 2010. 4. John Taylor, interview by FCIC, September 23, 2010. 5. William A. Fleckenstein and Frederick Sheeham, Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve (New York: McGraw-Hill, 2008), p. 181. 6. Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble,” Wall Street Journal, March 11, 2009. See also Ben Bernanke, “Monetary Policy and the Housing Bubble,” speech at the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010. 7. Alan Greenspan, testimony before the Senate Committee on Banking, Housing, and Urban Affairs, 109th Cong., 1st sess., February 16, 2005. 8. Fed Chairman Ben S. Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,” re- marks at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, March 10, 2005. 9. Frederic Mishkin, interview by FCIC, October 1, 2010. 10. Pierre-Olivier Gourinchas, written testimony for the FCIC, Forum to Explore the Causes of the Financial Crisis, day 1, session 2: Macroeconomic Factors and U.S. Monetary Policy, February 26, 2010, pp. 25–26. . 11. Paul Krugman, interview by FCIC, October 6, 2010. 571 12. Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners,” Center for Responsible Lending, December 2006, p. 22. 13. 2009 Mortgage Market Statistical Annual , vol. 1, The Primary Market , p. 4, “Mortgage Originations by Product.” 14. Christopher Mayer, Karen Pence, and Shane M. Sherlund, “The Rise in Mortgage Defaults,” Jour- nal of Economic Perspectives 23, no. 1 (Winter 2009): Table 2, Attributes for Mortgages in Subprime and Alt-A Pools, p. 31. 15. 2009 Mortgage Market Statistical Annual, 2:13, “Non-Agency MBS Issuance by Type.” 16. 2009 Mortgage Market Statistical Annual , 1:6, “Alternative Mortgage Originations”; previous data extrapolated in FCIC estimates from Golden West, Form 10-K for fiscal year 2005, and Federal Reserve, “Residential Mortgage Lenders Peer Group Survey: Analysis and Implications for First Lien Guidance,” November 30, 2005. 17. Inside Mortgage Finance. 18. Countrywide, 2005 Form 10-K, p. 39; 2007 Form 10-K, p. 47 (showing the growth in Country- wide’s originations). 19. Angelo Mozilo, email to Sambol and Kurland re: Sub-prime Seconds. See also Angelo Mozilo, email to Sambol, Bartlett, and Sieracki, re: “Reducing Risk, Reducing Cost,” May 18, 2006; Angelo Mozilo, interview by FCIC. September 24, 2010. 20. David Sambol, interview by FCIC, September 27, 2010. 21. See Countrywide, Investor Conference Call, January 27, 2004, transcript, p. 5. See also Jody Shenn, “Countrywide Adding Staff to Boost Purchase Share,” American Banker, January 28, 2004. 22. Patricia Lindsay, written testimony for the FCIC, hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 1, sess. 2: Subprime Origination and Securitization, April 7, 2010, p. 3 23. Andrew Davidson, interview by FCIC, October 29, 2020. 24. Ibid. 25. David Berenbaum, testimony before Senate Committee on Banking, Subcommittee on Housing, CHRG-111hhrg56766--274 Mr. Foster," As you know, I am an enthusiast for actually looking into this as a way of stabilizing our economy against future, especially real estate, bubbles. We had some testimony from our snow-canceled hearing by a gentleman called Richard Koo from Nomura Securities Institute, and he talked about what he called a ``balance sheet recession.'' He said there was a qualitative difference between normal business circumstances where businesses respond to a lower interest rate by actually expanding operations, and a situation where after the bursting of a bubble that was fueled by deficits and so on, that you behave differently. If you are terrified you are insolvent, then a lower interest rate does not interest you, except in helping you pay off your debt faster. I was wondering if you think that is a valid point of view and really if there is an element to that. He made the comparison also of Japan 15 years ago and the United States today. I was wondering if you would comment on that. " FinancialCrisisReport--74 Home Equity originations were projected to grow from $4 billion in 2005 to $30 billion in 2008. On the other hand, WaMu’s low risk originations were expected to be curtailed dramatically. Government backed loan originations, which totaled $8 billion in 2005, were projected to be eliminated by 2008. Fixed rate loan originations were projected to decline from $69 billion in 2005 to $4 billion in 2008. The 2007 “Strategic Direction” memorandum to the Board is dated June 18, 2007, well after U.S. housing prices had begun to decline, as Mr. Killinger acknowledged: “For the past two years, we have been predicting the bursting of the housing bubble and the likelihood of a slowing housing market. This scenario has now turned into a reality. Housing prices are declining in many areas of the country and sales are rapidly slowing. This is leading to an increase in delinquencies and loan losses. The sub-prime market was especially rocked as many sub-prime borrowers bought houses at the peak of the cycle and now find their houses are worth less and they are having difficulties refinancing their initial low-rate loans.” 192 While the memorandum’s section on home loan strategy no longer focused on overall growth, it continued to push the shift to high risk lending, despite problems in the subprime market: “Home Loans is a large and important business, but at this point in the cycle, it is unprofitable. The key strategy for 2008 is to execute on the revised strategy adopted in 2006. … We need to optimize the sub-prime and prime distribution channels with particular emphasis on growing the retail banking, home loan center and consumer direct channels. We also expect to portfolio more of Home Loans’ originations in 2008, including the new Mortgage Plus product. We will continue to emphasize higher-risk adjusted return products such as home equity, sub-prime first mortgages, Alt A mortgages and proprietary products such as Mortgage Plus.” 193 The testimony of other WaMu executives further confirms the bank’s implementation of its High Risk Lending Strategy. Ronald Cathcart, who joined WaMu in 2006, to become the company’s Chief Risk Officer, testified: “The company’s strategic plan to shift its portfolios towards higher margin products was already underway when I arrived at WaMu. Basically, this strategy involved moving away from traditional mortgage lending into alternative lending programs involving adjustable-rate mortgages as well as into subprime products. The strategic shift to 192 6/18/2007 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic Direction,” JPM_WM03227058-67 at 60, Hearing Exhibit 4/13-6a. 193 Id. at 66 [emphasis in original removed]. See also 1/2007 Washington Mutual presentation, “Subprime Mortgage Program,” JPM_WM02551400, Hearing Exhibit 4/13-5 (informing potential investors in its subprime RMBS securities that: “WaMu is focusing on higher margin products”). higher-margin products resulted in the bank taking on a higher degree of credit risk because there was a greater chance that borrowers would default.” 194 fcic_final_report_full--13 While many of these mortgages were kept on banks’ books, the bigger money came from global investors who clamored to put their cash into newly created mortgage-re- lated securities. It appeared to financial institutions, investors, and regulators alike that risk had been conquered: the investors held highly rated securities they thought were sure to perform; the banks thought they had taken the riskiest loans off their books; and regulators saw firms making profits and borrowing costs reduced. But each step in the mortgage securitization pipeline depended on the next step to keep demand go- ing. From the speculators who flipped houses to the mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the financial firms that created the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough skin in the game. They all believed they could off-load their risks on a moment’s no- tice to the next person in line. They were wrong. When borrowers stopped making mortgage payments, the losses—amplified by derivatives—rushed through the pipeline. As it turned out, these losses were concentrated in a set of systemically im- portant financial institutions. In the end, the system that created millions of mortgages so efficiently has proven to be difficult to unwind. Its complexity has erected barriers to modifying mortgages so families can stay in their homes and has created further uncertainty about the health of the housing market and financial institutions. • We conclude over-the-counter derivatives contributed significantly to this crisis. The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis. From financial firms to corporations, to farmers, and to investors, derivatives have been used to hedge against, or speculate on, changes in prices, rates, or indices or even on events such as the potential defaults on debts. Yet, without any oversight, OTC derivatives rapidly spiraled out of control and out of sight, growing to  tril- lion in notional amount. This report explains the uncontrolled leverage; lack of transparency, capital, and collateral requirements; speculation; interconnections among firms; and concentrations of risk in this market. OTC derivatives contributed to the crisis in three significant ways. First, one type of derivative—credit default swaps (CDS)—fueled the mortgage securitization pipeline. CDS were sold to investors to protect against the default or decline in value of mortgage-related securities backed by risky loans. Companies sold protection—to the tune of  billion, in AIG’s case—to investors in these newfangled mortgage se- curities, helping to launch and expand the market and, in turn, to further fuel the housing bubble. Second, CDS were essential to the creation of synthetic CDOs. These synthetic CDOs were merely bets on the performance of real mortgage-related securities. They amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread them throughout the financial system. Goldman Sachs alone packaged and sold  billion in synthetic CDOs from July , , to May , . Synthetic CDOs created by Goldman referenced more than , mortgage securities, and  of them were referenced at least twice. This is apart from how many times these securities may have been referenced in synthetic CDOs created by other firms. FOMC20050630meeting--10 8,MR. PEACH.," Hardly a day goes by without another anecdote-laden article in the press claiming that the U.S. is experiencing a housing bubble that will soon burst, with disastrous consequences for the economy. Indeed, housing market activity has been quite robust for some time now, with starts and sales of single- family homes reaching all time highs in recent months and home prices rising rapidly, particularly along the east and west coasts of the country. But such activity could be the result of solid fundamentals underlying the housing market. After all, both nominal and real long-term interest rates have declined substantially over the last decade. Productivity growth has been surprisingly strong since the mid-1990s, producing rapid real income growth primarily for those in the upper half of the income distribution. And the large baby-boom generation has entered its peak earning years and appears to have strong preferences for large homes loaded with amenities. One of the conditions of an asset bubble is that the price of the asset has risen well above what is consistent with underlying fundamentals. In the current debate, two measures of relative value have been applied to single-family home prices— price relative to income and rent relative to price. In the comments that follow I will concentrate on the price-to-income measure, but my conclusions apply equally to the rent-to-price measure. June 29-30, 2005 12 of 234 average price of homes purchased (or mortgages refinanced) with loans purchased by Fannie Mae and Freddie Mac, or conforming conventional loans. Therefore, it excludes cash sales as well as purchases or refinancings financed with FHA [Federal Housing Administration], VA [Veterans Affairs], and jumbo conventional mortgages. It is called a repeat-sales index because it is derived by observing the sales prices—or appraised values, in the case of refinancings—of properties at specific addresses at two or more points in time. Finally, it is a transactions-based index in that it reflects the prices of homes that are sold (or refinanced) rather than the entire universe of single-family homes. A lesser known home price index is the constant-quality new home price index published by the Bureau of the Census (exhibit 2). This index is based on a sample of new homes sold, regardless of how the sale was financed. Hedonic methods are employed to hold the physical and locational characteristics constant over time. This index is part of the Census Bureau statistical program through which the single- family residential investment deflator of the national income and product accounts is derived. As shown in exhibit 3, the increase in prices indicated by these two indexes is quite different. For example, over the four years from 2000 to 2004, the OFHEO index increased at a compound annual rate of 8.2 percent, while the constant-quality index increased at a 5.4 percent annual rate. As shown in exhibit 4, the current ratio of price over median family income derived from these two indexes is vastly different. If the OFHEO index is giving an accurate picture of what is happening to home prices, I think one could say with some confidence that prices have been bid up to unsustainable levels. However, if the constant-quality index is a better reflection of reality, home prices actually look somewhat low relative to median family income, particularly compared to the late 1970s. I believe the constant- quality index provides a more accurate indication of what is happening to the price of a typical single-family home. In contrast, the OFHEO index is subject to upward biases that accumulate over time and distort ratios such as price-to-income and income-to-rents. To help us understand the biases in the OFHEO index, exhibit 5 presents the distribution by value of all single-family homes in the U.S. in 2003, with the specific values at the 25th, 50th, 75th, and 80th percentiles. 4 The median value in 2003 was $150,000 with the distribution skewed toward the right. The value at the 25th percentile was $90,000 while the value at the 75th percentile was $250,000. We do not know with certainty where the OFHEO index falls on this distribution, as it is an index rather than a series of values. But we can be reasonably certain that it lies somewhere between the average price of all existing single-family homes sold and the average price of homes purchased with conventional loans. That means the OFHEO index is a closer reflection of what is happening at the 75th percentile rather than the 50th percentile. Moreover, it is very likely that over time the point on that distribution represented by the OFHEO index has been drifting to the right. One June 29-30, 2005 13 of 234 cause of this rightward drift is what I call transaction bias. As shown in exhibit 6, the American Housing Survey (AHS) data suggest that both appreciation rates and turnover rates increase as one moves out the home value distribution. For example, from 1997 to 2003 the compound annual rate of appreciation at the 25th percentile was 4.5 percent, increasing to 8.7 percent at the 80th percentile. Corresponding average turnover rates for the period from 1997 to 2003 were 5.9 percent and 7.4 percent. That means, of course, that the average rate of appreciation of the units that turn over is higher than the average rate of appreciation of the entire distribution. While the amount of bias in any one year is likely to be small, it does cumulate over time and becomes quite important when one is comparing levels versus income or rents. Another potential upward bias in the OFHEO index is that while it is a repeat- sales index, there is evidence to suggest that it is not a constant-quality index. In addition to the strong pace of new housing starts, another aspect of the housing boom of the past decade has been a significant increase additions and alterations to the existing housing stock. Exhibit 7 presents in the top panel the ratio of the OFHEO index over the constant-quality index plotted over the period from 1977 to the present. In the lower panel are plotted real improvements per unit of housing stock per year over the same period. Over the past decade real improvements per unit have increased about 25 percent, which appears to be associated with a further increase in the ratio of the OFHEO index over the constant-quality home price index. Research suggests that higher-income households have a higher income elasticity of demand for improvements to their primary residences, suggesting that this source of upward bias is likely to be more pronounced in the right half of the distribution of all single-family homes. 5 Another way of looking at the issue of home prices over income is to go back to the AHS data and see what is happening at various points on the distribution of all single-family homes. This information is presented in exhibit 8. At the 25th percentile the ratio of home price to income has been relatively stable, while it has increased sharply at the 75th and 80th percentiles, reminiscent of the price-to­ income ratio computed with the OFHEO index. Let me pause just a moment and emphasize that I am comparing home prices at a percentile with the incomes of the people who live in those homes at the same percentile. This chart is likely the equivalent of the finding that the increase of home prices has been most pronounced in areas of the country where home prices were already relatively high due in part to relatively inelastic supply. It is likely that in these areas of the country, where land values are high, the inclination to make substantial improvements to existing properties is the greatest. Clearly, not everyone agrees that the constant-quality new home price index provides an accurate indication of what is happening to the price of a typical single- family home. For example, it has been argued that most new construction takes June 29-30, 2005 14 of 234 place at the fringe of metropolitan areas where land prices may not be rising as fast as is intra-marginal land. There are several counter arguments. First, the theory leading to the conclusion that intra-marginal land values increase at a faster rate than land at the fringe is based on a theory of the development of a metropolitan area with fairly restrictive assumptions. Modern metropolitan areas have multiple commercial/employment centers. Many households have preferences for rural or suburban residences over urban residences. Restrictions on development to counter suburban sprawl have reportedly resulted in sharp increases in prices of parcels of land suitable for home building. Finally, I would like to note that the increases in land prices implicit in the constant-quality home price index, shown in exhibit 9, are substantial, particularly in the Northeast and the West. These estimates were derived assuming that land represents 50 percent of the value of the total property and that the prices of the other inputs increase at the same rate in all regions of the country. In closing, I would like to comment on one other aspect of the housing bubble issue that has received substantial attention. Earlier this year a major real estate related trade association released the results of a survey indicating that a significant percentage of single-family home sales were of investment properties and second homes. This was widely interpreted as evidence of speculative buying of rental properties, another feature of a housing bubble. Again, I believe that such reports should be viewed skeptically. According to the AHS, in 2003 single-family investment properties, defined as homes renter-occupied or for rent, represented 14.2 percent of all single-family homes while second homes represented another 4.7 percent. Therefore, we should not be surprised that such properties represent about 20 percent of the sales that take place at any point in time. Moreover, the American Housing Survey data indicate that single-family investment properties have been declining as a share of all single-family homes for some time and declined in absolute numbers from 2001 to 2003. A principal reason the rental vacancy rate for single-family homes has risen in recent years is that the number of renter-occupied single-family homes has declined as people switch from renting to owning. So if a lot of people are buying rental properties, it must also be the case that a lot are selling as well. That concludes my report. Thank you." FOMC20050630meeting--78 76,MR. RUDEBUSCH.," I guess I’d make a distinction there, in that I think the proponents are talking not about setting asset prices in general but about trying perhaps to reduce the bubble component. Clearly, if asset prices are set equal to the fundamentals, that’s going to lead to the proper functioning of—" CHRG-110hhrg44901--143 Mr. Bernanke," That was a very difficult episode for Japan when the bubbles in both the stock market and in property prices collapsed at the same time. I think the key lesson that we learned from that experience was that in Japan, banks had very wide holdings in land and equity and other assets whose values came down, and so the banks were in very, very bad financial condition, but they were not required to disclose or inform the public about what their actual condition was. For many, many years they kind of limped along. The same with the companies they lent to. They didn't call those loans because they knew they couldn't be paid. So it was a situation in which there was a reluctance to act and in which transparency was quite limited. I think one benefit of our current system here in the United States is that as painful as it is to see the losses that financial institutions are suffering, at least they are getting that out, they are providing that information to the public, and they have been proactive in raising capital to replace those losses. In order to avoid a prolonged stagnation, as in Japan, it is important for us to get through this period of loss and readjustment and get back to a point where the financial system can again support good, strong, stable growth for the United States. " CHRG-111hhrg61852--19 Mr. Koo," My idea of the situation is that once the bubble burst, the economy began to weaken because of all these balance sheet problems that I mentioned. But we had one accident in between, which was, in my view, totally unnecessary, and that was the Lehman shock. The fact that Lehman Brothers was allowed to fail when so many other financial institutions had the same problem at the same time, that caused a massive panic, which was, in my view, totally unnecessary. " FOMC20070628meeting--81 79,MS. LIANG.," If we had started this series in the early ’90s, this would be the high. We have the stock market bubble of 2000 in here, and it has come off, but it is 5½. Even at the end of the projection period, it is 5½ times disposable income. That is historically high. Before ’96, it would have been about 3½ or 4." FOMC20070628meeting--117 115,MR. HOENIG.," Thank you. I will spend just a couple of minutes extra on the District this time because, generally speaking, our District economy continues to perform very well despite the weakness in the housing sector. Energy and agriculture remain very strong, and manufacturing remains generally strong although we have seen some leveling-off of that in the past month. The strength in these three sectors has helped spur broad-based job growth throughout the District and a significant tightening of our labor markets and their conditions. Many of our contacts report labor shortages and higher wage pressures. Demand for skilled labor remains very strong, and some firms have limited hiring plans because of the unavailability of qualified workers. To bolster recruiting, a few companies have partnered with vocational schools to offer industry- specific training programs to try to fill the gap. Since our last meeting, hiring announcements, which we try to track, have outpaced layoff announcements by a margin of 6 to 1. One anecdotal piece of information—we have some fairly large engineering firms in Kansas City that build power plants globally, including in China, and also ethanol plants. Last year, one CEO told me that they hired 2,100 engineers and were unable to fill 900 positions on a global basis. So there is a lot of activity going on out there. Construction activity remains mixed, with weakness in residential construction balanced by strength in commercial construction. On the residential side, we have seen some pickup in sales, but high inventories have limited new construction. For us, problems with subprime loans are concentrated in Colorado and in a few other areas. But because of the strength in energy and agriculture, some parts of the region are actually experiencing a housing boom, with strong home-price appreciation. Relative to the total market, that is small, but it is a rather sharp contrast. Conditions in agriculture are the best in recent years. Spring rains have alleviated drought conditions in much of our region. Strong demand and limited supplies continue to boost farm commodity prices and farm incomes. However, we are also beginning to see the effects of higher livestock and crop prices on retail food prices themselves. An additional concern is the sharp rise in land prices throughout much of our District. First-quarter cropland values in the District rose roughly 12 percent above year-ago levels, and ranchland values have strengthened as well, that much or perhaps a little more. Our contacts in the real estate industry indicate that some of the recent surge in land prices is speculative in nature, and some District bankers have expressed concern about the bubble in farmland values driven in part by the ethanol boom that we have heard about. In recent examination reports, our supervision staff have begun to see some increases in nonperforming real estate loans, and that includes some pickup in other real estate owned as well. These developments are very preliminary, but they are reminiscent of an earlier time, and we are trying to pay a little more attention to that. On the national outlook, data released since the last meeting support the view that growth will pick up over the year. I have been encouraged by the recent pickup in retail sales and by positive news on employment and personal income. At the same time, the recent increase in longer-term interest rates, if sustained, is likely to damp growth somewhat in the period ahead. In particular, the rise in the thirty-year fixed mortgage rate may deepen and prolong the ongoing housing slump. The combined effects of weaker growth in the first quarter and the rise of long-term rates have led me to lower my estimate of growth in 2007 to about 2.3 percent. I expect growth of 2.7 in ’08 and 2.8 in ’09. I now think the risks, perhaps, are roughly balanced. While the downside risk from housing remains, the outlook for other sectors, as others have reported, has appeared to improve. Markets seem to have adopted this view as well, as removal of the expected policy easing has contributed to the flattening of the yield curve at this point. In terms of the inflation outlook, recent data have been favorable, with core CPI on a twelve-month basis down to 2¼ percent. I expect continued moderation over the year. In particular, if owners’ equivalent rent continues at the slower pace of the past three months, it will help bring down the twelve-month core inflation number over time. Despite these recent improvements, I continue to believe that upside risks to inflation remain. The possible pass-through of recent energy and food price inflation to core inflation may slow progress toward lower inflation. In addition, pressures from resource utilization and slow productivity growth, if that happens to be the case, could affect that outlook as well. Finally, I am somewhat concerned with the recent uptick in longer-term inflation expectations. We have talked about the TIPS five-year, five-year-ahead breakeven inflation rate; as mentioned in the earlier briefing, it has increased about 20 basis points over the past month. So in light of these factors, I believe it is important that we continue to signal to the markets that current inflation rates are not acceptable over the longer term. Thank you." fcic_final_report_full--20 Veteran bankers, particularly those who remembered the savings and loan crisis, knew that age-old rules of prudent lending had been cast aside. Arnold Cattani, the chairman of Bakersfield, California–based Mission Bank, told the Commission that he grew uncomfortable with the “pure lunacy” he saw in the local home-building market, fueled by “voracious” Wall Street investment banks; he thus opted out of cer- tain kinds of investments by .  William Martin, the vice chairman and chief executive officer of Service st Bank of Nevada, told the FCIC that the desire for a “high and quick return” blinded people to fiscal realities. “You may recall Tommy Lee Jones in Men in Black, where he holds a device in the air, and with a bright flash wipes clean the memories of everyone who has witnessed an alien event,” he said.  Unlike so many other bubbles—tulip bulbs in Holland in the s, South Sea stocks in the s, Internet stocks in the late s—this one involved not just an- other commodity but a building block of community and social life and a corner- stone of the economy: the family home. Homes are the foundation upon which many of our social, personal, governmental, and economic structures rest. Children usually go to schools linked to their home addresses; local governments decide how much money they can spend on roads, firehouses, and public safety based on how much property tax revenue they have; house prices are tied to consumer spending. Down- turns in the housing industry can cause ripple effects almost everywhere. FOMC20060920meeting--75 73,MR. STOCKTON.," I would say you have it just about right—somewhere on the order of 1 percent in the second half and something certainly under 2 percent in 2007. Obviously, in putting our forecast together we were contending both with weaker housing and with some of these offsets that we factored in that have provided some cushion to the downside surprise that we have had in housing through greater labor income, more purchasing power from lower energy prices, and a little higher stock market. In some sense, those effects get us back to just modestly below trend growth rather than significantly below trend growth." CHRG-111hhrg63105--73 Mr. Conaway," Speaking of the crisis, I have a short amount of time. I take that that you are fine with these dates. Mr. Chilton, you mentioned that some time frame in the run-up to the bubble in 2008 that there was $200 billion in new money in the system. How much of that money has fled the system? What are the levels today versus then? " CHRG-111hhrg53245--127 Mr. Zandi," My view is bubbles are created largely by leverage, that if they have a very clear ability to control or manage leverage throughout the entire financial system, which they would have as the systemic risk regulator, then they would have the tool they need to be able to manage that aspect of monetary policy. Ms. Rivlin. May I? " FOMC20060920meeting--74 72,MR. STERN.," Thank you, Mr. Chairman. Dave, I’m trying to understand your forecast and its evolution. As I read the Greenbook, at least on the demand side, it seemed to be largely a housing story as you cut through everything. So my question is, If I put myself back in August before I knew that incomes were going to be as high as they were, that energy prices were going to come down, that equity values were going to go up, and so forth, and I plug the current view of housing into that, what would it give me? I assume it would give me growth for the second half of this year at something close to maybe 1 percent and maybe growth next year of less than 2 percent. I know that there are a lot of moving parts, but anyway, that is the question. If we had known about housing and not plugged in this other stuff, where would we be?" FOMC20070321meeting--113 111,MR. KOHN.," Thank you, Mr. Chairman. Like many others, I view the data over the intermeeting period as not fundamentally undermining the basic contours of our expected forecast. We’re still on track for moderate growth and gradually ebbing inflation. The economy has enough underlying strength, bolstered by financial conditions that remain quite supportive of growth, so that the housing correction should not be enough to knock the economy off the moderate growth track. Growth modestly below potential, along with the unwinding of some special factors like rent increases, should allow further declines in inflation. Real-side data reflect the fact that the downshift from above-trend growth for several years to expansion at or a little below trend hasn’t been entirely smooth, and maybe we never should have expected it to be so. Besides the overpricing and overbuilding of housing, businesses apparently built their stocks of inventories and fixed capital in anticipation of continued strong growth, and we’re seeing downshifts in demand for inventories and capital to align them with the slower pace of expected growth. Businesses typically also hoard labor under these circumstances, resulting in weaker productivity growth, and we may just be seeing this adjustment getting under way, judging from the gradual upcreep in initial and continuing claims. The inherently uneven nature of the stock adjustment process and the uncertainty around it help to explain both the overall contours of the recent data and the short-run swings in the data and perceptions of them. A number of factors, most of them mentioned by others, do support expectations of moderate growth ahead. Outside the subprime market, financial conditions remain supportive of growth. Intermediate and long-term rates are low in real as well as in nominal terms. The dollar has fallen. The fallout from the recent turbulence has been very limited. Aside from housing, a good portion of the inventory correction is behind us or is being put behind us. So over time production ought to line up better with sales. Both a rise in the national ISM index and increases in industrial commodity prices, especially in metals, support the notion of a coming recovery in manufacturing, though I admit the increase in metals prices may be a factor of the global economic expansion as well. Continued good growth of jobs to date will support increases in personal income, and as many have remarked, growth in the rest of the world has been pretty strong. I was struck by the upward revision in rest-of-world growth in the Greenbook despite weakness in the United States, the rise in oil prices, and the decline in equity values. So as Karen remarked, domestic demand abroad seems to be strengthening, and I think this bodes well for global external adjustment as well as for U.S. exports. But the information we have received over the intermeeting period not only shifted expected growth down a little but also highlighted some downside risk to activity. In housing, those downside risks center on the implications of the subprime debacle. Will it affect housing demand? Will lending terms tighten beyond the subprime market and the mortgage market? How much will tightening spill over to other lending markets, such as home equity lines of credit, and perhaps affect consumer demand? The possible answers to these questions seem to me to have downside tails that are fatter than the upside tails. Unexpected weakness in investment spending outside housing and auto-related industries is another risk factor. The question is whether this weakness represents just a short-term adjustment to moderate growth or whether businesses themselves see a downside shift in underlying demand that we don’t see. Financial conditions may not remain as supportive of growth, besides the possibility of the dropping of other shoes, such as private equity, as many have mentioned. I see a distinct downside risk to the staff’s assumption of continued increases in equity prices given the likelihood that, if the economy evolves the way the staff anticipates, long-term interest rates will rise and profits will be very disappointing to market analysts. Despite weaker spending, we still face upside risks to the gradual downdrift in inflation. Recent data haven’t been as favorable to deceleration as we would have hoped: Softer investments, slower growth of productivity, and continued strength in labor markets could suggest a slower path of trend productivity growth. If so, we would need to adjust down our expectations for growth, and labor costs would get a boost even at slower growth rates unless increases in nominal wages also downshifted pretty promptly. Good growth in labor demand could suggest a stronger path for demand and less slack than the staff is estimating. Finally, the NAIRU could well be lower than the 5 percent that the staff is estimating, especially in light of the relatively slow updrift in many measures of compensation. But, at 4½ percent, the unemployment rate is low by historical standards, and this suggests to me that the risks from resource utilization remain toward higher inflation. In sum, downside risks to our maximum employment objective have increased, but I do not think they outweigh the continuing upside risk to more-moderate inflation, at least not yet. Thank you, Mr. Chairman." FOMC20050630meeting--368 366,MS. YELLEN.," Thank you, Mr. Chairman. At our last FOMC meeting, I worried about a slowdown in growth and a pickup in inflation. I hypothesized and hoped that both would prove transitory. On the whole, I consider recent data reassuring that the soft patch in the spring was just that—maybe not even that—and not a precursor of a more entrenched slowdown. While the Greenbook subscribes to the view that the slowdown in growth was transitory, the staff has made an upward revision, by a couple of tenths, to its forecast for core PCE inflation for this year and next year, now projecting inflation of about 2 percent in both years. I’m a bit less pessimistic on inflation than the staff. Recent data on core inflation have been pretty good of late. Moreover, I see the fundamentals—namely, the pressures on future inflation—as providing room on balance for some optimism. The most worrisome factor is that oil prices have risen further, although this should tend to boost core inflation more this year than next year. As David noted, the recent jump in compensation per hour should probably be discounted, since it appears to be due to one-time factors. On the encouraging side, I see a noticeable decline— about 17 basis points—in inflation compensation at both the 5- and 10-year horizons, high markups, an appreciation in the dollar, a leveling off of commodity prices, very modest increases in the ECI, June 29-30, 2005 132 of 234 The situation with regard to slack, as David noted and emphasized, is complicated because the unemployment rate is relatively low, near most estimates of NAIRU. But several other measures, as he pointed out and as we also routinely monitor—including the employment-to­ population ratio, capacity utilization, the output gap, and the other indicators that David showed us— do suggest that slack remains. One final point on the inflation outlook is that one of the best forecasters of future inflation is past inflation. And I’m told that this is a point that was emphasized at a special topic session a couple of years ago. On this score, things look fairly good, with core PCE price inflation at 1.7 percent over the past 12 months. While I guess I can and have quibbled a bit about the inflation outlook for the next year, overall I think the Greenbook forecast seems reasonable. Real GDP appears poised to grow just slightly above its potential rate, gradually eliminating remaining slack. And core inflation, while currently near the upper end of my comfort zone, at least to me seems likely to moderate a bit over the next few years. The Greenbook forecast depicts an almost textbook scenario of an economy continuing along the path toward a rather attractive steady state. Going forward, there are obviously some sizable risks, and I count the unwinding of possible house and bond market bubbles as one or two that are high on my list. But I think the most likely outcome is—as in the Greenbook projection— that we will continue to move in a positive direction over the next couple of years. And given what we now know, I think the funds rate path assumed in the Greenbook, which is very close to the market’s current view, is appropriate. That is, we are likely to need to raise rates a couple more times before slowing the pace of tightening rather substantially. And I want to emphasize that, in June 29-30, 2005 133 of 234 economy moving along this textbook path during a period characterized by some quite difficult circumstances. I know that Monday’s pre-FOMC briefing emphasized that economic activity has been burdened by some major drags over the past year or so. These include the oil shock, the deterioration in the trade balance, and the still low level of investment spending relative to GDP. The result is that we’ve had to keep interest rates exceptionally low for a long time, just to get respectable economic growth. In fact, respectable and not stellar growth is all we have gotten, even with exceptionally low long-term yields and unexpectedly rapid gains in house prices. And those are two factors that, on their own, would be working to push up the equilibrium real funds rate. So the merely respectable growth in the economy has really rested on the backs of just a few interest rate-sensitive sectors: business investment, consumer durables, and housing. From that perspective, it’s really not all that surprising that house prices have risen a great deal, and it’s not surprising to hear our directors and other contacts comment that liquidity is abundant and that lending is taking place for deals that one of our directors simply characterized as “stupid.” I think he meant by historical standards. [Laughter] My point is that to offset the drags, we’ve needed to give the economy a strong dose of stimulus, which inevitably boosted the housing sector—and that just to get reasonable economic growth. That is equivalent to saying that the equilibrium real fed funds rate is unusually low—1.4 percent in the Greenbook path. So, for me, the policy imperative that follows is that we need to be careful not to overdo the pace of policy tightening. I noted that in recent months several FOMC members have commented that we usually know we’ve come to the end of the tightening phase when we have tightened one or two times too many. I think we should be especially attentive to this concern this time around, June 29-30, 2005 134 of 234 John Williams’s analysis yesterday highlighted the fact that if house and/or bond prices fall, the zero bound could become an issue we would be discussing again. To conclude, I’m all for raising the funds rate by 25 basis points at this meeting, and I believe the language in the press release should seek to maintain the path for the expected fed funds rate that now exists in the market. My worry is that unless we’re careful in crafting the language as we raise the rate today—and likely again in August—markets will start to build in more increases in subsequent months than they have so far. I think we are nearing the point when we will need to start pausing, and I hope we can maintain that expectation in the market in the period ahead." fcic_final_report_full--471 Even today, there are few references in the media to the number of NTMs that had accumulated in the U.S. financial system before the meltdown began. Yet this is by far the most important fact about the financial crisis. None of the other factors offered by the Commission majority to explain the crisis—lack of regulation, poor regulatory and risk management foresight, Wall Street greed and compensation policies, systemic risk caused by credit default swaps, excessive liquidity and easy credit—do so as plausibly as the failure of a large percentage of the 27 million NTMs that existed in the financial system in 2007. It appears that market participants were unprepared for the destructiveness of this bubble’s collapse because of a chronic lack of information about the composition of the mortgage market. In September 2007, for example, after the deflation of the bubble had begun, and various financial firms were beginning to encounter capital and liquidity diffi culties, two Lehman Brothers analysts issued a highly detailed report entitled “Who Owns Residential Credit Risk?” 34 In the tables associated with the report, they estimated the total unpaid principal balance of subprime and Alt-A mortgages outstanding at $2.4 trillion, about half the actual number at the time. Based on this assessment, when they applied a stress scenario in which housing prices declined about 30 percent, they still found that “[t]he aggregate losses in the residential mortgage market under the ‘stressed’ housing conditions could be about $240 billion, which is manageable, assuming it materializes over a five-to six-year horizon.” In the end, of course, the losses were much larger, and were recognized under mark-to-market accounting almost immediately, rather than over a five to six year period. But the failure of these two analysts to recognize the sheer size of the subprime and Alt-A market, even as late as 2007, is the important point. Along with most other observers, the Lehman analysts were not aware of the true composition of the mortgage market in 2007. Under the “stressed” housing conditions they applied, they projected that the GSEs would suffer aggregate losses of $9.5 billion (net of mortgage insurance coverage) and that their guarantee fee income would be more than suffi cient to cover these losses. Based on known losses and projections recently made by the Federal Housing Finance Agency (FHFA), the GSEs’ credit losses alone could total $350 billion—more than 35 times the Lehman analysts’ September 2007 estimate. The analysts could only make such a colossal error if they did not realize that 37 percent—or $1.65 trillion—of the GSEs’ credit risk portfolio consisted of subprime and Alt-A loans (see Table 1, supra ) or that these weak loans would account for about 75% of the GSEs’ default losses over 2007- 34 Vikas Shilpiekandula and Olga Gorodetski, “Who Owns Resident i al Credit Risk?” Lehman Brothers Fixed Income U.S. Securitized Products Research , September 7, 2007. 2010. 35 It is also instructive to compare the Lehman analysts’ estimate that the 2006 vintage of subprime loans would suffer lifetime losses of 19 percent under “stressed” conditions to other, later, more informed estimates. In early 2010, for example, Moody’s made a similar estimate for the 2006 vintage and projected a 38 percent loss rate after the 30 percent decline in housing prices had actually occurred. 36 The Lehman loss rate projection suggests that the analysts did not have an accurate estimate of the number of NTMs actually outstanding in 2006. Indeed, I have not found any studies in the period before the financial crisis in which anyone— scholar or financial analyst—actually seemed to understand how many NTMs were in the financial system at the time. It was only after the financial crisis, when my AEI colleague, Edward Pinto, began gathering this information from various unrelated and disparate sources that the total number of NTMs in the financial markets became clear. As a result, all loss projections before Pinto’s work were bound to be faulty. FOMC20070321meeting--87 85,MS. MINEHAN.," Thank you very much, Mr. Chairman. Perhaps unlike in the rest of the country, most of the recent cyclical data point to some reasons for optimism about near-term growth in New England, with the possible exception of the rate of foreclosure initiations related to subprime mortgages. The annual benchmark revisions by the BLS paint a happier picture of the current state of regional job growth, especially in Massachusetts and Connecticut. The overall message is that the region has been growing at a pace that is about at its long-term trend and has been adding jobs consistently in recent months. This picture is a bit different from the one we’ve been seeing for some time. The region’s unemployment rate remains about at the nation’s, and demand for skilled labor, as measured by both online and newspaper help-wanted ads and by anecdotal reports, is quite strong. Indeed, many continue to note that hiring the skilled workers they need has been difficult. Both temporary-help service firms and software and IT firms report strong demand for labor, particularly to meet finance and technical positions and to meet a growing backlog in activity in high-tech businesses. This aspect of the region’s labor market may be pulling some discouraged workers back into the labor force, as reflected in the perhaps temporary uptick in unemployment. Reflecting this better news on regional job growth, the Philadelphia Fed’s coincident economic indexes point to economic activity in the region’s two largest states that is on a par with national growth. When we surveyed a wide swath of retail contacts, we saw a bit of gloom on the retail side. But the fact that in New England you have an array of very small companies, sometimes in unique circumstances, may have given a little downbeat sense to the retail climate. The reports from larger retailers in the survey—and we have a couple of them— show solid year-over-year growth. Manufacturing employment continued to decline, but manufactured exports last quarter rose at a pace just a bit slower than the nation’s and were buoyed by airline-related products, fabricated metals, and general machinery. As I’ve noted before, downtown vacancy rates in most of the cities in New England are declining, as are suburban office vacancies; rents are rising; and one or two corridors fanning out from Boston are reportedly hot sites for new biotech firm locations. Business confidence, as measured by local surveys, is up, as is consumer confidence. So, overall, things are not too bad. A concern among this mostly brighter news is the rising rate of initiations of real estate foreclosures, especially those related to properties financed with subprime adjustable-rate mortgages. According to data from the Mortgage Bankers Association, whether one looks at the rate of total foreclosures or at the pace of foreclosures among just subprime mortgages, initiations have risen rapidly in New England from a very low base and now outstrip the nation’s. This is not a contest you want to win. Anecdotes abound about individual borrowers lured into what appear to be quite inappropriate mortgages, and the Federal Reserve Bank of Boston has been working with local bankers’ associations and the Massachusetts Banking Department and others on outreach and education. Why New England generally, and Massachusetts specifically, should be outstripping the nation in this area isn’t really clear. The local banking industry does not appear to have played much of a role in subprime lending, nor were we an area of bubble-like real estate growth, though clearly prices rose rapidly in the region over a fairly long time. The detrimental effects to local communities from the rise in foreclosures and the potential for negative political fallout—not unlike what President Lacker mentioned—seem obvious. On the national scene, the incoming data on the real economy, with the possible exception of job growth, have been slower than I expected. Inflation data, if anything, have been higher. The picture is not comforting, and it is complicated by questions related both to the housing market and the surprisingly slow pace of business spending. Many people around the table have mentioned both those things. The degree of national fallout from problems in subprime mortgage lending is a question right now, as it bears both on the pace of recovery in residential real estate investment and on the potential for wider spillovers from housing to consumption. At present, we in Boston, like the Greenbook authors, don’t expect that subprime mortgage problems will by themselves have much of an effect on overall growth. But we do have a concern if these problems lead to tighter lending standards, making mortgages and other borrowing more difficult to obtain and thereby exacerbate housing inventory overhangs, extend the current period of sluggish new home starts, and create further downward pressure on home prices. So far, we don’t see much of that happening. Trends in overall market and banking liquidity, mortgage interest rates, and new mortgage issuance are all positive. We think that those trends, combined with positive consumer home-buying attitudes, paint a reassuring picture that some of the downward trends will not be as severe as they otherwise might be. Indeed, I spoke to members of the advisory board of Harvard’s Joint Center for Housing Studies in late February. The group was composed of about fifty major homebuilders and major suppliers to the building industry. They were in a bit of collective shock regarding the rapid deterioration that they saw in their industry from late last year into the current quarter and seemed to be focused on inventory and cost control rather than on profits this year, which they didn’t expect. However, they saw continuing spending on home improvement, growth from commercial construction, and strength in non-U.S. markets as partial offsets. No one in the group mentioned the subprime issue or potential problems in mortgage financing, but that may have just been the fact of the moment. It was actually the day before the market break in late February, so it’s possible that they are not thinking along the same lines today. We have also been asking ourselves why business fixed investment has been so slow relative to fundamentals. We had been assuming that this inexplicable trend would right itself and that growth of producers’ durable equipment would show greater signs of health, but that hasn’t happened. We, like the Greenbook, have written down expectations regarding PDE. I’d really like to be wrong on the downside regarding this area, as it worries me a bit more than subprime mortgages or any of the recent financial market ups and downs. If businesses lack the confidence to invest in new equipment as much as they might be expected to given the fundamentals, how much longer will they continue to hire staff? If job growth slows, what will happen to consumption? To date, both hiring and consumption remain pretty solid. But while I saw some upside risks here at our last meeting, now I’m a little worried on the downside. In view of the incoming data, we have written down our forecast, much as the Greenbook has, and we have joined the Greenbook in a lower estimate of potential. We see growth a bit above 2 percent this year, rising to the mid 2s in ’08, with slightly rising unemployment and only slightly slowing core PCE inflation. However, as I probably implied before, I think the risks around this forecast on both sides seem to have risen. Will housing trends and the possible effects of diminished business spending affect the resilient consumer more than we now expect? Will the underlying pattern of core inflation continue to surprise on the upside, with the moderation we expect remaining mostly in the forecast? I don’t mean to overreact here. There are positives. External growth is strong. Fiscal spending at both the state and the national levels should be supportive. Financial markets, though certainly a bit more volatile and nervous, remain accommodative. Perhaps the downside risks to growth that I see are simply the ebb and flow of the U.S. economy continuing its transition from an above-trend rate of expansion just a year ago, not unlike the slow patch we saw in the late summer and early fall of last year. All in all, I remain somewhat more concerned about risks on the inflation side than about risks to growth. But it does seem to me as though the balancing act in meeting our two objectives has gotten a bit more difficult." FOMC20070131meeting--99 97,MR. SLIFMAN.," I don’t think so. Personally, I could think of equally plausible reasons that we could get stronger aggregate demand growth or somewhat weaker aggregate demand growth over the next year. We highlighted one possibility in the Greenbook with regard to the weaker investment scenario. Another could be the housing forecast: Housing could turn out to be weaker than we’re forecasting. So, on the aggregate demand side, I’d give them equal weighting. With regard to the aggregate supply side, I suspect there, too, the weighting probably is equal. It’s a little harder for me to judge. I don’t know whether Bill wants to add something." CHRG-110shrg50415--29 Mr. Stein," Good afternoon. Chairman Dodd and Members of the Committee, thank you for the opportunity to testify. In the middle part of this decade, Wall Street demand led to literally trillions of dollars of subprime and Alt-A loans to be originated. What was interesting about it was that Wall Street paid more the more dangerous the loan was. For example, in 2004, Countrywide, if they gave a borrower a fixed-rate conventional mortgage, they received 1 percent. If they put that exact same borrower in a subprime loan, they received 3.5 percent. It is not a surprise that they paid their originators more if they put that borrower in the more expensive loan, the one that statistically has been shown more likely to cause a foreclosure. Wall Street then bundled these mortgages into mortgage-backed securities, and credit rating agencies, paid by the issuers only when they are issued, found many too many of them to be AAA quality. And then they were sold around the world. In 2006, the top five investment banks earned $1.7 billion in revenues structuring and packaging these subprime mortgage-backed securities. These are the loans that helped cause the housing bubble, and what they have in common, the subprime and the Alt-A loans, are that they start at what seems like an affordable level, but built into the structure of the loan is unsustainability. They start cheaper, but then they get more expensive. There is no free lunch in a mortgage. And that is what they have in common, and that helped build the housing bubble because people were put in a larger loan than they could actually afford, and on the flip side, once the bubble burst, it caused the massive foreclosures that we have now because when the housing bubble was going up, that unsustainability was masked. Once people could not afford the mortgage, they could refinance or they could sell. When the bubble comes back down, they no longer have those options, and that is why we have the foreclosure crisis that we have today. This leaves the question: This is what Wall Street was doing. Where were the regulators? I will not repeat what has been said. I will just identify a couple, and my testimony goes into more regulatory failings. The first is the Federal Reserve. Back in 2000, my boss testified, and Chairman Leach, I remember him saying that the Federal Reserve is AWOL because they received the authority to prevent abusive lending in 1994 and had not used it. The second one that I would like to mention is the Office of Thrift Supervision. They allowed Washington Mutual and IndyMac to push abusive mortgages until they failed and did not even put them on the watchlist until right before they failed, so the FDIC could not clean them up sooner. It is clear now that a lack of common-sense rules, like how about only making a loan if the borrower can afford it, actually impeded the flow of credit beyond anybody's wildest dreams. Many of us who were trying to get the regulators to crack down on predatory lending abuses were fighting a defensive action in Congress, saying don't preempt the State laws that are there, since the proposed bills would have made the situation worse. And the regulators would always say, ``We cannot stop the free flow of credit,'' and we can see the results today. Since the problem is rooted in excessive foreclosures, the solutions must start there. I would like to identify five very briefly. The first is that Congress should lift the ban on judicial loan modifications, which would allow hundreds of thousands of families to have their loans restructured and stay in their homes at no cost to taxpayers. We are spending $700 billion when we can do something that is free. In Chapter 13 bankruptcy, the only secure debt that cannot be modified is the home on the principal residence, whereas loans on a yacht or investment property can be modified now. I would like to illustrate that point for a second. If you consider Candace Weaver, who is a school teacher from Wilmington, North Carolina, in 2005 her husband had a heart attack, and she refinanced her mortgage with a lender called BMC. She received what seemed like a reasonable rate, a little bit high, 8.9 percent. Two years later, it turns out--she was not told this--it was an exploding 2-28 subprime mortgage. The rate goes up to 11.9 percent, which she just could not afford. She was diagnosed with kidney cancer and had surgery scheduled. She called the servicer and said, ``I cannot make my July payment. This payment is too high. I can barely make it. But I cannot make the July payment because of surgery.'' The servicer said, ``I am sorry. I cannot even talk to you until you are delinquent.'' She had the surgery, became delinquent because she could not keep it up, called again, and they said, ``We cannot talk to you until you are in foreclosure.'' Then she can't keep up, she actually goes into foreclosure, calls again, and they say, ``OK, we will give you a repayment plan. Make your current payments of 11.9 percent, and on top of that catch up the past payments that you did not make,'' which she could not do. The bankruptcy judge cannot help her even though she could afford a market rate mortgage. Consider, on the other hand, Lehman Brothers. They were among the biggest purchasers and securitizers of subprime loans, earning hundreds of millions of dollars. They were a huge investor in these mortgages at 30:1 leverage, which caused their failure, and hurt everybody. Finally, they owned a mortgage lender named BMC, the exact same lender that is potentially costing Ms. Weaver her home--hopefully not because she has representation now. The Wall Street Journal investigated BMC Mortgage and found widespread falsification of tax forms, cutting and pasting documents, forging signatures, ignoring underwriter warnings. Lehman Brothers last month, as everybody knows, went to bankruptcy court. They can have their debts restructured, but Ms. Weaver cannot. The second thing I would focus on is for Treasury under the TARP program to maximize loan modifications, as some of the Senators have mentioned. Whenever Treasury buys equity in a bank, buys securities from a bank, buys a whole loan or controls a whole loan, they should do the streamlined modification program that Sheila Bair is doing at FDIC. What she does is target an affordable payment, first by reducing the interest rate, then by extending the term, then by reducing principal if you need to. And they should focus on a 34-percent debt-to-income ratio, which is the target in the Attorney General settlement with Bank of America over Countrywide. The other thing that they should do, which I think you had something to do with, Senator Dodd, is to guarantee modified mortgages, which would be cost-effective, but you need to make sure that the mortgage is modified well. But that could be a powerful tool. The third thing I would suggest is go ahead and merge OTS into OCC. They have not proven up to the challenge. Fourth, the Federal Reserve should extend their HOEPA rules to cover yield-spread premiums, broker upselling, and, second, extend the subprime protections to nontraditional mortgages. Those are problematic now, too. And, finally, Congress should pass the Homeownership Preservation and Protection Act--two things to mention there--that Senator Dodd sponsored and many Members of the Committee co-sponsored. This would stop abuses. First, no preemption. If there is preemption, there should not be a bill because the States are doing all they can. And, second, if anything is clear by now, it is that Wall Street will pay best money for mortgages and loans that help their short-term profits and that originators will supply those if they are paid well for it. But that is not necessarily the same thing as a long-term sustainable mortgage for the homebuyer. Purchasers need a continuing financial incentive to ensure good lending through the imposition of strong assignee liability. Thank you very much. " FOMC20050630meeting--80 78,MR. RUDEBUSCH.," I’m sympathetic to that view. It seems as if there might be a threshold. That is, policymakers might be more interested in certain asset markets or might be more interested in prices in asset markets in general at certain times. But I think you’re alluding to the moral hazard or political complications that could arise from this type of intervention or from trying to use this bubble component as a monetary transmission mechanism." CHRG-111shrg50564--69 Mr. Volcker," I believe this is an area that has to be reviewed. We made a few suggestions in the report, including the one that you mentioned. I don't feel that that is the last word, frankly, what we say in this report. The whole compensation structure is important and we allude to it, but we don't say what the answer is. I am not prepared now to say I think I know the answer to that, but it is not an unimportant question, obviously. Senator Reed. Let me ask you a final sort of set of questions. The Chairman raised the issue of 1,800 economists at the Federal Reserve. Did anyone sort of notice the implications of the housing bubble building up and other problems? The Ranking Member has talked about sort of looking into the regulatory practices of the Federal Reserve, particularly regulating these large institutions. My assumption is that on a daily basis, the Federal Reserve would have hundreds, perhaps, of examiners within these institutions. Why wasn't anyone aware of some of these off-balance sheet devices, liquidity puts? Was it an area of concern? Was this an issue they were aware or, or were they completely blindsided? I think it goes to the point of trying to discover who knew what when so we have an idea of how we can restructure the---- " CHRG-110hhrg41184--119 The Chairman," Thank you. The gentleman from Texas, a ranking member of the subcommittee. Dr. Paul. Thank you, Mr. Chairman. Chairman Bernanke, earlier you were asked a question about the value of the dollar, and you sort of deferred and said, ``You know that is the Treasury's responsibility.'' I always find this so fascinating, because it has been going on for years. Your predecessor would always use that as an excuse not to talk about the value of the dollar. But here I find the Chairman of the Federal Reserve, who is in charge of the dollar, in charge of the money, in charge of what the money supply is going to be, but we don't deal with the value of the dollar. You do admit you have a responsibility for prices, but how can you separate the two? Prices are a mere reflection of the value of the dollar. If you want to control prices, then you have to know the value of the dollar. But if you are going to avoid talking about the dollar, then all you can do then is deal with central economic planning. You know, if we stimulate the economy, maybe there will be production and prices will go down, and if prices are going up too fast you have to bring on a recession. You have to try to balance these things, which I think is a totally impossible task and really doesn't make any sense, because in a free market if you had good economic growth you never want to turn it off, because good economic growth brings prices down just like we see the prices of computers and cell phones, those prices come down where there is less government interference. But you know the hard money economists who have been around for awhile, they have always argued that this would be the case. Those who want to continue to inflate will never talk about the money, because it isn't the money supply that is the problem, it is always the prices. And that is why the conventional wisdom is, everybody refers to inflation as rising prices, instead of saying inflation comes from the unwise increase and supply of money and credit. When you look at it, and I mentioned in my opening statement that M3, now measured by private sources, is growing by leaps and bounds. In the last 2 years, it increased by 42 percent. Currently, it is rising at a rate of 16 percent. That is inflation. That will lead to higher prices. So to argue that we can continue to do this, continue to debase the currency, which is really the policy that we are following, is purposely debasing, devaluing a currency, which to me seems so destructive. It destroys the incentives to save. It destroys--and if you don't save, you don't have capital. Then it just puts more pressure on the Federal Reserve to create capital out of thin air in order to stimulate the economy, and usually that just goes in to mal-investment, misdirected investment into the housing bubbles, and the NASDAQ bubble. And then the effort is once the market demands the correction, what tool do you have left? Let's keep pumping--pump, pump, pump. And it just is an endless task, and history is against you. I mean, history is on the side of hard money. If you look at stable prices, you have to look to the only historic, sound money that has lasted more than a few years, fiat money always ends. Gold is the only thing where you can get stable prices. For instance, in the last 3 to 4 years, the price of oil has tripled, a barrel of oil went from $20 to $30 up to $100 a barrel. And yet, if you look at the price of oil in terms of gold it is absolutely flat, it is absolutely stable. So if we want stable prices, we have to have stable money. But I cannot see how we can continue to accept the policy of deliberately destroying the value of money as an economic value. It destroys, it is so immoral in the sense that what about somebody who saved for their retirement and they have CDs. And we are inflating the money at a 10 percent rate, their standard of living is going down and that is what is happening today. The middle class is being wiped out and nobody is understanding that it has to do with the value of money, prices are going up. So how are you able to defend this policy of deliberate depreciation of our money? " CHRG-109hhrg23738--6 The Chairman," The gentlelady's time has expired. The gentlelady from Ohio, Judge Pryce? Ms. Pryce. Thank you, Chairman Oxley. Welcome, Chairman Greenspan. Thank you for taking time to discuss with us your insightful thoughts on monetary policy and the state of our economy. I am pleased to read in your testimony that you believe overall the economy remains steady. Many financial analysts have credited the strong, vibrant housing market as a vital segment of the health of our economy. Recent studies have found that housing accounted for more than one-third of economic growth during the previous 5 years. Many observers, including yourself, have noted that mortgage refinancing provided crucial support to the economy during the past recession, enabled homeowners to reduce their debt burdens and maintain adequate levels of consumer spending by tapping into the equity of their homes. I for one took great advantage of that. Despite these latest gains in home ownership, I am concerned about the recent surge in home prices in many metropolitan areas. In most countries, the recent surge in home prices has gone hand in hand with a much larger jump in household debt than in previous booms. Not only are new buyers taking out bigger mortgages, but existing owners have increased their mortgages to turn capital gains into cash that they can spend. So I hope to hear your views on the current status of this country's housing market and whether a nationwide bubble exists, also what effect a measured rise in inflation will have on the housing market. As we have seen in the Australian economy, they experienced a surge and were able to slowly raise rates and control real estate speculation, keeping that economy healthy after the market peaked. So I look forward to talking more about that with you. Shifting gears, I would also like to know--and I will ask later--whether you feel the recent string of data security breaches has affected consumer confidence in our payment systems. As you know, Mr. Chairman, I, along with many of my colleagues on both sides of the aisle here, are working hard on some legislation that will provide uniform national standards for consumer protection and data breach notification, and we would appreciate any insights you care to share. Data security breaches are something that all of us are concerned with, as we see more and more instances of breaches in the headlines every day. I am pleased to be working with many members, Congressman Castle and LaTourette, Moore, Hooley, even Mr. Frank, on these important issues. And we appreciate the leadership of Chairman Oxley and Chairman Baucus as well. But under Gramm-Leach-Bliley, financial services firms already have an obligation to keep consumer information secure and confidential, and we need to extend those safeguards to information brokers and others. When a breach occurs that could lead to financial fraud or misuse of sensitive financial identity information, customers have the right to be informed about the breach and what steps they should take to protect themselves. I believe there should be one federal standard for data security and for notification. Disparate standards that vary from state to state are an administrative nightmare and make compliance very difficult. Varying standards can cause consumer confusion, and customers should be assured that when their information is breached, they receive the same notification no matter where they live. So, thank you, Mr. Chairman, for your appearance today. I look forward to your testimony. And thank you, Chairman Oxley. I yield back. " fcic_final_report_full--43 This new system threatened the once-dominant traditional commercial banks, and they took their grievances to their regulators and to Congress, which slowly but steadily removed long-standing restrictions and helped banks break out of their tra- ditional mold and join the feverish growth. As a result, two parallel financial sys- tems of enormous scale emerged. This new competition not only benefited Wall Street but also seemed to help all Americans, lowering the  costs  of their mortgages and boosting the returns on their (k)s. Shadow banks and commer- cial banks were codependent competitors. Their new activities were very prof- itable—and, it turned out, very risky. Second, we look at the evolution of financial regulation. To the Federal Reserve and other regulators, the new dual system that granted greater license to market par- ticipants appeared to provide a safer and more dynamic alternative to the era of tradi- tional banking. More and more, regulators looked to financial institutions to police themselves—“deregulation” was the label. Former Fed chairman Alan Greenspan put it this way: “The market-stabilizing private regulatory forces should gradually dis- place many cumbersome, increasingly ineffective government structures.”  In the Fed’s view, if problems emerged in the shadow banking system, the large commercial banks—which were believed to be well-run, well-capitalized, and well-regulated de- spite the loosening of their restraints—could provide vital support. And if problems outstripped the market’s ability to right itself, the Federal Reserve would take on the responsibility to restore financial stability. It did so again and again in the decades leading up to the recent crisis. And, understandably, much of the country came to as- sume that the Fed could always and would always save the day. Third, we follow the profound changes in the mortgage industry, from the sleepy days when local lenders took full responsibility for making and servicing -year loans to a new era in which the idea was to sell the loans off as soon as possible, so that they could be packaged and sold to investors around the world. New mortgage products proliferated, and so did new borrowers. Inevitably, this became a market in which the participants—mortgage brokers, lenders, and Wall Street firms—had a greater stake in the quantity of mortgages signed up and sold than in their quality. We also trace the history of Fannie Mae and Freddie Mac, publicly traded corpora- tions established by Congress that became dominant forces in providing financing to support the mortgage market while also seeking to maximize returns for investors. Fourth, we introduce some of the most arcane subjects in our report: securitiza- tion, structured finance, and derivatives—words that entered the national vocabu- lary as the financial markets unraveled through  and . Put simply and most pertinently, structured finance was the mechanism by which subprime and other mortgages were turned into complex investments often accorded triple-A ratings by credit rating agencies whose own motives were conflicted. This entire market de- pended on finely honed computer models—which turned out to be divorced from reality—and on ever-rising housing prices. When that bubble burst, the complexity bubble also burst: the securities almost no one understood, backed by mortgages no lender would have signed  years earlier, were the first dominoes to fall in the finan- cial sector. CHRG-109hhrg23738--1 Speaker,Speech The Chairman," [Presiding.] The committee will come to order. The chair recognizes himself for an opening statement. Chairman Greenspan, once again, we welcome you back to the Financial Services Committee for now your 35th appearance before this committee and our predecessor, the House Banking Committee, for the Monetary Policy Report. I know I speak for all of our 70 members when I say that your economic analysis and our discussion with you is the highlight of our calendar year here at the Financial Services Committee. Welcome once again, in what will likely be your final appearance here before the Financial Services Committee. To that end, we have enjoyed the opportunity to work with you in a number of capacities over the years, and I know I speak for the entire committee when I say that. We can report to the nation today that our U.S. economic growth is steady and strong. While we face some uncertainty abroad, and we can be assured of the likelihood that there will always be uncertainty abroad, our national economic performance is the envy of the world. More Americans are working than ever before. We recently received the news that 146,000 jobs were created in June, achieving a 5 percent unemployment rate, the lowest since the fateful month of September 2001. Not so long ago, many economists believed that there was a structural unemployment floor of 6 percent or 7 percent. They did not believe that our economy had the ability to reach the goal of 5 percent unemployment, and yet it has done so this month, with a total of 1.1 million jobs created this year alone. An important leading indicator, durable goods, increased 5.5 percent in May, and U.S. manufacturing continues to expand at rates that exceed expectations. Our GDP is growing at a good clip of nearly 4 percent, and the important non-manufacturing sector has been increasing each month now for over 2 years. The markets have risen nicely, recovering from their post-bubble and post-9/11 declines and selloffs, with the Dow now just 500 points shy of its historic high. These positive economic conditions mean that more Americans than ever before have reached the goal of home ownership. With President Bush's housing policies and the American Dream Downpayment Act, home ownership will soon be within reach for even more American families. With 14 consecutive quarters of economic growth, there is further good news for American consumers, and that is, inflation has remained in check. The prices of goods and services did not go up during the month of June. Prices for businesses, the producer price index, actually went down slightly, indicating that businesses have been able to handle recent high energy prices. Americans are well aware of the economy's steady growth, low inflation, and strong housing markets. Consumer confidence numbers are optimistic, and economic predictions show annual growth in the 3 percent to 4 percent range. A thriving economy, growing businesses, and working Americans are the components of a healthy tax base and strong revenues. President Bush's tax cuts have been an important factor in the recent projection that the federal budget deficit will be far lower than previously expected, perhaps up to $100 billion lower, and that will help to keep interest rates as low as possible. Over the long term, the president's programs to make the tax cuts permanent, to restrain government spending, to ensure retirement security, and to expand U.S. exports through free trade will further enhance our economic success. Mr. Chairman, according to the Federal Reserve Web site, its objectives include ``economic growth in line with the economy's potential to expand, a high level of employment, stable prices, and moderate long-term interest rates.'' It is an immense achievement that all of those objectives have been met, and we congratulate you and your colleagues at the Fed. You have the distinction of having served the Council of Economic Advisers under President Ford and serving as the Fed chairman under every president since Reagan. Certainly the confidence of five presidents is also a testament to the nation's faith in your economic leadership. We thank you for your extraordinary service to our country, for the stalwart policies that have guided us to many years of prosperity. This success has advanced American businesses, has increased American influence throughout the world, and has created economic conditions in which American families thrive. I again thank you for your service. I now yield to the gentleman from Massachusetts for an opening statement. " FinancialCrisisInquiry--154 THOMPSON: So a bubble mentality. BASS: Well, do we prick the bubble or not? All right? THOMPSON: Mr. Mayo? MAYO: Yes, three things. Number one, I went back. I did a thousand-page report in 1999, and, right upfront, I talked about what—the real estate situation and how that could fall out and cause a lot of difficulties. So I had to think about why did I put that in there. And I remembered, because every—not every—many management presentations I went to—we as analysts sit in an audience, hear what the company wants to do over the next three, five years. Many management presentations I went to, they said, “We want to expand home equity.” “We want to expand home equity.” “We want to expand home equity.” And so, they all had the same goal. So the goal by itself may have made sense. They just weren’t paying enough attention to what their competition was doing. By the way, the same thing happened with branches. Right? They said, “Oh, I think there’s a good spot for a branch,” they just weren’t anticipating the other two or three banks also opening up a branch on that corner. Right? So that’s what happened in home equity, and that was certainly a tipoff to me. And that is a tipoff that might not have been gotten by the regulators that early, but analysts who were going to all these meetings would get that. The second thing would be deposit insurance. I’ve written about this nonstop since 1994. And in the early part of this decade, I thought it would be increased. It wasn’t. I was wrong. And some of my clients, you know, reminded me of that. CHRG-111hhrg61852--99 Mr. Koo," I think consumers were shell-shocked after the so-called Lehman crisis because the whole economy collapsed and then everybody thought they would be losing jobs left and right. But that was countered very strongly by what the Federal Reserve has done, Treasury, everybody. According to the IMF, the amount of money the governments in the world threw in was something like $8.9 trillion. If you threw in $8.9 trillion to a problem, which is basically due to a policy mistake of allowing Lehman to fail, then people say, oh, we don't have to worry about so much after all. So they are coming back, which is good. That is the V-shaped recovery we saw from March of 2009 to the present period. But whether we can extend this going forward, I am a little more skeptical, because all the balance sheet problems in the private sector, the consumers are still with us. And house prices are not recovering back to the bubble levels. They are still falling. And so these people will still have to worry about their balance sheets. Many of them will continue to deleverage. And if that is the case, just because we recovered to this point doesn't mean we can stay here or that this recovery will continue. I think we have to be very vigilant. " fcic_final_report_full--438 In effect, many of the largest financial institutions in the world, along with hun- dreds of smaller ones, bet the survival of their institutions on housing prices. Some did this knowingly; others not. Many investors made three bad assumptions about U.S. housing prices. They assumed: • A low probability that housing prices would decline significantly; • Prices were largely uncorrelated across different regions, so that a local housing bubble bursting in Nevada would not happen at the same time as one bursting in Florida; and • A relatively low level of strategic defaults , in which an underwater homeowner voluntarily defaults on a non-recourse mortgage. When housing prices declined nationally and quite severely in certain areas, these flawed assumptions, magnified by other problems described in previous steps, cre- ated enormous financial losses for firms exposed to housing investments. An essential cause of the financial and economic crisis was appallingly bad risk management by the leaders of some of the largest financial institutions in the United States and Europe. Each failed firm that the Commission examined failed in part be- cause its leaders poorly managed risk. Based on testimony from the executives of several of the largest failed firms and the Commission staff ’s investigative work, we can group common risk management failures into several classes: • Concentration of highly correlated (housing) risk. Firm managers bet mas- sively on one type of asset, counting on high rates of return while comforting themselves that their competitors were doing the same. • Insufficient capital. Some of the failed institutions were levered : or higher. This meant that every  of assets was financed with  of equity capital and  of debt. This made these firms enormously profitable when things were go- ing well, but incredibly sensitive to even a small loss, as a  percent decline in the market value of these assets would leave them technically insolvent. In some cases, this increased leverage was direct and transparent. In other cases, firms used Structured Investment Vehicles, asset-backed commercial paper conduits, and other off-balance-sheet entities to try to have it both ways: fur- ther increasing their leverage while appearing not to do so. Highly concen- trated, highly correlated risk combined with high leverage makes a fragile financial sector and creates a financial accident waiting to happen. These firms should have had much larger capital cushions and/or mechanisms for contin- gent capital upon which to draw in a crisis. • Overdependence on short-term liquidity from repo and commercial paper markets. Just as each lacked sufficient capital cushions, in each case the failing firm’s liquidity cushion ran out within days. The failed firms appear to have based their liquidity strategies on the flawed assumption that both the firm and these funding markets would always be healthy and functioning smoothly. By failing to provide sufficiently for disruptions in their short-term financing, management put their firm’s survival on a hair trigger. • Poor risk management systems. A number of firms were unable to easily ag- gregate their housing risks across various business lines. Once the market be- gan to decline, those firms that understood their total exposure were able to effectively sell or hedge their risk before the market turned down too far. Those that didn’t were stuck with toxic assets in a disintegrating market. fcic_final_report_full--98 Mortgage credit became more available when subprime lending started to grow again after many of the major subprime lenders failed or were purchased in  and . Afterward, the biggest banks moved in. In , Citigroup, with  billion in assets, paid  billion for Associates First Capital, the second-biggest subprime lender. Still, subprime lending remained only a niche, just . of new mortgages in .  Subprime lending risks and questionable practices remained a concern. Yet the Federal Reserve did not aggressively employ the unique authority granted it by the Home Ownership and Equity Protection Act (HOEPA). Although in  the Fed fined Citigroup  million for lending violations, it only minimally revised the rules for a narrow set of high-cost mortgages.  Following losses by several banks in sub- prime securitization, the Fed and other regulators revised capital standards. HOUSING: “A POWERFUL STABILIZING FORCE ” By the beginning of , the economy was slowing, even though unemployment re- mained at a -year low of . To stimulate borrowing and spending, the Federal Reserve’s Federal Open Market Committee lowered short-term interest rates aggres- sively. On January , , in a rare conference call between scheduled meetings, it cut the benchmark federal funds rate—at which banks lend to each other overnight—by a half percentage point, rather than the more typical quarter point. Later that month, the committee cut the rate another half point, and it continued cut- ting throughout the year— times in all—to ., the lowest in  years. In the end, the recession of  was relatively mild, lasting only eight months, from March to November, and gross domestic product, or GDP—the most common gauge of the economy—dropped by only .. Some policy makers concluded that perhaps, with effective monetary policy, the economy had reached the so-called end of the business cycle, which some economists had been predicting since before the tech crash. “Recessions have become less frequent and less severe,” said Ben Bernanke, then a Fed governor, in a speech early in . “Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed.”  With the recession over and mortgage rates at -year lows, housing kicked into high gear—again. The nation would lose more than , nonfarm jobs in  but make small gains in construction. In states where bubbles soon appeared, con- struction picked up quickly. California ended  with a total of only , more jobs, but with , new construction jobs. In Florida,  of net job growth was in construction. In , builders started more than . million single-family dwellings, a rate unseen since the late s. From  to , residential construction con- tributed three times more to the economy than it had contributed on average since . fcic_final_report_full--477 PRECIPITATED A FINANCIAL CRISIS Although the Commission never defined the financial crisis it was supposed to investigate, it is necessary to do so in order to know where to start and stop. If, for example, the financial crisis is still continuing, then the effect of government policies such as the Troubled Asset Repurchase Program (TARP) should be evaluated. However, it seems clear that Congress wanted the Commission to concentrate on what caused the unprecedented events that occurred largely in the fall of 2008, and for this purpose Ben Bernanke’s definition of the financial crisis seems most appropriate: The credit boom began to unravel in early 2007 when problems surfaced with subprime mortgages—mortgages offered to less-creditworthy borrowers—and house prices in parts of the country began to fall. Mortgage delinquencies and defaults rose, and the downturn in house prices intensified, trends that continue today. Investors, stunned by losses on assets they had believed to be safe, began to pull back from a wide range of credit markets, and financial institutions—reeling from severe losses on mortgages and other loans—cut back their lending. The crisis deepened [in September 2008], when the failure or near-failure of several major financial firms caused many financial and credit markets to freeze up.” 45 In other words, the financial crisis was the result of the losses suffered by financial institutions around the world when U.S. mortgages began to fail in large numbers; the crisis became more severe in September 2008, when the failure of several major financial firms—which held or were thought to hold large amounts of mortgage-related assets—caused many financial markets to freeze up. This summary encapsulates a large number of interconnected events, but it makes clear that the underlying cause of the financial crisis was a rapid decline in the value of one specific and widely held asset: U.S. residential mortgages. The next question is how, exactly, these delinquencies and losses caused the financial crisis. The following discussion will show that it was not all mortgages and mortgage-backed securities that were the source of the crisis, but primarily NTMs— including PMBS backed by NTMs. Traditional mortgages, which were generally prime mortgages, did not suffer substantial losses at the outset of the mortgage meltdown, although as the financial crisis turned into a recession and housing prices continued to fall, losses among prime mortgages began to approach the level of prime mortgage losses that had occurred in past housing crises. However, those levels were far lower than the losses on NTMs, which reached levels of delinquency and default between 15 and 45 percent (depending on the characteristics of the loans in question) because the loans involved were weaker as a class than in any previous housing crisis. The fact that they were also far larger in number than any 45 Speech at Morehouse College, April 14, 2009. 471 previous bubble was what caused the catastrophic housing price declines that fueled the financial crisis. 1. How Failures Among NTMs were Transmitted to the Financial System FOMC20070131meeting--172 170,MR. KOHN.," Thank you, Mr. Chairman. In preparation for submitting my forecast, I looked at my previous forecasts—a humbling but instructive experience usually. [Laughter] Going back a year, I found that, based on the staff’s estimate for 2006, inflation and growth had each turned out within a quarter point of my projections. I’m quite certain that this is not a consequence of any particular expertise on my part. Rather, it is indicative that, in a broad sense, the economy is performing remarkably close to our expectations. President Poole was making this point. Even going back a few years to when we started to remove accommodation, despite large fluctuations in energy prices in recent years, huge geopolitical uncertainties, and a housing boom and bust the dimensions of which we really didn’t anticipate three years ago, the economy is in the neighborhood of full employment, and core inflation is at a fairly low rate by historical standards. Now, the surprises last year were the surge of inflation in the spring and early summer. That has not been entirely reversed. The extent of the slowdown in productivity growth, both in terms of trend and of actual relative to the lower estimated trend, and the related decline in the unemployment rate suggest that we are entering 2007 with a higher risk of inflation than I had anticipated a year ago. Given this risk, it is especially important that economic growth be no greater and perhaps a little less than the growth rate of potential, and that is my forecast—a small uptrend in the unemployment rate. The issue I wrestled with was how fast the economy will be growing when the drag from housing abates. In early December, the debate might have been about whether demand would be sufficient to support growth as high as potential. But given the stabilization of housing demand, the strength of consumption, and ongoing increases in employment, I asked myself whether we might not find the economy growing faster than its potential beginning in the second half of 2007 and in 2008, thereby adding to inflation pressures. A couple of forces, however, gave me a little comfort in supporting my projection of only moderate growth. One is the modest restraint on demand from the recent rise in interest rates, especially the restraint on the housing market, and the dollar exchange rate. Another is the likelihood that consumption will grow more slowly relative to income and will lag the response to housing as housing prices level out and as energy prices begin to edge higher. Consumption late last year was probably still being boosted substantially by the past increases in housing wealth and by the declines in energy prices, which combined with warm weather to give a considerable lift to disposable income. On the housing wealth factor, I think our model suggests that it takes several quarters for a leveling out in housing wealth to build into consumption. In fact, the data through the third quarter suggest that prices were really just about leveling out in the third quarter. So it may be a little early to conclude that, just because we’re not seeing a spillover from the housing market to consumption, there isn’t going to be any. I expect some, though modest, spillover. Moreover, some of the impulse in the fourth quarter was from net exports. These were spurred in part by a temporary decline in petroleum imports and an unexpected strength in exports. Those conditions are unlikely to be sustained. In addition, business investment spending has been weaker than we anticipated. Now, I suspect this is, like the inventory situation, just an aspect of adapting to a slower pace of growth, and investment will strengthen going forward. But it does suggest that businesses are cautious. They are not anticipating ebullient demand and a pressing need to expand facilities to meet increases in sales, and their sense of their market seems worth factoring into our calculations. Finally, the fact that I would have been asking just the opposite question seven weeks ago suggests that we’re also putting a lot of weight on a few observations, [laughter] whether regarding the weakness then or the strength more recently. I do continue to believe that growth close to the growth rate of potential will be consistent with gradually ebbing inflation. For this I would round up the usual suspects, reflecting the ebbing of some temporary factors that increased inflation in 2006. One factor is energy prices. Empirical evidence since the early 1980s to the contrary notwithstanding, the coincidence that President Lacker remarked between the rise and fall in energy prices in 2006 and the rise and fall in core inflation suggests some cause and effect. The increase in energy prices into the summer has probably not yet been completely reversed in twelve-month core inflation rates, so I expect some of that to be dying out as we go into the future. Increases in rents are likely to moderate as units are shifted from ownership to rental markets. The slowdown in growth relative to earlier last year seems to have made businesses more aware of competitive pressures, restraining pricing power. When we met last spring, we had a lot of discussion about businesses feeling that they had pricing power—that they could pass through increases in costs. I haven’t heard any of that discussion around the table today. The recent slowdown in inflation is encouraging but not definitive evidence that the moderation is in train. The slowdown could have been helped by the decline in energy prices, and that decline won’t be repeated. Goods prices might have been held back by efforts to run off inventories, and that phenomenon, too, would be temporary. As I already noted, the initial conditions—the recent behavior of productivity and the relatively low level of the unemployment rate—suggest upward inflation risks relative to this gentle downward tilt. To an extent, the staff has placed a relatively favorable interpretation on these developments. They haven’t revised trend productivity down any further. They expect a pickup in realized productivity growth over this year. They see a portion of the strength in labor markets as simply lagging the slowdown in growth—a little more labor hoarding than usual as the economy cools, along with some statistical anomalies. Thus, in the Greenbook, the unemployment rate rises, and inflation pressures remain contained as activity expands at close to the growth rate of potential. President Yellen at the last meeting and Bill Wascher today pointed out two less benign possibilities. One is that demand really has been stronger, as indicated by the income-side data, and that the labor and product markets really are as tight as the unemployment rate suggests. In this case, the unemployment rate wouldn’t drift higher with moderate growth. Businesses might find themselves facing higher labor costs and being able to pass them on unless we take steps to firm financial conditions. The second possibility is that trend productivity is lower. In this case, actual productivity growth might not recover much this year. Unit labor costs would rise more quickly. Given the apparent momentum in demand, we might be looking at an even further decline in the unemployment rate in the near term. Now, my outlook is predicated on something like the staff interpretation, but I think these other possibilities underline the inflation risks in an economy in which growth has been well maintained. Thank you, Mr. Chairman." FOMC20070628meeting--105 103,MS. YELLEN.," Thank you, Mr. Chairman. Data relating to both economic activity and inflation during the intermeeting period have been encouraging. Economic indicators have strengthened considerably, and recent readings on core inflation have been quite tame. Although a portion of the recent deceleration of core prices likely reflects transitory influences, the underlying trend in core inflation is still quite favorable. I view the conditions for growth going forward as being reasonably solid. The main negative factors are tied to housing. The latest data don’t point to an imminent recovery in this sector, and I fear that the recent run-up in mortgage rates will only make matters worse. In addition, housing prices are unlikely to rise over the next few years and, indeed, may well fall, and the absence of the housing wealth gains realized in the past should damp consumption spending. I agree with the Greenbook that the recent run-up in bond and mortgage rates reflects primarily a shift in market expectations for the path of policy and, therefore, implies only a small subtraction to my forecast for growth in 2008. In my view, the stance of monetary policy over the next few years should be chosen to help move labor and product markets from being somewhat tight today to exhibiting a modest degree of slack in order to help bring about a further gradual reduction in inflation toward a level consistent with price stability. The stance of monetary policy will need to remain modestly restrictive, along the lines assumed in the Greenbook and by markets, in order to achieve that goal. My forecast is for growth to be around 2½ percent in the second half of this year and in 2008, slightly below my estimate of potential growth, and for the unemployment rate to edge up gradually, reaching nearly 5 percent by the end of next year. Under these conditions, core inflation should continue to recede gradually, with the core PCE price index increasing 2 percent this year and 1.9 percent in 2008. This forecast is predicated on continued well-anchored inflation expectations and the eventual appearance of a small amount of labor market slack. In addition, special factors such as rising energy prices and the sustained run-up in owners’ equivalent rent that have boosted inflation should ebb over time, contributing a bit to the expected decline in core inflation. In terms of risks to the outlook for growth, I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector. The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst. Indeed, the repercussions of falling house prices are already playing out in some areas where past price rises were especially rapid and subprime lending soared. For example, in the Sacramento metropolitan area east of San Francisco, house prices shot up at an annual rate of more than 20 percent from 2002 to 2005. Since then, however, they have been falling at an annual rate of 3½ percent. Delinquencies on subprime mortgages rose sharply last year, putting Sacramento at the top of the list of MSAs in terms of the changes in the rate of subprime delinquencies. Research by my staff examining metropolitan areas across the country indicates that the experience of Sacramento reflects a more general pattern. They found that low rates of house price appreciation, and especially house price decelerations, are associated with increases in delinquency rates even after controlling for local economic conditions such as employment growth and the unemployment rate. One possible explanation for these findings is that subprime borrowers, especially those with very low equity stakes, have less incentive to keep their mortgages current when housing no longer seems an attractive investment, either because prices have decelerated sharply or interest rates have risen. These results highlight the potential risks that rising defaults in subprime could spread to other sectors of the mortgage market and could trigger a vicious cycle in which a further deceleration in house prices increases foreclosures, in turn exacerbating downside price movements. The risks to inflation are also significant. In addition to the upside risks associated with continued tight labor markets, a slowdown in productivity growth could add to cost pressures. Although recent productivity data have been disappointing, I expressed some optimism at the last meeting about productivity growth on the grounds that at least some of the slowdown appeared to reflect labor hoarding and lags in the adjustment of employment to output, especially in the construction industry. Data since that meeting have reinforced my optimism concerning trend productivity growth. In particular, new data in the recently released Business Employment Dynamics report suggest that productivity growth may have been stronger than we have been thinking. This report, which includes data that will be used in the rebenchmarking of the payroll survey in January, shows a much smaller increase in employment in the third quarter of 2006 than is reported in the payroll survey; it, therefore, implies a larger increase in output per worker. A second risk to inflation is slippage in the market’s perceptions of our inflation objective. Although inflation compensation over the next five years is essentially unchanged since our last meeting, long-run breakeven inflation rates implied by the difference between nominal and indexed Treasury securities are up about 20 basis points. However, our analysis suggests that this increase reflects in good part an elevation in risk premiums or the influence of various—let me call them “idiosyncratic”—factors of the type that Bill Dudley mentioned, such as a possible shift in the demand by foreign central banks for Treasuries or special factors affecting the demand for inflation-indexed securities and not an increase in long-run inflation expectations. We base this conclusion on the fact that long-run breakeven inflation rates have also climbed in the United Kingdom—a country where inflation expectations have been remarkably well anchored over the past decade and where inflation has been trending downward. The fact that breakeven inflation rates rose in both countries, despite their different monetary policy regimes, suggests that a common explanation is needed rather than one specific to the United States. I think this conclusion is supported by the Board staff model that attributes about half of the movement in breakeven inflation to risk premiums. That said, our understanding and estimates of risk premiums are imprecise, so we must continue to monitor inflation expectations very carefully—of course, along with everything else. [Laughter]" FOMC20060629meeting--111 109,MS. BIES.," Thank you, Mr. Chairman. I continue in my concern, which I expressed at the last meeting, about the recent pickup in inflation, especially given the news that we’ve had since the last meeting. In the past three months, core CPI prices and core PCE prices have grown, respectively, at 3.8 percent and 3.4 percent, twice their rate of growth in the previous three months. It has been interesting to listen to and read the analyses that many folks are doing, trying to parse the reasons for the jump in the inflation rates, no matter what index people are following. The question, as several of you have mentioned, is really whether the reason is persistent inflation or whether it’s one-off kinds of changes. We’ve already had several thoughts about how to look at the relation of energy-price increases and their persistence to the rate of inflation. I won’t add any more to what has already been said, but I thought Mr. Wilcox had a good discussion of the owners’ equivalent rent problem. What are we really looking at here? Some of the possibilities I found amusing. One of them, for example, pointed out that the index used to look at the cost of bank services was up significantly because the opportunity cost on demand deposits had gone up. If that’s the problem, we can cure it by just stopping the raising of rates. [Laughter] So I do think we need to really focus on where we are. Without being able to really understand the underlying framework here, I am very concerned about the trend. When I looked at the dramatic drop in forecast growth, at first I became very pessimistic about the outlook, as several of you have also commented. But the more I looked at the numbers, the more I came to realize that the reduction is all coming from residential housing construction. Everything else is basically a push from the last forecast for this year and next year. When I look at the forecast with that perspective, I see things differently. I’ve been concerned about the amount of speculation in housing construction throughout the country. To the extent that what’s coming out of the housing sector is this excess speculation, that’s healthy both for the long-run economy and for the stability of the financial system. One of our challenges in looking at some of the recent indicators is to determine whether we will really have a soft transition to more sustainable long-term growth of new housing or whether the transition will be bumpier or perhaps more abrupt. A chart in the Greenbook that got my attention was how rapidly the cancellation of sales orders for new housing had jumped within the past five months, from its long-run trend of 22 percent since ’95 to a high rate of 30 percent. Some of these sales data or permit data that we’re seeing today may mean more additions to excess inventory, and so we may see more of a blip; that’s something I think we need to watch. I think we can’t be complacent that a nice easing into long-term sustainable growth of housing is a sure thing at this point. At the same time, because the drop in the forecast is all housing, the question is how to look at the relative growth of the rest of the economy. Since on net it’s basically moving the way it was, I said to myself that I was comfortable with that. But why am I uncomfortable going forward? I, too, hear anecdotes about companies’ optimism about what they can do in terms of increasing revenues and profits. Regarding the capacity issue, we need to realize that a lot of the resources in housing construction are not necessarily transferable to other sectors, except perhaps to commercial real estate. That sector is forecast to pick up, and so some of the growth could happen there. But the inability to transfer resources still raises issues, in terms of both fixed investments and people, and I don’t believe that the apparent slowdown to below trend, since it is driven by housing construction, is really going to create much excess capacity. So that situation makes me concerned about inflation. Finally, I’d like to talk about how housing affects liquidity and monetary policy and our accommodation. Several of you and the staff said earlier that we have seen a bit of adjustment in debt spreads since the last meeting—and volatility is up—but we all agree that spreads are still very narrow by historical standards. Focusing on the staff’s forecast of the flow of funds for the next two years, I found an interesting thing if you look at what’s happening when housing drops to the level forecasted in the Greenbook. Households, in borrowing for mortgages, basically have been the major user of net borrowing in the past couple of years. The forecast is for households’ need for funds, the net borrowing, to drop one-third between 2005 and 2007. The amount by which net household borrowing drops is more than the borrowing by all other sectors combined last year. So part of the issue is that, because households are such a powerful engine in net borrowing, there will be plenty of funds available. Also, as to the extent that bank borrowing and funds provision are forecast to drop, the bankers I talked with said that they aren’t going to let the amount of loans that they extend drop as much as I think is in that forecast. So I really believe that the drop in housing is actually on net going to make liquidity available for other sectors rather than being a drain going forward and that will also get the growth rate more positive than the current Greenbook forecasts." fcic_final_report_full--42 SHADOW BANKING CONTENTS Commercial paper and repos: “Unfettered markets” ...........................................  The savings and loan crisis: “They put a lot of pressure on their regulators” ...........................................................................  The financial crisis of  and  was not a single event but a series of crises that rippled through the financial system and, ultimately, the economy. Distress in one area of the financial markets led to failures in other areas by way of interconnections and vulnerabilities that bankers, government officials, and others had missed or dis- missed. When subprime and other risky mortgages—issued during a housing bubble that many experts failed to identify, and whose consequences were not understood— began to default at unexpected rates, a once-obscure market for complex investment securities backed by those mortgages abruptly failed. When the contagion spread, in- vestors panicked—and the danger inherent in the whole system became manifest. Fi- nancial markets teetered on the edge, and brand-name financial institutions were left bankrupt or dependent on the taxpayers for survival. Federal Reserve Chairman Ben Bernanke now acknowledges that he missed the systemic risks. “Prospective subprime losses were clearly not large enough on their own to account for the magnitude of the crisis,” Bernanke told the Commission. “Rather, the system’s vulnerabilities, together with gaps in the government’s crisis-re- sponse toolkit, were the principal explanations of why the crisis was so severe and had such devastating effects on the broader economy.”  This part of our report explores the origins of risks as they developed in the finan- cial system over recent decades. It is a fascinating story with profound conse- quences—a complex history that could yield its own report. Instead, we focus on four key developments that helped shape the events that shook our financial markets and economy. Detailed books could be written about each of them; we stick to the essen- tials for understanding our specific concern, which is the recent crisis. First, we describe the phenomenal growth of the shadow banking system—the investment banks, most prominently, but also other financial institutions—that freely operated in capital markets beyond the reach of the regulatory apparatus that had been put in place in the wake of the crash of  and the Great Depression.  fcic_final_report_full--474 Of course, in the early 2000s there was no generally understood definition of the term “subprime,” so Fannie and Freddie could define it as they liked, and the assumption that the GSEs only made prime loans continued to be supported by their public disclosures. So when Fannie and Freddie reported their loan acquisitions to various mortgage information aggregators they did not report those mortgages as subprime or Alt-A, and the aggregators continued to follow industry practice by placing virtually all the GSEs’ loans in the “prime” category. Without understanding Fannie and Freddie’s peculiar and self-serving loan classification methods, the recipients of information about the GSEs’ mortgage positions simply seemed to assume that all these mortgages were prime loans, as they had always been in the past, and added them to the number of prime loans outstanding. Accordingly, by 2008 there were approximately 12 million more NTMs in the financial system—and 12 million fewer prime loans—than most market participants realized. Appendix 1 shows that the levels of delinquency and default would be 86 percent higher than expected if there were 12 million NTMs in the financial system instead of 12 million prime loans. Appendix 2 shows that the levels of delinquency would be 150 percent higher than expected if the feedback effect of mortgage delinquencies—causing lower housing prices, in a downward spiral—were taken into account. These differences in projected losses could have misled the rating agencies into believing that, even if the bubble were to deflate, the losses on mortgage failures would not be so substantial as to have a more than local effect and would not adversely affect the AAA tranches in MBS securitizations. The Commission never looked into this issue, or attempted to determine what market participants believed to be the number of subprime and other NTMs outstanding in the system immediately before the financial crisis. Whenever possible in the Commission’s public hearings, I asked analysts and other market participants how many NTMs they believed were outstanding before the financial crisis occurred. It was clear from the responses that none of the witnesses had ever considered that question, and it appeared that none suspected that the number was large enough to substantially affect losses after the collapse of the bubble. It was only on November 10, 2008, after Fannie had been taken over by the federal government, that the company admitted in its 10-Q report for the third quarter of 2008 that it had classified as subprime or Alt-A loans only those loans that it purchased from self-denominated subprime or Alt-A originators, and not loans that were subprime or Alt-A because of their risk characteristics. Even then Fannie wasn’t fully candid. After describing its classification criteria, Fannie stated, “[H]owever, we have other loans with some features that are similar to Alt-A and subprime loans that we have not classified as Alt-A or subprime because they do not meet our classification criteria.” 43 This hardly described the true nature of Fannie’s obligations. On the issue of the number of NTMs outstanding before the crisis the Commission studiously averted its eyes, and the Commission majority’s report 43 Fannie Mae, 2008 3rd quarter 10-Q. p.115, http://www.fanniemae.com/ir/pdf/earnings/2008/q32008. pdf. 469 never addresses the question. HUD’s role in pressing for a reduction in mortgage underwriting standards escaped the FCIC’s attention entirely, the GSEs’ AH goals are mentioned only in passing, CRA is defended, and neither HUD’s Best Practices Initiative nor FHA’s activities are mentioned at all. No reason is advanced for the accumulation of subprime loans in the bubble other than the idea—implicit in the majority’s report—that it was profitable. In sum, the majority’s report is Hamlet without the prince of Denmark. fcic_final_report_full--32 Maker told the board that she feared an “enormous economic impact” could re- sult from a confluence of financial events: flat or declining incomes, a housing bub- ble, and fraudulent loans with overstated values.  In an interview with the FCIC, Maker said that Fed officials seemed impervious to what the consumer advocates were saying. The Fed governors politely listened and said little, she recalled. “They had their economic models, and their economic mod- els did not see this coming,” she said. “We kept getting back, ‘This is all anecdotal.’”  Soon nontraditional mortgages were crowding other kinds of products out of the market in many parts of the country. More mortgage borrowers nationwide took out interest-only loans, and the trend was far more pronounced on the West and East Coasts.  Because of their easy credit terms, nontraditional loans enabled borrowers to buy more expensive homes and ratchet up the prices in bidding wars. The loans were also riskier, however, and a pattern of higher foreclosure rates frequently ap- peared soon after. As home prices shot up in much of the country, many observers began to wonder if the country was witnessing a housing bubble. On June , , the Economist magazine’s cover story posited that the day of reckoning was at hand, with the head- line “House Prices: After the Fall.” The illustration depicted a brick plummeting out of the sky. “It is not going to be pretty,” the article declared. “How the current housing boom ends could decide the course of the entire world economy over the next few years.”  That same month, Fed Chairman Greenspan acknowledged the issue, telling the Joint Economic Committee of the U.S. Congress that “the apparent froth in housing markets may have spilled over into the mortgage markets.”  For years, he had warned that Fannie Mae and Freddie Mac, bolstered by investors’ belief that these in- stitutions had the backing of the U.S. government, were growing so large, with so lit- tle oversight, that they were creating systemic risks for the financial system. Still, he reassured legislators that the U.S. economy was on a “reasonably firm footing” and that the financial system would be resilient if the housing market turned sour. “The dramatic increase in the prevalence of interest-only loans, as well as the in- troduction of other relatively exotic forms of adjustable rate mortgages, are develop- ments of particular concern,” he testified in June. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is be- ginning to add to the pressures in the marketplace. . . . Although we certainly cannot rule out home price declines, espe- cially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages makes it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.  fcic_final_report_full--5 Much attention over the past two years has been focused on the decisions by the federal government to provide massive financial assistance to stabilize the financial system and rescue large financial institutions that were deemed too systemically im- portant to fail. Those decisions—and the deep emotions surrounding them—will be debated long into the future. But our mission was to ask and answer this central ques- tion: how did it come to pass that in  our nation was forced to choose between two stark and painful alternatives —either risk the total collapse of our financial system and economy or inject trillions of taxpayer dollars into the financial system and an array of companies, as millions of Americans still lost their jobs, their savings, and their homes? In this report, we detail the events of the crisis. But a simple summary, as we see it, is useful at the outset. While the vulnerabilities that created the potential for cri- sis were years in the making, it was the collapse of the housing bubble—fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages— that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of . Trillions of dollars in risky mortgages had become embedded throughout the financial system, as mortgage-related securities were packaged, repackaged, and sold to investors around the world. When the bubble burst, hun- dreds of billions of dollars in losses in mortgages and mortgage-related securities shook markets as well as financial institutions that had significant exposures to those mortgages and had borrowed heavily against them. This happened not just in the United States but around the world. The losses were magnified by derivatives such as synthetic securities. The crisis reached seismic proportions in September  with the failure of Lehman Brothers and the impending collapse of the insurance giant American Interna- tional Group (AIG). Panic fanned by a lack of transparency of the balance sheets of ma- jor financial institutions, coupled with a tangle of interconnections among institutions perceived to be “too big to fail,” caused the credit markets to seize up. Trading ground to a halt. The stock market plummeted. The economy plunged into a deep recession. The financial system we examined bears little resemblance to that of our parents’ generation. The changes in the past three decades alone have been remarkable. The financial markets have become increasingly globalized. Technology has transformed the efficiency, speed, and complexity of financial instruments and transactions. There is broader access to and lower costs of financing than ever before. And the financial sector itself has become a much more dominant force in our economy. CHRG-111hhrg48674--362 Mr. Bernanke," Well, by strengthening supervisory oversight over the risk management, making banks responsible for strengthening those controls. I think the system just got carried away by the credit bubble, and the risk management systems didn't succeed in protecting the system from that. There are also a lot of gaps in the regulatory system, places where there is duplicate oversight, places where there is not enough oversight. So we have a lot of work to do. " FinancialCrisisReport--260 Subprime lending fueled the overall growth in housing demand and housing price increases that began in the late 1990s and ran through mid-2006. 1008 “Between 2000 and 2007, backers of subprime mortgage - backed securities – primarily Wall Street and European investment banks – underwrote $2.1 trillion worth of [subprime mortgage backed securities] business, according to data from trade publication Inside Mortgage Finance .” 1009 By 2006, subprime lending made up 13.5% of mortgage lending in the United States, a fivefold increase from 2001. 1010 The graph below reflects the unprecedented growth in subprime mortgages between 2003 and 2006. 1011 1008 See 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 36. See also “A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched this Industry’s Role in the Subprime Mortgage Debacle of 2007 – 2008,” Mercatus on Policy (10/2009), at 2. 1009 “The Roots of the Financial Crisis: Who is to Blame?” The Center for Public Integrity (5/6/2009), http://www.publicintegrity.org/investigations/economic_meltdown/articles/entry/1286. 1010 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 7. 1011 1/25/2010, “Mortgage Subprime Origination,” chart prepared by Paulson & Co. Inc., PSI-Paulson&Co-02-0001- 21, at 4. fcic_final_report_full--419 On November , , a bankruptcy court ruled that the Bank of New York could not foreclose on a loan it had purchased from Countrywide, because MERS had failed to endorse or deliver the note to the Bank of New York as required by the pooling and servicing agreement. This ruling could have further implications, be- cause it was customary for Countrywide to maintain possession of the note and re- lated loan documents when loans were securitized.  Across the market, some mortgage securities holders have sued the issuers of those securities, demanding that the issuers rescind their purchases.  If the legal challenges succeed, investors that own mortgage-backed securities could force the is- suers to buy them back at the original price—possibly with interest. The issuers would then be the owners of the securities and would bear the risk of loss.  The Congressional Oversight Panel, in a report issued in November , said it is on the lookout for such risks: “If documentation problems prove to be pervasive and, more importantly, throw into doubt the ownership of not only foreclosed prop- erties but also pooled mortgages, the consequences could be severe.”  This sentiment was echoed by University of Iowa law professor Katherine Porter who has studied foreclosures and the law: “It is lack of knowledge of how widespread the problems may be that is turning the allegations into a crisis. Lack of knowledge feeds specula- tion and worst-case scenarios.”  Adam Levitin, a Georgetown University associate professor of law, has estimated that the claims could be in the trillions of dollars, ren- dering major U.S. banks insolvent.  NEIGHBORHOOD EFFECTS: “I ’M NOT LEAVING ” For the millions of Americans who paid their bills, never flipped a house, and had never heard of a CDO, the financial crisis has been long, bewildering, and painful. A crisis that started with a housing boom that became a bubble has come back full cir- cle to forests of “for sale” signs—but this time attracting few buyers. Stores have shut- tered; employers have cut jobs; hopes have fled. Too many Americans today find themselves in suburban ghost towns or urban wastelands, where properties are va- cant and construction cranes do not lift a thing for months. Renters, who never bought into the madness, are also among the victims as lenders seize property after landlords default on loans. Renters can lose the roof over their heads as well as their security deposits. In Minneapolis, as many as  of buildings with foreclosures in  and  were renter-occupied, according to sta- tistics cited in testimony by Deputy Assistant Secretary Erika Poethig from the U.S. Department of Housing and Urban Development to the House of Representatives Subcommittee on Housing and Community Opportunity.  CHRG-111shrg54533--33 Secretary Geithner," Our plan does not address a range of other causes of this crisis, including policies pursued around the world that helped produce a long period of very low interest rates and a very, very substantial boom in asset prices, housing prices, not just in this country but in countries around the world. And I think you are right to underscore the basic fact that a lot of things contributed to this crisis. It was not just failures in supervision and regulation. And as part of what the world does, major countries around the world, in trying to reduce the risk we have a crisis like this in the future, it will require thinking better through how to avoid the risk that monetary macroeconomic policies contribute to future booms and asset prices and credit bubbles of this magnitude. Senator Bunning. Your plan puts a lot of faith in the Federal Reserve's ability to spot risk and exercise its power to prevent the next crisis. However, if the Fed and other regulators have been doing their jobs and paying attention to what the banks and other firms were doing earlier this decade, they almost certainly could have prevented the mess. And the Fed has proven it is unwilling to use its power it has. Let me give you an example. Just look how slow it addressed the credit card abuses, and it took 14 years for the Fed to write one regulation on mortgages after we gave them the power to do that. So giving them the power and making them act are two different things. What makes you think that the Fed will do better this time around? " fcic_final_report_full--413 THE FORECLOSURE CRISIS CONTENTS Foreclosures on the rise: “Hard to talk about any recovery” ..............................  Initiatives to stem foreclosures: “Persistently disregard” .....................................  Flaws in the process: “Speculation and worst-case scenarios” ...........................  Neighborhood effects: “I’m not leaving” .............................................................  FORECLOSURES ON THE RISE: “HARD TO TALK ABOUT ANY RECOVERY ” Since the housing bubble burst, about four million families have lost their homes to foreclosure  and another four and a half million  have slipped into the foreclosure process or are seriously behind on their mortgage payments. When the economic damage finally abates, foreclosures may total between  million and more than  million, according to various estimates.  The foreclosure epidemic has hurt families and undermined home values in entire zip codes, strained school systems as well as community support services, and depleted state coffers. Even if the economy began suddenly booming the country would need years to recover. Prior to , the foreclosure rate was historically less than . But the trend since the housing market collapsed has been dramatic: In , . of all houses, or  out of , received at least one foreclosure filing.  In the fall of ,  in every  outstanding residential mortgage loans in the United States was at least one payment past due but not yet in foreclosure—an ominous warning that this wave may not have crested.  Distressed sales account for the majority of home sales in cities around the country, including Las Vegas, Phoenix, Sacramento, and Riverside, California.  Returning to the , borrowers whose loans were pooled into CMLTI - NC: by September , many had moved or refinanced their mortgages; by that point, , had entered foreclosure (mostly in Florida and California), and  had started loan modifications. Of the , still active loans then,  were seriously past due in their payments or currently in foreclosure.  The causes of foreclosures have been analyzed by many academics and govern- ment agencies. Two events are typically necessary for a mortgage default. First, monthly payments become unaffordable owing to unemployment or other financial  hardship, or because mortgage payments increase. And second (in the opinion of many, now the more important factor), the home’s value becomes less than the debt owed—in other words, the borrower has negative equity. “The evidence is irrefutable,” Laurie Goodman, a senior managing director with Amherst Securities, told Congress in : “Negative equity is the most important predictor of default. When the borrower has negative equity, unemployment acts as one of many possible catalysts, increasing the probability of default.”  CHRG-111hhrg53244--201 Mr. Bernanke," I think that could be addressed under the systemic risk regulation rubric that we have been discussing with the Council or with the Fed overseeing large financial institutions, that when you have an asset whose prices is rising quickly, you could require greater capital against it, for example, or greater downpayments. So even if you don't know there is a bubble or not, that still might be a prudent thing to do. So I do think that looking at asset price fluctuations in a supervisory context could be very helpful. " FOMC20061212meeting--179 177,MS. MINEHAN.," Let me put in another plug for section 2 of alternative C: “Economic growth has slowed over the course of the year, partly reflecting a substantial cooling of the housing market.” Why do you want to go on and on about it?" FOMC20071031meeting--62 60,MR. LACKER.," Conditioning on the Philadelphia index, we actually have marginal predictive value for the national ISMs. But I continue. A modest housing spillover into business investment plans seems to be unfolding as well. In the recent Board-commissioned survey of capital investment plans, our District was among those in which more businesses plan to trim rather than boost spending in the months ahead. Again, a more detailed look reveals that most firms planning reductions have ties to housing. Reports on retail sales in the District remain soft, with sales of automobiles and building materials notably weak. In addition, an executive from a major transportation firm headquartered in the District told us that freight volumes, both rail and trucking, are now at the lowest level since the 2001 recession. Although in a number of District markets commercial real estate activity remains healthy, we are hearing scattered reports of commercial construction projects being shelved. One director from D.C. said that commercial development there “doesn’t have the pulse it had six weeks ago.” The turmoil in financial markets has not appreciably constrained business lending in our District, however. Contacts generally describe credit as readily available to creditworthy borrowers, but some say spreads have widened a bit. On the price front, our monthly measures suggest some moderation in growth despite ongoing complaints of higher input costs. At our last meeting, I was more optimistic than the Greenbook on the national economy. A significant part of the difference was related to housing, where I saw greater probability of the drag receding sooner. Longer term, I had a somewhat higher estimate of trend productivity growth, which supported a somewhat stronger outlook for household consumption. The main shift in my perspective since the last meeting is that I am now at least as pessimistic as the Greenbook about prospects for housing bottoming out anytime soon. The 10 percent fall in housing starts in September was certainly eye catching, and it indicates that the weak summer housing market tailed off further toward the end. In our District, and this seems to be true elsewhere as well, the housing downturn appears to have spread into many formerly unaffected markets. It is hard for me to believe that any discernible stabilization is likely before the spring, when the seasonal pickup in housing activity typically takes place. Even then a prolonged period of depressed activity seems more likely than any noticeable bounceback. Other recent news suggests a bit more demand-side fallout from the housing market than I had been expecting. Manufacturing production was sluggish in August and September, and durable goods orders have shown only modest growth, especially outside the aircraft industry. I mentioned a minute ago that our survey of the Fifth District manufacturing sector—which, by the way, is larger than the Philadelphia and New York manufacturing sector—[laughter] is showing a significant slowdown for October, particularly in housing-related industries. Consumer spending has been a source of stability during this housing correction, and I expect that to remain true over the forecast period. I think household spending will generally expand in line with disposable income, but even though consumption advanced broadly in the third quarter, it now seems we’re in for a bit of a slowdown this quarter. In that regard, I’m feeling sympathy for what President Yellen said. So I’m less sanguine overall about the near-term outlook for growth at this meeting, although that may just represent catching up on my part to the Greenbook’s past level of gloominess. Having said all that, I do believe that the effects of this summer’s financial market adjustments are likely to be limited; and out beyond the middle of the next year, I’m, again, more optimistic than the Greenbook and for the usual reasons. I think that productivity growth and, thus, real income growth will be somewhat higher than in the Greenbook forecast, and my outlook for the personal saving rate is centered on its current value rather than a steady increase. Inflation appears to have ticked up a bit in September, at least according to the CPI. Still, year-over-year core PCE inflation remained reasonably contained, and I’ve been struck by the extent to which TIPS inflation compensation has held relatively steady in recent months, especially given our easing move last month and the run-up in oil prices. While I would like to see inflation come down further, I’m somewhat more comfortable about inflation than I was at the beginning of the year. Thank you, Mr. Chairman." FinancialCrisisInquiry--401 MAYO: I think about your question a lot. And, you know, accountants try to recreate reality in numbers, and we, January 13, 2010 as financial analysts, take those numbers and try to recreate reality. So if the numbers that accountants give us aren’t good, then the conclusions of the analysts won’t be good either. So, definitely, more disclosure is good and would be helpful. I’d say innovation always outpaces regulation, but in this case, it was just much further ahead. And, you know, you certainly need more capital for newer activities or more risky activities or other activities without a long enough track record. And you saw that. And, as Mr. Solomon said, we’ve had a lot of once-in-a-lifetime events. And you—you know, whether it’s Enron and WorldCom or Russia and Asia and Mexico or, you know, the tech bubble and then the real estate bubble. It seems as though these once-in-a- lifetime events happen every couple of years. So the idea of more capital overall makes a lot of sense for these once-in-a-lifetime events for these new activities. And as far as additional disclosure, no question. It would have been very helpful during the crisis and would still be helpful now especially with regard to problem loans at U.S. banks. I would make one point, though. We can’t be too pro-cyclical. If you try to correct all at once, then you’re going to kill the economy. So you have to do this in a balanced way. fcic_final_report_full--490 III. THE U.S. GOVERNMENT ’S ROLE IN FOSTERING THE GROWTH OF THE NTM MARKET The preceding section of this dissenting statement described the damage that was done to the financial system by the unprecedented number of defaults and delinquencies that occurred among the 27 million NTMs that were present there in 2008. Given the damage they caused, the most important question about the financial crisis is why so many low quality mortgages were created. Another way to state this question is to ask why mortgage standards declined so substantially before and during the 1997-2007 bubble, allowing so many NTMs to be created. This massive and unprecedented change in underwriting standards had to have a cause—some factor that was present during the 1990s and thereafter that was not present in any earlier period. Part III addresses this fundamental question. The conventional explanation for the financial crisis is the one given by Fed Chairman Bernanke in the same speech at Morehouse College quoted at the outset of Part II: Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain . One important consequence was a housing boom in the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of this lending was poorly done, involving, for example, little or no down payment by the borrower or insuffi cient consideration by the lender of the borrower’s ability to make the monthly payments . Lenders may have become careless because they, like many people at the time, expected that house prices would continue to rise--thereby allowing borrowers to build up equity in their homes--and that credit would remain easily available, so that borrowers would be able to refinance if necessary. Regulators did not do enough to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation. [Emphasis supplied] 59 In other words, the liquidity in the world financial market caused U.S. banks to compete for borrowers by lowering their underwriting standards for mortgages and other loans. Lenders became careless. Regulators failed. Unregulated originators made bad loans. One has to ask: is it plausible that banks would compete for borrowers by lowering their mortgage standards? Mortgage originators—whether S&Ls, commercial banks, mortgage banks or unregulated brokers—have been competing for 100 years. That competition involved offering the lowest rates and the most benefits to potential borrowers. It did not, however, generally result in 59 Speech at Morehead College April 14, 2009. 485 or involve the weakening of underwriting standards. Those standards—what made up the traditional U.S. mortgage—were generally 15 or 30 year amortizing loans to homebuyers who could provide a downpayment of at least 10-to-20 percent and had good credit records, jobs and steady incomes. Because of its inherent quality, this loan was known as a prime mortgage. FOMC20060131meeting--76 74,MR. SANTOMERO.," I wanted to go to the housing issue. In the projection in the Greenbook, as I understand it, you’ve got housing prices going up at about a 5½ percent rate as compared with last year’s number, which I think is 12 percent. We’ve been looking at the sensitivity of what happens to our GDP growth rate in ’06 and ’07 to the extent that housing prices stay flat. Our numbers suggest that a flat housing price associated with the decline in residential investment would shave about ½ percentage point off GDP in ’06 and about 0.6 or 0.7 if you add the consumption effects. Does that sound like a reasonable sensitivity to you?" FOMC20070628meeting--138 136,MR. MISHKIN.," Thank you. My view of what has been happening in the economy is that we have been basically going through a rebalancing. We had a sector that was clearly bubble-like with excessive spending, and now we are getting the retrenchment, which is taking a bit longer than we expected. But the good news is that we are going through a rebalancing in which we are just moving resources to other sectors and that is actually going much along the lines that we want to see. The problem in a rebalancing episode is that you are always worried about the risk that is possible because these transitions don’t always occur smoothly. I think that we were much more worried about that—at least I was more worried—at the previous meeting. But we have been seeing that the rebalancing is actually going along pretty well. In particular, although the housing market is very weak, very much along the lines of the Greenbook forecast, it hasn’t surprised us this particular period. It’s just that it is pretty bad. But the risks are actually fairly balanced on housing because we do not see it as very strong and that is part of the process of undoing the previous excesses. Another very important thing is that we have not seen any surprising spillovers from the housing market. As time goes on and nothing really bad happens, we become more confident that, in fact, the downside risk isn’t there either. We have also seen that the investment sector has been looking a little stronger. Again, that really did concern me at the last FOMC meeting. Yet we have had some reasonable numbers; they are not spectacular, but I think the downside risks have dissipated. So the bottom line is that I see the economy as rebalancing and doing it in a fairly good way. In fact, from a long-run perspective, this is a good thing and not a bad thing. The downside risk has dissipated, and the risks are now quite balanced. So I am quite comfortable with the Greenbook forecast on this, which is that we have growth somewhat below trend but moving back toward trend, and I see that there has been a shift in a positive direction and the risks are not excessively on the downside but are much more balanced. When I look at the inflation picture, I am in a way pleased with the recent numbers because there is no strong indication that we are far from potential output and, in particular, there is a little indication that the tightness in the economy certainly will be unraveled. According to our forecast, not much is going on in that area, so what’s going on in inflation expectations will be dominant. I mean, given that inflation expectations have been pretty well anchored around 2 percent, although there is some uncertainty, I thought that we would have a return to 2 percent numbers a bit more quickly than the original Greenbook forecast showed. I was really pleased because the Greenbook has basically moved closer to the picture that I had all along; so now I’m very comfortable with the Greenbook forecast. In contrast to some other people, I think the risks are pretty balanced. Now, maybe that is not really different because of the people who have inflation going below 2 percent, and I don’t see that. So I believe it’s going to be 2 now and it’s going to be 2 for a while unless we make a concerted effort to change inflation expectations. Then there is the whole issue of how we might go about doing that. But given the current environment, my view is that risks are fairly balanced. Other people are saying that there is risk on the upside, but I think that’s because they just have slightly lower numbers regarding where they think inflation will be. But probably when we look at it from that perspective, it is about the same. So right now I think the economy is evolving in a pretty reasonable way, and I’m sure we will be surprised in one direction or another in the future. Thank you very much." CHRG-110shrg50409--30 Mr. Bernanke," So the second quarter appears to be actually better than expected, and, therefore, our forecast for the entire year might actually be stronger than it was earlier. But with that strength having been brought forward to some extent into the second quarter, we are looking at the remainder of the year as being probably positive growth, but certainly not robust growth. Senator Bennett. The one thing the markets hate more than anything else is uncertainty, and I have the feeling that that is part of the problem with respect to oil prices and part of the problem with respect to the housing market. Now, you have suggested that the housing market might stabilize over the next 6 to 12 months so that people will begin to say, OK, we have now reached bottom and we are starting to build back up again. Do you feel that the deal that was made over the weekend with Fannie and Freddie can help eliminate some of the uncertainty and cause people to have a greater degree of confidence that the timeframe that we have been talking about will indeed come to pass? " FOMC20061212meeting--118 116,MR. MADIGAN.," I think the basic answer to that is “yes,” but there are perhaps things going on here at a cyclical level and at a more structural level. Chairman Bernanke’s hypothesis was more of a structural or a secular explanation of interest rates. What we’re seeing in the upper panel of chart 5 obviously has important cyclical characteristics with, among other things, investment spending being depressed for quite a while in the aftermath of the bubble that apparently prevailed earlier." FOMC20061025meeting--227 225,MS. BIES.," Thank you, Mr. Chairman. First, I support leaving the fed funds rate unchanged at this meeting. I’ve puzzled over section 2, and I like what Governor Kohn has suggested because one of the challenges I have had in this whole thing is what I heard around the table yesterday, which in general supports the conclusion I’ve been coming to. We really are going from very rapid growth to slowing, but if you parse out the pieces, what’s really changing is housing. The rapid growth from 2003 to 2005 was due to unsustainable housing construction; it’s coming down, and it’s a big chunk of that change. Now, other sectors have noise or are weak. Sectors like autos and exports are jumping around, but it’s housing that has to adjust. I think it’s going to run below trend as the Greenbook says. At the same time, as we all were mentioning yesterday, we have tightness in the labor market, which again signals that in most sectors of the economy it’s hard to find people who are available to work to sustain the economy. It’s almost as though we have a dichotomy right now whereby housing is running below trend but the rest of the economy is running at or above potential. So I think it’s important to leave in the comment about the housing sector—that is what we’re focusing on. To me that is bringing the aggregate number below potential and is moderating the growth rate. But in terms of the way to go on section 2, I can go either way. I do like the change that Governor Kohn suggested in section 3. I think that is a good change. I believe that we should not change section 4, the assessment of risk, at this meeting. It has been only five weeks. We’ve had a discussion about changing more frequently; again, I think we ought to leave that to the communications subcommittee to think about. But I think we ought to leave it as it is because it says what we really mean. The first sentence says that there are inflation risks, and that’s a sense that we need to convey. Too much could be read into a change that may be unintended, and so I’d rather just at this meeting leave it the way it was at the previous meeting. Thank you." FOMC20070628meeting--201 199,CHAIRMAN BERNANKE.," The proposal is, “Economic growth appears to have been moderate,” and then it goes on, as it says here, “during the first half of this year, despite the ongoing adjustment in the housing sector.” I see nodding, so I think that is accepted. I’m sorry. No?" FOMC20070628meeting--120 118,MS. PIANALTO.," Thank you, Mr. Chairman. News from the Fourth District is little changed from my last report. The District economy continues to be weighed down by weakness in the housing market, and there is general consensus among my contacts that the housing sector has not yet seen bottom. To date, adverse spillovers from housing to other sectors of the economy have not been observed, although this remains a significant risk to the outlook. While I have heard some reports from my business contacts that the labor market is strengthening, the official data still do not show net employment growth in the region. My projections for the national economy still call for growth to resume to a more typical expansionary pace as we move beyond 2007. My projection for GDP is slightly stronger than what is seen in the latest Greenbook because of my assumption for slightly stronger growth in potential. Obviously, I don’t make that judgment with great confidence. However, the business leaders I talk with tell me that their plans to expand capital are consistent with a pickup in productivity growth from its recent cyclical low. This includes the Cleveland Cavaliers—[laughter]—a franchise which, as many of you know, experienced a substantial productivity shortfall against the San Antonio Spurs a couple of weeks ago. [Laughter] Here, too, we are projecting a good rebound, so to speak, in 2008. In the meantime, I would like the record to show that I am making good on my wager with President Fisher. I brought with me a selection of Cleveland’s finest, and I will present those to Richard after this meeting with my heartfelt congratulations. I am putting this back, because it feels funny having a beer bottle in my hand. [Laughter]" fcic_final_report_full--523 Freddie Mac. As noted earlier, in its limited review of the role of the GSEs in the financial crisis, the Commission spent most of its time and staff resources on a review of Fannie Mae, and for that reason this dissent focuses primarily on documents received from Fannie. However, things were not substantially different at Freddie Mac. In a document dated June 4, 2009, entitled “Cost of Freddie Mac’s Affordable Housing Mission,” a report to the Business Risk Committee, of the Board of Directors, 136 several points were made that show the experience of Freddie was no different than Fannie’s: • Our housing goals compliance required little direct subsidy prior to 2003, but since then subsidies have averaged $200 million per year. • Higher credit risk mortgages disproportionately tend to be goal-qualifying. Targeted affordable lending generally requires ‘accepting’ substantially higher credit risk. • We charge more for targeted (and baseline) affordable single-family loans, but not enough to fully offset their higher incremental risk. • Goal-qualifying single-family loans accounted for the disproportionate share of our 2008 realized losses that was predicted by our models. (slide 2) • In 2007 Freddie Mac failed two subgoals, but compliance was subsequently deemed infeasible by the regulator due to economic conditions. In 2008 Freddie Mac failed six goals and subgoals, five of which were deemed infeasible. No enforcement action was taken regarding the sixth missed goal because of our financial condition. (slide 3) • Goal-qualifying loans tend to be higher risk. Lower household income correlates with various risk factors such as less wealth, less employment stability, higher loan-to-value ratios, or lower credit scores. (slide 7) • Targeted affordable loans have much higher expected default probabilities... Over one-half of targeted affordable loans have higher expected default probabilities than the highest 5% of non-goal-qualifying loans. (Slide 8) The use of the affordable housing goals to force a reduction in the GSEs’ underwriting standards was a major policy error committed by HUD in two successive administrations, and must be recognized as such if we are ever to understand what caused the financial crisis. Ultimately, the AH goals extended the housing bubble, infused it with weak and high risk NTMs, caused the insolvency of Fannie and Freddie, and—together with other elements of U.S. housing policy—was the principal cause of the financial crisis itself. When Congress enacted the Housing and Economic Recovery Act of 2008 (HERA), it transferred the responsibility for administering the affordable housing goals from HUD to FHFA. In 2010, FHFA modified and simplified the AH goals, and eliminated one of their most troubling elements. As Fannie had noted, if the AH goals exceed the number of goals-eligible borrowers in the market, they were being forced to allocate credit, taking it from the middle class and providing it to low- income borrowers. In effect, there was a conflict between their mission to advance affordable housing and their mission to maintain a liquid secondary mortgage 136 Freddie Mac, “Cost of Freddie Mac’s Affordable Housing Mission,” Business Risk Committee, Board of Directors, June 4, 2009. 519 market for most mortgages in the U.S. The new FHFA rule does not require the GSEs to purchase more qualifying loans than the percentage of the total market that these loans constitute. 137 FOMC20061025meeting--85 83,MR. KOHN.," Thank you, Mr. Chairman. The Committee’s focus has been on encouraging a gradual abatement of core inflation, and I think the limited evidence we’ve gotten since the last meeting is consistent with this outcome. The price data themselves show some signs of deceleration of core inflation on a three-month basis from the very high levels of last spring and summer, though the rates are still elevated. A further decline in energy prices should help to keep inflation expectations down and will take a little pressure off business costs and core inflation even if pass-throughs are fairly small. As expected, the rent-of-shelter component has been increasing less rapidly, supporting the projection that, in a soft housing market with overhangs of unsold housing units, this component will not be boosting measured inflation rates very much. Inflation expectations as derived from financial market quotes remain at the lower levels reached earlier this fall. As the Bluebook notes, the exact level of these expectations is really impossible to tease out of the data; and although they may be a bit higher than we would like, they do look lower than the recent twelve-month inflation rates and, at these levels, should exert some downward gravitational pull on realized inflation. The economy appears to be running modestly below the rate of growth of its potential, and this should relieve pressure on labor and product markets. How far the economy is running below potential in an underlying sense is uncertain. I suspect it is not as weak as the estimated third-quarter GDP number but is somewhat softer than the labor market indicators, which show no slackening in the pace of demand or decline in resource utilization. I base this conclusion in part on the data and projections of final domestic and total demand, which the Greenbook has averaging in the neighborhood of 2 percent in the second half of the year. Industrial production was weak in August and September, pulled down by the ongoing inventory corrections in housing and autos, and this reinforced my sense that, at least for a time, the economy is growing a bit below the rate of growth of its potential. Going forward, I think a projection of economic growth gradually recovering next year as the drag from housing abates is reasonable, with growth supported by favorable financial conditions and lower energy prices. How quickly it returns to potential is an open question. Though other forms of spending have proven resilient to date, I agree with the staff analysis that some spillovers on consumption and investment from the weakness in housing and in housing wealth are likely to restrain growth at least a little next year. I also see that the spending risk is still pointed somewhat to the downside, although less so than at the last meeting. To be sure, the recent signs are somewhat reassuring that the housing market isn’t weakening faster than expected. Still, in the staff forecast the housing market is left with a relatively high level of inventory at the end of 2008, and prices are still elevated relative to rents, suggesting the possibility of greater declines in activity and prices. In addition, equity prices are vulnerable to disappointing earnings as labor costs rise even gradually. The economy is most likely to grow a little below its potential for a while and inflation to trend gradually lower. All in all, this is a pretty good outcome following the earlier oil price shock and rise in core inflation and housing market correction. With demand outside of housing as resilient as it has been and inflation as high as it has persisted, the extent and trajectory of the expected inflation trend is uncertain and should remain our focus. A failure of inflation to reverse the uptick of earlier this year before it becomes embedded in higher inflation expectations continues to be the main risk to good, sustained economic performance over time. Thank you, Mr. Chairman." CHRG-111hhrg54867--161 Mr. Lucas," Because, after all, Secretary, in my region, we went through both an agricultural and energy property boom, bust, and bubble in the 1980's. We were slaughtered economically. We did not receive capital injections. Our industries were not propped up. It took us, 10, 15 years in some segments to recover from it. We do not wish that on anyone else, but by the same token, let us not make the matter worse because the feud back home is, it was the big boys that damn near killed us all, not the little players. " CHRG-110hhrg34673--19 Mr. Bernanke," Congressman, the story was misreported, and you misunderstand my position. I did not address the affordable housing fund, either pro or con. The concern that the Federal Reserve has had for a long time about GSE's is the potential for their portfolios to create systemic risk in our financial system. I should say that we very much support the GSE's housing mission, and we believe, in particular, that the securitization function contributes to liquidity in the mortgage market. Again, our concern is about the portfolios and their enormous size and the complex derivative exercises that are needed to maintain the balance of those portfolios. My comment was one that built on suggestions that Chairman Greenspan had made in previous testimonies, which was that one way to limit the growth of the portfolios, but also to achieve the stated public purpose of the GSE's was, in some way, to anchor the portfolios in the public purpose, which is affordable housing. According to OFHEO, only about 30 percent of the portfolios are related in any way to affordable housing. So I think what I would like to see would be the portfolios to be more directly connected to a public purpose, perhaps holding affordable housing mortgages or another way, more directly promoting affordable housing rather than acquiring all different kinds of assets that are not related to affordable housing. " FOMC20050322meeting--132 130,MR. OLSON.," Thank you, Mr. Chairman. In my comments I want to follow up on President March 22, 2005 70 of 116 increasing anecdotal evidence and concern about this issue, and I think the characterization in yesterday’s Wall Street Journal that day trading is now occurring in residential housing markets is a further indication of the concern. Of course, the extent to which the speculative purchases make a difference is reflected not only in the possibility of its impacting the pace of the growth in housing values but also the pricing of risk, as Jack suggested. But I think the question has been whether or not the size of the market was significant enough to have an impact. Clearly, the trend was eye- catching, but was the market significant enough to make a significant difference? Data collected recently and provided by our economists indicate that non-owner-occupied mortgages constitute 5½ percent of the total outstanding and have fluctuated around 7 percent of new originations. With respect to second homes, the numbers were about 2.8 percent of total mortgage loans and 3 percent of new originations. However, this week, the National Association of Realtors revised significantly their sense of the size of the market, based on surveys they had made and also on information from the 2003 Census Bureau report. They indicated that, in their view, 23 percent of all home purchases in 2004 were for investment and an additional 13 percent were for vacation homes. The difference was that through their surveys they have been able to isolate the investment purchaser of single-family homes as distinct from the purchaser of a second home. The implications of that are significant, and the size of the market is much larger than they had perceived. Also, those numbers would suggest that many of those buyers have made multiple purchases of single-family homes, which brings in another element of risk—the risk associated with the debt service capability they need to maintain those purchases in the event of a downturn. I think it’s appropriate that we are going to be looking at the issue of real estate bubbles and the speculative component of that market at our meeting in June. There are a number of indications March 22, 2005 71 of 116 tightened their loan requirements for interest-only loans and for those with low down payments. And we have seen the criteria for loans being tightened in other places also. With respect to our policy decision today, I think the question is not so much what we should do but how we explain why we are doing it. As Governor Ferguson did, let me take you back 18 months, when we began using the phrase “for a considerable period.” Notwithstanding the impact on implied volatility, also implicit in the statement “for a considerable period” was that there needed to be an exit strategy. And the exit strategy—or transition, if you will—went from “considerable period” to “patient” to “measured pace.” I don’t think today is the time to change “measured pace,” but it’s time to think about an exit strategy from it. Thank you." CHRG-111hhrg48867--11 Mr. Hensarling," Thank you, Mr. Chairman. No doubt we would all love to figure out a way to properly end systemic risk, but it kind of begs the question who, what, how, and at what cost? I have a number of questions. Number one, do we have any other examples where this has been tried before and tried successfully? Has it worked? And if not, why not? Who are the so-called experts on the subject? Second of all, what is our accepted definition of systemic risk? Is it too big to fail, too interconnected to fail? I note that mutual funds have worldwide assets of $26.2 trillion at the end of the last fourth quarter. Are they too big to fail? Are they representative of systemic risk? Next, which of our regulators is to be trusted with this responsibility? Should it be the Federal Reserve that many economists view helped lead us into this housing bubble in the first place? Perhaps it should be the SEC, who apparently knew about the Madoff fraud and did nothing about it. Perhaps OTS, who is responsible for IndyMac, the largest bank failure in American history. If not them, who? The next question is to what extent does this become a self-fulfilling prophecy? Once you designate a firm too big to fail, then is this not Fannie and Freddie revisited with only the taxpayers left to pick up the tab? There are many questions to be asked. I look forward to hearing from our witnesses, and I yield back the balance of my time. " FinancialCrisisReport--67 Mr. Schneider told the Subcommittee that the numbers listed on the chart were not projections, but the numbers generated from actual, historical loan data. 172 As the chart makes clear, the least profitable loans for WaMu were government backed and fixed rate loans. Those loans were typically purchased by the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac which paid relatively low prices for them. Instead of focusing on those low margin loans, WaMu’s management looked to make profits elsewhere, and elected to focus on the most profitable loans, which were the Option ARM, home equity, and subprime loans. In 2005, subprime loans, with 150 basis points, were eight times more profitable than a fixed rate loan at 19 basis points and more than 10 times as profitable as government backed loans. The gain on sale data WaMu collected drove not only WaMu’s decision to focus on higher risk home loans, but also how the bank priced those loans for borrowers. In determining how much it would charge for a loan, the bank calculated first what price the loan would obtain on Wall Street. As Mr. Beck explained in his testimony before the Subcommittee: “Because WaMu’s capital markets organization was engaged in the secondary mortgage market, it had ready access to information regarding how the market priced loan products. Therefore my team helped determine the initial prices at which WaMu could offer loans by beginning with the applicable market prices for private or agency-backed mortgage securities and adding the various costs WaMu incurred in the origination, sale, and servicing of home loans.” 173 (5) Acknowledging Unsustainable Housing Price Increases In 2004, before WaMu implemented its High Risk Lending Strategy, the Chief Risk Officer Jim Vanasek expressed internally concern about the unsustainable rise in housing prices, loosening lending standards, and the possible consequences. On September 2, 2004, just months before the formal presentation of the High Risk Lending Strategy to the Board of Directors, Mr. Vanasek circulated a prescient memorandum to WaMu’s mortgage underwriting and appraisal staff, warning of a bubble in housing prices and encouraging tighter underwriting. The memorandum also captured a sense of the turmoil and pressure at WaMu. Under the subject heading, “Perspective,” Mr. Vanasek wrote: “I want to share just a few thoughts with all of you as we begin the month of September. Clearly you have gone through a difficult period of time with all of the changes in the mortgage area of the bank. Staff cuts and recent defections have only added to the stress. Mark Hillis [a Senior Risk Officer] and I are painfully aware of the toll that this has taken on some of you and have felt it is important to tell you that we recognize it has been and continues to be difficult. 172 Subcommittee interview of David Schneider (2/16/2010). 173 April 13, 2010 Subcommittee Hearing at 53. “In the midst of all this change and stress, patience is growing thin. We understand that. We also know that loan originators are pushing very hard for deals. But we need to put all of this in perspective. “At this point in the mortgage cycle with prices having increased far beyond the rate of increase in personal incomes, there clearly comes a time when prices must slow down or perhaps even decline. There have been so many warnings of a Housing Bubble that we all tend now to ignore them because thus far it has not happened. I am not in the business of forecasting, but I have a healthy respect for the underlying data which says ultimately this environment is no longer sustainable. Therefore I would conclude that now is not the time to be pushing appraisal values. If anything we should be a bit more conservative across the board. Kerry Killinger and Bill Longbrake [a Vice Chair of WaMu] have both expressed renewed concern over this issue. “This is a point where we should be much more careful about exceptions. It is highly questionable as to how strong this economy may be; there is clearly no consensus on Wall Street. If the economy stalls, the combination of low FICOs, high LTVs and inordinate numbers of exceptions will come back to haunt us.” 174 CHRG-109hhrg28024--106 Mr. Bernanke," Our expectation is that if and when the housing market slows, that savings rates will tend to rise. We have built into the forecast, so to speak, some increase in personal savings. As home values grow more slowly, then consumers can rely less on the increase in equity as a source of wealth building and, therefore, must save more out of their current income. Again, that's to be expected. As I've indicated, our current expectation is that process will be gradual and is consistent with continued strong growth in the economy. However, as I also indicated, the housing market and the consumer response to any changes in the housing market is one of the risks to the forecasts and one we will be monitoring closely as we try to assess the state of the economy in the coming year. " fcic_final_report_full--457 SUMMARY Although there were many contributing factors, the housing bubble of 1997- 2007 would not have reached its dizzying heights or lasted as long, nor would the financial crisis of 2008 have ensued, but for the role played by the housing policies of the United States government over the course of two administrations. As a result of these policies, by the middle of 2007, there were approximately 27 million subprime and Alt-A mortgages in the U.S. financial system—half of all mortgages outstanding—with an aggregate value of over $4.5 trillion. 4 These were unprecedented numbers, far higher than at any time in the past, and the losses associated with the delinquency and default of these mortgages fully account for the weakness and disruption of the financial system that has become known as the financial crisis. Most subprime and Alt-A mortgages are high risk loans. A subprime mortgage is a loan to a borrower who has blemished credit, usually signified by a FICO credit score lower than 660. 5 Typically, a subprime borrower has failed in 4 Unless otherwise indicated, all estimates for the number of subprime and Alt-A mortgages outstanding, as well as the use of specific terms such as loan to value ratios and delinquency rates, come from research done by Edward Pinto, a resident fellow at the American Enterprise Institute. Pinto is also a consultant to the housing finance industry and a former chief credit offi cer of Fannie Mae. Much of this work is posted on both my and Pinto’s scholar pages at AEI as follows: http://www.aei.org/docLib/Pinto-Sizing- Total-Exposure.pdf , which accounts for all 27 million high risk loans; http://www.aei.org/docLib/ Pinto-Sizing-Total-Federal-Contributions.pdf , which covers the portion of these loans that were held or guaranteed by federal agencies and the four large banks that made these loans under CRA; and http:// www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf , which covers the acquisition of these loans by government agencies from the early 1990s. The information in these memoranda is fully cited to original sources. These memoranda were the data exhibits to a Pinto memorandum submitted to the FCIC in January 2010, and revised and updated in March 2010 (collectively, the “Triggers memo”). 5 One of the confusing elements of any study of the mortgage markets is the fact that the key definitions have never been fully agreed upon. For many years, Fannie Mae treated as subprime loans only those that it purchased from subprime originators. Inside Mortgage Finance , a common source of data on the mortgage market, treated and recorded as subprime only those loans reported as subprime by the originators or by Fannie and Freddie. Other loans were recorded as prime, even if they had credit scores that would have classified them as subprime. However, a FICO credit score of less than 660 is generally regarded as a subprime loan, no matter how originated. That is the standard, for example, used by the Offi ce of the Comptroller of the Currency. In this statement and in Pinto’s work on this issue, loans that are classified as subprime by their originators are called “self-denominated” subprime loans, and loans to borrowers with FICO scores of less than 660 are called subprime by characteristic. Fannie and Freddie reported only a very small percentage of their loans as subprime, so in effect the subprime loans acquired by Fannie and Freddie should be added to the self-denominated subprime loans originated by others in order to derive something closer to the number and principal amount of the subprime loans outstanding in the financial system at any given time. One of the important elements of Edward Pinto’s work was to show that Fannie and Freddie, for many years prior to the financial crisis, were buying loans that should have been classified as subprime because of the borrowers’ credit scores and not simply because they were originated by subprime lenders. Fannie and Freddie did not do this until after they were taken over by the federal government. This lack of disclosure on the part of the GSEs appears to have been a factor in the failure of many market observers to foresee the potential severity of the mortgage defaults when the housing bubble deflated in 2007. 451 the past to meet other financial obligations. Before changes in government policy in the early 1990s, most borrowers with FICO scores below 660 did not qualify as prime borrowers and had diffi culty obtaining mortgage credit other than through the Federal Housing Administration (FHA), the government’s original subprime lender, or through a relatively small number of specialized subprime lenders. An Alt-A mortgage is one that is deficient by its terms. It may have an adjustable rate, lack documentation about the borrower, require payment of interest only, or be made to an investor in rental housing, not a prospective homeowner. Another key deficiency in many Alt-A mortgages is a high loan-to-value ratio—that is, a low downpayment. A low downpayment for a home may signify the borrower’s lack of financial resources, and this lack of “skin in the game” often means a reduced borrower commitment to the home. Until they became subject to HUD’s affordable housing requirements, beginning in the early 1990s, Fannie and Freddie seldom acquired loans with these deficiencies. FOMC20050630meeting--125 123,VICE CHAIRMAN GEITHNER.," My second question is about policy, but not monetary policy. Glenn, in your note, you allude to other instruments if monetary policy doesn’t seem to be the appropriate tool to address a concern about lower value prices. What do we know about the history of the use of the supervisory tool in past periods of concern about real estate bubbles or imprudent lending? Do we have a rich history on the use of those instruments that tells us something about the efficacy or about our foresight in deploying them?" FOMC20060808meeting--144 142,MS. MINEHAN.," I think that President Plosser has a good point there and President Poole did as well. Section 2 is aimed at explaining what has happened with growth in the past. Everything moderated. To me, the most surprising thing was how slow business fixed investment was. It was not so surprising that housing was slow because we expected housing to be slow, so I think you could easily take housing out of there. You have the lagged effects of increases in interest rates, which affect housing as well as a whole range of other things. I also think that Charlie has a good point. We don’t want to hang our action on one piece of data versus another piece of data going forward. I’m agnostic about productivity, to tell you the truth. I think the unit labor cost numbers are not good news—we have some problems there—and to hang it out as a saving factor again and again may not be what we want to do." CHRG-110shrg50417--28 PENNSYLVANIA Ms. Wachter. Thank you. Chairman Dodd and other distinguished Members of the Committee, it is my honor to be here today to provide my perspective on the ongoing mortgage crisis and how and why stabilizing the housing market is essential to stabilizing the broader U.S. economy. The ongoing crisis in our housing and financial markets derives from an expansion of credit through poorly underwritten and risky mortgage lending. Until the 1990s, such lending was insignificant. By 2006, almost half of mortgage originations took the form of risky lending. The unprecedented expansion of poorly underwritten credit induced a U.S. housing asset bubble of similarly unprecedented dimensions and a massive failure of these loans and to today's system breakdown. Today's economic downturn could become ever more severe due to the interaction of financial market stress with declines in housing prices and a worsening economy feeding back in an adverse loop. We have the potential for a true economic disaster. I do not believe we will solve our banking liquidity problems if the housing downturn continues, and the housing market decline shows no signs of abating. Moreover, despite bank recapitalization and rescue efforts, economically rational loan modifications that would help stabilize the market are not occurring. We must directly address the need for these loan modifications in order to halt the downward spiral in mortgage markets and the overall economy. It is critical to bring stability to the housing market. While today prices may not be far from fundamental levels, just as they overinflated going up, there is great danger for overcorrection on the downside. In our current situation, as prices fall, market dynamics give rise to further expectations of price decline, limiting demand, and supply actually increases due to increased foreclosures, causing prices to decline further. A deflationary environment with demand decreases due to expectations of further price decline was in part responsible for Japan's ``lost decade'' of the 1990s. We cannot rely on a price decrease floor at currently market-justified fundamental levels if we rely on market forces alone, even, it appears, if augmented by the interventions so far of the Federal Reserve and Treasury. In fact, home inventories are not declining, and up to half of the inventory of homes are being sold through foreclosures at fire-sale prices in many markets. The Case-Shiller Price Index reflects the massive deterioration of housing wealth so far. Since the peak in 2006, housing values have fallen over 20 percent. While another 5- to 10-percent fall could bring us to market-clearing levels, actual price declines may far exceed this. And as house prices decline, these declines undermine consumer confidence, decrease household wealth, and worsen the system-wide financial stress. While banks have been recapitalized through the Capital Purchase Program--and there is discussion of the use of this funding for acquisitions--as yet, there is little evidence that bank lending has expanded. In order for the overall economy to recover and for conditions not to worsen, prudent lending to creditworthy borrowers needs to occur. Without financing for everyday needs, for education, small business investment and health, American families are at risk. And today the U.S. economy and the global economy are depending on the stabilization of their financial well-being. Moreover, the plans that are already in place do not appear to be leading to the modification of loans at the scale necessary in order to assure a market turnaround at fundamental levels instead of a severe and ongoing overcorrection. Barriers to economically rational loan modifications include conflicting interests, poor incentives, and risks of litigation to modify loans, particularly to modify loans deriving from mortgage-servicing agreements. Given the freefall in housing markets and its implications for credit conditions and the overall economy, there is a need for policies to address these barriers today. It is both necessary and possible to take effective action now. While housing values may not be far from fundamental levels, as housing values continue to fall, resolving the problem will become increasingly difficult and costly. Thus, solutions that are now possible may not be available going forward. Without expeditiously and directly addressing the housing market mortgage crisis, the Nation is at risk. Thank you. " FOMC20070321meeting--179 177,MR. KOHN.," I think there was back in 2001, after we cut rates, but I’m not sure. Overall my concern about cutting things off after “quarters” or “gains in income” is that such a statement would be kind of weak. We say that indicators have been mixed and adjustment in the housing sector is ongoing, but there’s an act of faith here. Somehow not giving some rationale for the moderate growth in income ahead weakens the statement. The income phrase always struck me as endogenous: “We think that growth is going to be moderate and that income will go up with growth.” But I can see the worries about the mention of financial conditions. Most people around the table mentioned that concern." FinancialCrisisInquiry--478 BASS: When you look back—Mr. Mayo talked about loan growth doubling that of GDP growth. When you look back at the housing market—and you can go back through OFHEO’s raw data, all the way back to about I think it’s 1971, you look, you can go back and plot the housing price appreciation x inflation and chart that against median income. January 13, 2010 It only makes sense that as income moves up, housing prices should be able to move up in a perfectly parallel fashion—you make a little bit more money, you can afford a little bit more house. Those lines were parallel for the good part of 40 years. And what happened in 2001, when Dr. Greenspan traded the dot.com bust for the housing boom, he lowered rates down to 1 percent. He made money free, and encouraged all of the lending possible to try to restart the economy after the dot.com bust. I simply think he did a bad job. Other people think he did a great job. But I think that he enabled this housing market. So when you started seeing rates—rates started—they started raising rates in 2004? When rates started to be—started an increasing path, you saw prime mortgage origination in 2004 drop 50 percent. That just makes sense. Everybody refinanced their homes that could. Everyone got reset and settled, but subprime origination in 2004 doubled. And then it doubled again in ‘05, as prime originations fell off a cliff because rates were moving up. So what happened is Wall Street had these machines built to manufacture mortgages. We wanted affordable housing, so they could lower rates with exotic mortgages. And what you saw from 2001 on is you saw those two parallel lines, home price—median home price and median income—diverge. And not only did they diverge by—for those of you that are statisticians, it was an eight standard deviation divergence. OK? That doesn’t happen very often. I know we talk about once-in-a- lifetime calamities every 10 years, that one just hasn’t happened. FOMC20060328meeting--146 144,MR. KOHN.," Thank you, Mr. Chairman. Since the last meeting, as many of us have remarked, we have seen stronger domestic demand and a little less core inflation than expected. To a degree, this extends a pattern. In looking at the Greenbook chart on the evolution of the staff forecast, I was struck by the steady upward drift since last fall of projected growth in 2006 and 2007, coupled with flat to downward movement in projected inflation for those years. Now, much of the 2006 growth was shifted from 2005, but the unemployment rate at the end of this year and next is lower than it was projected last fall—without any more, and maybe even a little less, price pressure projected. One possibility is that we are seeing a smaller effect from higher energy prices than anticipated, at least on inflation and perhaps on demand as well. Since we expected the effect of energy prices on growth rates of output and core prices to be temporary in any case, this sort of information should not deflect us from our underlying view that growth is in the process of slowing to trend, holding underlying inflation roughly stable. The cooling of the housing market is the main impetus for a slight moderation in growth. In this regard, although the incoming data on housing have been distorted by unusual weather and subject to considerable noise, I judge them on balance to lend added support to the sense that activity and price increases are softening, albeit to an unknown extent. I agree with President Stern that an orderly cooling of these markets with moderate effects on growth is the most likely outcome, but we just do not know yet. Rising inventories, declining new home sales, downward movement in building permits, and a drop in mortgage applications—all point to an appreciable drop-off in the demand for housing. In the staff forecast, residential construction flattens out this year and next, after contributing nearly half a point to GDP growth last year. Logically, softer demand should also be reflected in prices. Unfortunately, data for prices are even harder to read than those for activity, but the recent monthly information on existing and new home prices seems consistent with the March slowdown in the rate of increase of these prices, which should feed through to wealth and consumption. And we probably haven’t seen the full effect of the rise in short-term interest rates on housing demand, particularly for those who are liquidity or income constrained. Mortgage rates have also picked up somewhat this year, and they are at the upper end of the range they have been in for the past several years. So we could see some of the long-term mortgage rate effects as well. It is possible, of course, that the damping influence of the housing market could be offset by greater strength elsewhere, and two logical contenders are exports sparked by stronger growth abroad and business investment. We have seen another in the series of upward revisions to foreign growth in the current Greenbook, but we have also seen greater tightening of monetary policy get built into financial markets, offsetting some of the increase in the strength of demand abroad. Moreover, the dollar has risen on balance, reducing the feed-through of higher demand abroad to purchases from U.S. producers. Business investment looks robust, albeit a little less so after Friday’s data on orders and shipments. If housing takes something out of consumption, however, prospective sales growth will not be quite so strong, and this will constrain the increase in investment demand. So, on balance, I see a moderation of growth to around the rate of increase in potential as a reasonable expectation, given the structure of interest rates built into markets. The key question is whether such a path for output will be consistent with low, stable inflation. I think we can be encouraged by the recent data on prices and compensation. Core consumer and inflation measures have been flat or declining on a twelve-month basis over the last six months or so, despite the uptrend in energy prices. And inflation expectations have remained quite stable on balance. Compensation measures are a bit more mixed. The broadest measures, ECI and total compensation, have not picked up despite the erosion of purchasing power implied by higher energy prices and despite good trend productivity growth. In this regard, Mr. Chairman, we do see an increase in average hourly earnings of nonsupervisory workers. Maybe we are beginning to see some of this feed-through to workers on the lower end of those wages. But, overall, I think compensation growth has been very well behaved. To be sure, we have not yet seen the effects of the recent increases in resource utilization, decline in the unemployment rate, or rise in capacity utilization—and these feed through to inflation pressures with pretty long lives. Given the flatness of the Phillips curve, it could take some time to perceive the inflationary effects if, indeed, the economy is operating beyond its sustainable potential. Moreover, the staff is looking for a notable pickup in compensation. The unit labor costs this year and next are partly absorbed by smaller markups. At this point, however, given the recent data, I would judge these potential developments to weigh on the side of upside risks to inflation rather than tilting the most likely outcome. Both compensation and price increases have fallen short of model projections in recent quarters. While the less-than-expected effects of energy prices could explain this more favorable relationship of output and inflation, we can’t reject the hypothesis that we are seeing something more fundamental developing, especially on the supply side of the economy. Recent data suggest it is not an unexpected increase in productivity. Some combination of the lower NAIRU and the anchored inflation expectations alternative simulations in the Greenbook or other factors could be holding down wages and prices. It is far too soon to say whether anything is going on or to tease out the policy implications, but we would do well to remember just how wide those confidence intervals are, how little we know about price and output determination, and especially how little we know about the level and growth rate of potential GDP. Thank you, Mr. Chairman." FOMC20060920meeting--142 140,MR. KOHN.," Thank you, Mr. Chairman. Whatever you want to call me is fine. [Laughter] I’m just glad to be here. [Laughter] I don’t think I can follow that up. Given the initial conditions—the doubling and more of energy prices over the past two years, the overexuberant housing market coming to grips with a renormalization of interest rates, a very low personal saving rate, and an uncomfortable increase in inflation this spring—a period of modestly below-trend growth and gradually ebbing inflation, as in the Greenbook forecast, is about as good an outcome as we can expect, as Dave Stockton noted. In that regard, several developments over the intermeeting period have made me a bit more comfortable with the plausibility of such an outlook. The weakness in housing has deepened and is more definitively leading to growth of output below potential. In fact, in my view the behavior of the housing market constitutes the main downside risk to sustained moderate economic growth. We’re in the middle of a housing adjustment, which has been hard to forecast, especially because it involves the unwinding of an unknown amount of speculative demand. With inventories rising and reports of price cuts getting greater prominence, the market isn’t yet showing signs of clearing and stabilizing. In the Greenbook forecast, residential investment, though weak, is supported by continued growth of income and relatively low mortgage rates, while house prices basically level out in nominal terms. As the Greenbook notes, however, this forecast leaves some aspects of the existing disequilibrium intact, most notably the high level of prices relative to rents. Also, the cutback in construction doesn’t completely offset the apparent excess building of the boom period. As a consequence, I see the housing forecast in the Greenbook as very far from the worst-case scenario that President Minehan characterized it as. And, we are just beginning to see the effect of the downshift in house-price inflation on consumption starting to play out. Outside of housing, however, recent developments should help to sustain continued economic expansion. Financial conditions remain quite supportive of both business and household spending. Long-term interest rates have fallen appreciably since midyear, and they are low in both real and nominal terms. Risk spreads are narrow, banks have not pulled back on business credit, and equity prices have risen on balance in recent months. Lenders and investors appear to remain confident that the economy will continue to expand at a decent pace. Higher levels of labor income in the first half of the year, along with a favorable effect on disposable income of a decline in energy prices, will help support consumer spending going forward. Economies elsewhere seem to be expanding at a solid clip. Moreover, they are probably less vulnerable to spillovers from a housing-led slowdown of growth in the United States than they were to weakness in 2001. That weakness was centered in a global market for investment goods and was reflected in global declines in equity prices. The less robust economy should present businesses with a more competitive environment in which it will be harder to pass through cost increases. In addition, the decline in energy prices, along with the leveling out of other commodity prices, will reduce cost pressures on businesses and should feed through in some measure to lower core inflation, especially as slower growth damps pricing power. The drop in energy prices has already restrained inflation expectations a bit. For all these reasons, I’m also a little more comfortable with the forecast of gradually ebbing core inflation. Nonetheless, I still see significant upside risk to such a path for inflation. In part, this reflects my uncertainty as to the reasons for the rise in inflation this spring and summer. Feed- through of energy and other commodity prices must have contributed to some extent, and we can see evidence of this in the greater price increases for some of the more energy-intensive sectors, such as for airfares. A portion of the pickup is in the rent-of-shelter category, likely from a shift to rental housing as expectations of house-price appreciation have been scaled back. But price increases have picked up in a number of other categories, and although energy costs probably accounted for some of this acceleration, we can’t dismiss the possibility that other forces were at work—for example, more general pressure of demand on potential output. A reduction of those types of pressures is still only a forecast. On the cost side, as many have commented, the compensation and unit labor cost data, while flawed in many respects, could be pointing to a risk that higher labor costs will persist, putting pressure on prices that might only be partially and reluctantly absorbed by profit margins. In sum, Mr. Chairman, I’m a bit more comfortable with something like the path for the economy and inflation in the Greenbook forecast, but uncertainties are quite high. They might even justify the “higher than usual” description. The downward path for inflation remains at risk, and as others have noted, the costs of exceeding that path could be disproportionate. Thank you." CHRG-110shrg38109--59 Chairman Bernanke," I would say that qualitatively it is fairly similar to the recovery that followed the 1991 recession, with many of the same features. There was weakness for some time after the recession ended, including a period of so-called ``jobless growth.'' Senator Bunning. But we did not have a housing market that---- " FinancialCrisisReport--27 To ensure an ongoing supply of loans for sale, lenders created compensation incentives that encouraged their personnel to quickly produce a high volume of loans. They also encouraged their staffs to issue or purchase higher risk loans, because those loans produced higher sale prices on Wall Street. Loan officers, for example, received more money per loan for originating higher risk loans and for exceeding established loan targets. Loan processing personnel were compensated according to the speed and number of the loans they processed. Loan officers and their sales associates received still more compensation, often called yield spread premiums, if they charged borrowers higher interest rates or points than required in the lender’s rate sheets specifying loan prices, or included prepayment penalties in the loan agreements. The Subcommittee’s investigation found that lenders employed few compensation incentives to encourage loan officers or loan processors to produce high quality, creditworthy loans in line with the lender’s credit requirements. As long as home prices kept rising, the high risk loans fueling the securitization markets produced few problems. Borrowers who could not make their loan payments could refinance their loans or sell their homes and use the sale proceeds to pay off their mortgages. As this chart shows, over the ten years before the crisis hit, housing prices shot up faster than they had in decades, allowing price increases to mask problems with the high risk loans being issued. 36 36 See “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/13-1j. CHRG-111hhrg51698--63 Mr. Gooch," They are the members, but, that you definitely require their cooperation. But you also require global cooperation, because these instruments are also traded throughout Europe. So you can't have a clearing mechanism that considers that all of the transactions are only in the U.S. Additionally, of course, there are highly illiquid instruments that just dump themselves for clearing, and that the financial system benefits from the willingness of investors to put capital at risk that provides liquid markets. I am a free marketeer myself, so I believe that it is important to have free liquid markets. If you create price controls, you create shortages. This price control, which is what it would amount to be, would be creating a shortage of credit. You know, blaming the CDS is like shooting the messenger, because the CDS were the instruments that were certainly used in the financial markets, but there was no ultimate failure in the CDS market. The CDS markets performed perfectly. What is failing is the mortgages and the lending that was done to persons that shouldn't have been borrowing. And to that extent we have a sort of global responsibility for having just enjoyed living beyond our means and having a massive global credit bubble, and that credit bubble also drove oil prices to $140. I mean, until it burst, investors overseas that would be concerning themselves with the future needs of the growing economy in countries like China, buying up oil reserves, was what partly was driving the price of oil. So it is not the credit derivatives that are at fault, it is the entire free, cheap credit in the system that was the problem. " CHRG-111shrg56262--36 Mr. Miller," Right. And I am distinguishing here--I am speaking at the security level, so the mortgage---- Senator Bunning. I understand that, but those securitized mortgages were the things that were sold as AAA rated, and that is where we got into all kind of the devil is in the details. And I find that the rating agencies were right in the middle of all that. In other words, they were the ones that were selling those as AAA quality to not only other banks, but the same banks that had sold them the mortgages in the first place, and all around the world. And that is why when the bubble burst, it didn't just burst here in the United States, it burst in Europe and other places. " FOMC20050630meeting--378 376,MS. BIES.," Thank you, Mr. Chairman. I thought I’d focus my remarks today on the topic we discussed yesterday—the housing markets. And then I’d like to talk a little bit about some of the liquidity issues in housing markets and relate that to monetary policy. Let me start by saying that overall I agree that there is not a major risk of significant problems in the housing markets. But there is momentum building in the housing area that is raising some issues about which I am not as sanguine as many of the staff who gave the presentations yesterday. But I want to compliment the staff from both the Board and the Reserve Banks. I thought they did a fantastic job in pulling all of the information together While inflation overall is apparently well contained, I, too, am generally concerned about the continued ratcheting up of our expectations. The one thing that stands out is how much housing prices have jumped relative to overall price levels. We know that the average price for new homes in May was up 8 percent from a year ago. Existing home prices were up 10.2 percent, as was said yesterday. But inventories remain relatively lean, even though the supply has risen by about half a month since the beginning of the year. When I look at the jump in housing prices, I’m trying to see if consumers are saying, “We have good, strong income growth and we’re able to afford more.” Or are they seeing these price increases and trying to jump in while they still can afford a house, before home prices get totally out of their range? Are they viewing real estate as an alternative for investment purposes, after being stung in the stock market drop of a few years ago? Really, all of these factors may be at the heart of the strong demand for housing. But I also think that the financing markets are sending different signals in these areas. I know Mark is going to talk about some of the specifics but I want to discuss some of the macro June 29-30, 2005 149 of 234 customers going to banks to refinance and take advantage of low, long-term fixed interest rates. So most of the mortgage originations in the 2001-2002 period were predominantly fixed-rate loans or they were ARMs that had fairly long fixed-rate periods before becoming adjustable. What is striking is how this has been changing in the last 12 months. ARMs of all types have jumped from about 16 percent of originations in 2001 to about one-fourth in 2002 and 2003, to over half of mortgage originations last year. This is happening in a period when short rates are rising and long rates are flat to down. If bankers are really working to the benefit of their customers, why aren’t they locking in long rates in this environment? It is also the case, when we look at the mix of products, that more of the mortgages are subprime products. Subprime originations have climbed to over 18 percent of total originations. In terms of where these mortgages are being parked—whether they are on the books of banks and other financial institutions or are being securitized—about two-thirds of originations continue to be securitized. So the use of the markets is about the same. But the types of mortgages being securitized are changing. Again, these are predominantly ARMs, and more of them tend to be option ARMs—the higher-risk kinds of structures. As we saw in the information presented about the real estate mortgage pools that are being created, the risk profile in those pools is changing. Interest-only mortgages were basically nonexistent in those pools two years ago; they are now running over 3.6 percent of them. Whereas a lot of these IO mortgages had very conservative loan-to-value ratios—under 80 percent—more and more of them now have loan-to-value ratios in excess of 80 percent. And about 9 percent of the IOs in these pools are going to subprime borrowers—that is, the riskiest customers. Yet those loans require interest-only payments, no amortization. Two weeks ago S&P required additional June 29-30, 2005 150 of 234 HELOCs are being used more for purchase money down payments. People no longer have to save to make a down payment. And when we look at HELOCs in general, for the last three years they’ve grown at a compound rate of over 30 percent a year. As would any supervisor, when I see a product growing 30 percent a year for three years, I tend to get a little nervous about the concentration risk. Where is the liquidity coming from for these? Again, a big chunk of it is going to the securitization markets. I think one of the challenges we have as bank supervisors is that, to the extent the banks are originating these loans with the intent to sell them to the market, they’re looking to the market for the credit definitions. We know from our QIS-4 [Quantitative Impact Study 4] results, looking at the Basel II exercise, that we had a huge disparity in the results on loss expectations on home equity loans and other mortgage products. A lot of these are new types of products. The confidence intervals around the expected defaults, I think, are a lot wider for them than for those that have traditional structures. We also know that there’s a lot of correlation risk that could happen here. If the housing price bubble does break in a market where employment is dropping, people could be leaving an area and we could have more defaults. In addition, we know that the dropping of home prices, in and of itself, tends to create more defaults, especially with negligible equity in these properties. Also, to the extent that people default and the banks have more properties to foreclose, there are neighborhood effects, with losses getting bigger when the defaults do occur. So, what I am concerned about from a liquidity perspective, since these are being securitized and moving into the markets—and there is plenty of appetite in the market to take these products— is the lack of discipline relative to previous periods. In the ancient days, when mortgage loans stayed on the books of financial institutions, liquidity limitations forced them to choose the higher June 29-30, 2005 151 of 234 understands the structure of these loans any better than some of us do in terms of pricing the risk, as evidenced by the S&P move two weeks ago. So, again, I’m not overly concerned. Especially with the record profits and capital in banks, I think there’s a huge cushion. But the implications of this for housing wealth and for investors who take the ultimate risk in these securities could create some problems in terms of the way economic growth proceeds going forward. And it’s something that I think was appropriate to spend the time talking about today." fcic_final_report_full--476 The forest metaphor turns out to be an excellent way to communicate the difference between the Commission’s report and this dissenting statement. What Summers characterized as a “cigarette butt” was 27 million high risk NTMs with a total value over $4.5 trillion. Let’s use a little common sense here: $4.5 trillion in high risk loans was not a “cigarette butt;” they were more like an exploding gasoline truck in that forest. The Commission’s report blames the conditions in the financial system; I blame 27 million subprime and Alt-A mortgages—half of all mortgages outstanding in the U.S. in 2008—and a number that appears to have been unknown to most if not all market participants at the time. No financial system, in my view, could have survived the failure of large numbers of high risk mortgages once the bubble began to deflate, and no market could have avoided a panic when it became clear that the number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected. This conclusion has significant policy implications. If in fact the financial crisis was caused by government housing policies, then the Dodd-Frank Act was legislative overreach and unnecessary. The appropriate policy choice was to reduce or eliminate the government’s involvement in the residential mortgage markets, not to impose significant new regulation on the financial system. **** The balance of this statement will outline (i) how the high levels of delinquency and default among the NTMs were transmitted as losses to the financial system, and (ii) how the government policies summarized above caused the accumulation of an unprecedented number of NTMs in the U.S. and around the globe. CHRG-111hhrg54869--173 Mr. Cleaver," Thank you. We are going to have votes in maybe 15 or 20 minutes. I do think we can get all members in if the members will use the Reader's Digest version of your questions and if you will give the Cliff Notes version of the answer, I think we can get through all of these. We will begin with the gentlelady from Illinois, Ms. Bean. Ms. Bean. Thank you, Mr. Chairman, and to the witnesses for sharing your expertise today. Many of us have advocated for countercyclical capital requirements to avoid the kind of depth and width of the downfall that we recently experienced, specifically to discourage the type of leverage that we saw. And as Mr. Zandi said in his own testimony, if I understood it properly, suggesting that when we see a bubble in formation, obviously increasing capital requirements will maybe minimize how big that bubble gets. In a precipitous downfall we would ease up capital requirements as well, which we didn't do, so it doesn't get so wide as institutions divest themselves, even in this case non-subprime related assets. Given that history suggests that regulators, though they have the authority to impose those changes, tend not to want to be the buzzkill when the party is going, will regulators follow guidance from the Feds or does Congress really need to be more proscriptive in that regard and require those type of changes relative to capital requirements? I am asking Mr. Zandi specifically. " CHRG-110hhrg38392--88 Mr. Campbell," Thank you, Mr. Chairman. Oddly enough, Chairman Bernanke, I have a series of economic questions for you. I believe I am correct in characterizing that about 6 months ago, you said that you thought one of the greatest risks to economic growth would be a hard fall in the residential housing market. You have said that today some of our slow-down in growth is largely attributable to that sector. How would you assess the risk of a hard fall in that market at this point? What are the risks to that happening, or what are the opportunities for its not happening? " FOMC20070131meeting--55 53,MR. GAGNON.," Your first international exhibit (exhibit 9) covers recent market developments. As shown by the green line in the top left panel, oil prices dropped further this month, bringing the West Texas intermediate spot price back to pre- Katrina levels. The IMF index of nonfuel commodity prices (the red line) was little changed this month after a year of remarkable increases. Readings from futures markets imply a flattening out of nonfuel commodity prices and only a moderate increase in oil prices going forward. The top right panel shows that our real trade- weighted dollar indexes declined on balance last year. In recent weeks the dollar rebounded modestly against the major industrial-country currencies (the red line), but we estimate that it continued to decline in real terms against the currencies of our other important trading partners (the green line). As usual, our forecast calls for a small downward trend from current levels, reflecting our belief that the risk of significant depreciation is slightly greater than the risk of significant appreciation, owing to the unsustainably large U.S. trade deficit. The bottom panels report equity market indexes, with industrial countries shown on the left. The lines are set to equal 100 in March 2000, the previous peak month for the Wilshire 5000. Equity prices have risen broadly across the industrial countries over the past two years and are now just above their March 2000 levels in the United States, the United Kingdom, and Japan, but not in the euro area (the red line). For major emerging markets, on the right, equity indexes are well above March 2000 levels. In Mexico (the blue line), equity prices have more than tripled over this period. In Thailand (the green line), the government’s recent attempts to slow capital inflows and relieve upward pressure on the currency have taken their toll on equity prices, but contagion to other emerging equity markets has been minimal. Overall, commodity and financial market developments are consistent with expectations of strong global growth. Exhibit 10 focuses on financial flows between emerging markets and industrial countries. As shown in the top left panel, the major developing regions have continued the downward trend in their reliance on external borrowing. Fiscal deficits have declined in most countries, and many governments have turned increasingly to local, rather than external, borrowing. The panel to the right shows that yield spreads on dollar-denominated sovereign debt of emerging market countries have dropped to historically low levels. But emerging markets, in the aggregate, have gone much further than just reducing their borrowing. In recent years, emerging markets have experienced record outflows of official capital (the gold bars in the middle panel). These official outflows are composed of the accumulation of foreign exchange reserves, the servicing and paying down of sovereign debt, and the purchase of foreign assets by government-run investment funds such as the Kuwait Investment Authority. In all the emerging market regions, official capital outflows have recently exceeded current account surpluses (the blue bars), which are themselves at record levels. For example, the IMF estimates that in 2006, governments in emerging Asia invested on balance $270 billion outside their borders, a sum that greatly exceeds their combined current account surplus of $185 billion. Most of these official flows have taken the form of additions to foreign exchange reserves, as governments have built up war chests against future financial crises and sought to counter upward pressures on their currencies. The bottom panel looks at these flows from the point of view of the industrial countries, plotting aggregate emerging market net official flows (the gold bars) relative to industrial-country GDP, with negative values denoting net flows into the industrial countries. The statistical accounts do not report the destinations of all these flows, but the available evidence suggests that the overwhelming majority is destined for the industrial countries. Before 2003, net official inflows or outflows from the emerging markets had never exceeded 1 percent of industrial-country GDP. But since 2003, things have changed. Net official outflows from emerging markets are now estimated to equal 2½ percent of the combined GDP of the industrial countries. As shown in the panel, the timing of this unprecedented increase in net official flows corresponds well with the puzzling decline in real short-term interest rates in the industrial countries (the green line) that persisted long after industrial-country GDP growth (the purple line) rebounded from the slowdown early in this decade. The evidence suggests that aggregate policy-driven capital flows from the emerging markets may be an important factor behind low real interest rates in the industrial countries. Moreover, low real rates are not limited to short-maturity instruments. The top panels of exhibit 11 show that ten-year indexed bond yields are also low and have been for several years in the major industrial countries. These rates have ticked up over the past month or two, but only by a small amount. Long-term inflation compensation (shown in the middle row of panels) remains contained. Indeed, in Japan and Canada (the two panels on the right) inflation compensation has moved down in recent months. In the euro area and the United Kingdom (the two panels on the left), where inflation compensation lingers above policymakers’ targets, we project modest additional policy tightening early this year, shown in the bottom row of panels. Despite recent and expected future inflation rates close to zero, the Bank of Japan seems poised to tighten gradually over the next two years. In Canada, policy is expected to remain on hold. If these projections prove to be the peak policy rates for this cycle, they will be the lowest cyclical peaks for short-term interest rates in these countries for at least forty years. Nevertheless, we judge that these policy stances are likely to be consistent with low and stable inflation this year and next. The large capital inflows and low real interest rates in the industrial countries have contributed to rising housing prices in many of these countries. Higher home prices in turn have stimulated housing construction. The top panel of exhibit 12 shows that the extent and timing of the house-price boom differs markedly across countries. The Netherlands (the blue line) was one of the leaders of the global housing boom, with prices rising continuously since the early 1990s, though at much slower rates in recent years. Japan (the green line), on the other hand, is a notable exception to the trend of rising house prices in recent years, reflecting the lingering effects of the bursting of the 1980s asset bubble and Japan’s extended economic slump. The middle panels focus on two countries that experienced strong house-price increases (the purple lines) early in this decade but where house-price increases subsequently halted, at least temporarily. In both Australia and the United Kingdom, as in the United States, residential investment (the green lines) responded positively to higher house prices. In Australia, on the left, real house prices have been flat for the past three years, and residential investment has declined gradually about 1 percentage point of GDP, though it remains above its historical average. In the United Kingdom, on the right, house prices stabilized in 2005 and picked up again modestly last year. Despite lower house-price inflation, residential investment has continued to rise toward historically high levels. The relevance of these foreign experiences for the United States is difficult to gauge, but they provide some support for Larry’s forecast that the downturn in U.S. housing is nearly over. In light of the signals from financial and commodity markets, as well as other real-side indicators, we project continued solid growth in the foreign economies at rates that are not likely to strain resources or to put upward pressure on inflation. As shown in the bottom panel, total foreign growth (line 1) is estimated to have stepped down last year from 4½ percent in the first half to about 3½ percent in the second half, and it is projected to remain around 3½ percent over the forecast period. This projection is about 1 percentage point stronger than the staff’s projection for U.S. growth, shown at the bottom of the panel. The foreign industrial economies (line 2) overall are projected to grow at about the same rate as the United States, Japan a bit slower (line 4), and Canada a bit faster (line 5). The emerging market economies (line 6) are projected to grow at nearly twice the pace of the industrial economies over the forecast period. We expect that emerging Asia (line 7) will continue to grow very rapidly and that Latin America (line 8) will grow at a solid, though not exceptional, rate. Our forecast assumes that the Chinese government will take additional measures if necessary to reduce the growth rate of investment, and we project that Chinese GDP growth will be slower this year than last. But the risks to our growth forecast for China are probably greater on the upside. Exhibit 13 provides an assessment of what all these foreign influences mean for the U.S. economy. Overall import prices, the black line in the top left panel, fell sharply last quarter and are projected to continue to fall in the current quarter, primarily owing to the drop in the price of imported oil. As oil prices stop falling and begin to move gradually back up, overall import price inflation should turn positive. Prices of imported core goods (the red line), which exclude oil, gas, computers, and semiconductors, rose at a rate of nearly 4 percent in the middle of last year, primarily owing to sharply higher prices of nonfuel commodities. With commodity prices projected to stabilize and with only a small depreciation of the dollar in our forecast, prices of imported core goods should increase at a subdued pace over the next two years. The contributions of exports and imports to U.S. GDP growth are shown in the lower panel. We now estimate that the external sector made a positive arithmetic contribution to growth last year, the first positive annual contribution since 1995. Import growth stepped down from previous years as U.S. GDP grew more slowly. Export growth benefited from robust foreign economic activity, but exports turned out even stronger than our models project. Line 1 in the top right panel shows that, for the first eleven months of last year at an annual rate, exports of goods grew 10½ percent from the previous year in real terms. Lines 2 through 4 show that three categories of capital goods—aircraft, machinery, and semiconductors—contributed nearly half of total export growth. Although it is possible that blistering growth rates in exports of these goods may continue, we base our forecast on a return of export growth to a rate more consistent with historical relationships. With the vast majority of aircraft production being exported in recent months and with aircraft factories running at high utilization rates, further large increases in exports from this sector, at least, do not seem likely. Returning to the bottom panel, we project that the negative arithmetic contribution of imports (the red bars) to GDP growth will outweigh the export contribution (the blue bars) in 2007 and 2008 by about ¼ percentage point (the black line). This projection is driven by the historical tendency of U.S. imports to grow at a much faster rate than U.S. GDP. In addition, the larger value of imports relative to exports means that, even if imports and exports were to grow at the same rate, the negative contribution of imports would be greater than the positive contribution of exports. The projected strong growth rates of foreign GDP, discussed in your previous exhibit, are not large enough to outweigh these factors over the next two years. On balance, relative prices have little effect on net exports over the forecast period, as the real trade-weighted dollar has moved in a relatively narrow range over the past couple years and is not projected to move substantially over the forecast period. And now Larry will complete our presentation." FOMC20050630meeting--85 83,MS. YELLEN.," Thank you, Mr. Chairman. I just wanted to make a couple of comments June 29-30, 2005 35 of 234 seen. It seems to me that there might be a couple of factors that could explain at least some portion of the run-up, though probably not all of it, that weren’t mentioned in the presentations. First, it seems to me that financial innovations affecting housing could have improved the view of households regarding the desirability of housing as an asset to be held in portfolios and thus raised the equilibrium price-to-rent relationship for residential real estate. What I’m thinking of is the idea that equity held in residential real estate is a lot more accessible today than it has been in the past. Home equity credit at commercial banks is up fourfold since 1999, and many households obviously are now keenly aware that refinancing provides a low-cost avenue for tapping into the equity in their homes. So, in a sense, there might be less of a liquidity premium embodied in the return for housing. Also, if people feel that the liquidity constraints in holding housing as an asset are diminishing, that could explain a reduced need for precautionary saving in traditional liquid assets. It could even make people willing to put more of their wealth into down payments on houses and may have raised prices through that mechanism. The other thing that occurred to me is that there might be effects from tax changes. We’ve had changes in the rules for tax exemption and in 1997 on capital gains from the sale of primary residences that would make holding real estate assets more attractive. And the changes in capital gains taxes more generally in 1997 and then again in 2003 would have worked in the same direction. One of the things that we looked at that we thought was interesting was the behavior of price-rent ratios for residential housing and for commercial office space. Commercial office space price-rent ratios are highly cyclical—I guess they always have been—but it appears that the behavior of price-rent ratios in residential housing has closely mirrored what we’ve seen in June 29-30, 2005 36 of 234 1998, though the dynamics are totally different. Commercial office space rents have been falling— it’s not that the prices have been rising—but the price-rent ratios have moved very similarly. A second comment I wanted to make concerns the relationship of creative finance to the housing market. One view that I think is very prevalent is that the use of credit in the form of piggyback loans, interest-only mortgages, option ARMs [adjustable-rate mortgages], and so forth, involves financial innovations that are feeding a kind of unsustainable bubble. But an alternative perspective on that is that high house prices, in fact, are curtailing effective demand for housing at this point and that house appreciation probably is poised to slow. So the increasing use of creative financing could be a sign of the final gasps of house-price appreciation at the pace we’ve seen and an indication that a slowing is at hand. Previously, lenders applied very rigid constraints on loan-to­ value ratios, but essentially those constraints are now being eased at the margin through these creative financing techniques. And that’s providing some elasticity to what was a firm roof. It may slightly diminish the price elasticity of the demand for housing, but the fact that it is blossoming now basically suggests that we really are at the ceiling where it’s binding and will ultimately constrain appreciation. Finally, with those two comments, a question. It concerns the presentation by Andreas and the numbers cited on loan-to-value ratios at origination. One of the things we’re seeing in California and elsewhere in our District—and maybe this is true nationwide—is a growing use of piggyback loans. Loan-to-value ratios of 90 to 95 percent are common in California, and we’ve even seen combination loan-to-value ratios and piggyback loans going up to 125 percent. I guess that means two things, one of which is that the traditional first mortgage looks utterly conventional. Those mortgages have an 80 percent loan-to-value ratio and I suppose they are being sold off to June 29-30, 2005 37 of 234 and Freddie, there’s no need for private mortgage insurance. So Fannie’s and Freddie’s books may look better in some sense—less risky—than they really are because of all of the second mortgages going up to possibly 125 percent." CHRG-110shrg46629--140 PREPARED STATEMENT OF SENATOR JIM BUNNING Chairman Bernanke, I watched your testimony yesterday with interest. Apparently the markets did too, but I am not sure if they did or did not like what they heard. You covered a lot of ground yesterday, but there is some new ground I will cover in the questions and some things that are worth repeating. First, it has been interesting to watch market reactions and expectations to Fed policy statements over the last few months. For a while, the markets did not believe your clear statements that the biggest concern was that inflation would not moderate as expected. Market indicators have moved more in line with your view in the last month or two, and I hope both the markets and you have learned about communication and the way each other think. While this is a monetary policy hearing, I think it is worth repeating that many of us believe the Fed and other regulators share some responsibility for the current state of the housing market. Low interest rates fueled the housing boom, and loose supervision of mortgage writing allowed it to proceed. The market is certainly punishing bad behavior by lenders, but some of the damage could have been prevented by more careful scrutiny of some of the most undisciplined lending. The Fed should have been especially careful because of the credit bubble it created with cheap money. I am glad you and your fellow regulators have taken action, and that you did not overreact and cause further damage. It is important for you to remain vigilant, but not to give in to pressure to over regulate. I would also say to Chairman Dodd that I hope we can quickly confirm the new nominees so that the Fed board will have more industry experience when tackling these issues. I continue to be impressed by the current economy, which seems to have passed through the worst of the slowdown caused largely by Fed tightening. My biggest concerns are rising food and energy prices, and the negative effects on the economy of the massive tax increases the new majority in Congress seems determined to allow. The current economic expansion is driven by the 2001 and 2003 tax cuts, and allowing a tax increase in 2010 will reverse years of gains in the economy and the stock markets. I look forward to hearing your responses. ______ FOMC20071211meeting--118 116,CHAIRMAN BERNANKE.," Thank you, Governor. Well, again, thank you for a very helpful discussion. Let me just try to briefly summarize and then offer a few additional comments. Many participants obviously gave considerable attention to the resurgence of stresses in financial markets, including the increased losses by financial institutions, widening spreads, and poorly functioning markets. Some expressed concern that these developments were likely to result in tighter credit—not just in mortgages, where conditions are already tight, but in other areas as well— perhaps resulting in spillovers to the broader economy. A weakening economy could cause financial conditions to worsen further, leading to a negative feedback loop, and indeed, there are signs of some broader credit deterioration. Impending mortgage rate resets and foreclosures pose further risks. Some took these developments as increasing downside risk to growth, perhaps significantly. However, other participants noted some mitigating factors, including the fact that banks came into the situation with a lot of capital. Some institutions have raised capital. There’s the possibility that other credit providers could take over from money center banks. Corporate balance sheets are strong. The credit problems have a regional focus in some cases, and there is a lack of effect so far on many on Main Street. Some also noted that the price discovery process was inevitable and needed. With respect to the macroeconomic data, overall the incoming data were slightly weaker than expected, particularly in housing and consumption, although, again, the anecdotes were somewhat mixed. Fundamentals for consumption are weaker but not collapsing, with the labor market and perhaps wealth still providing some support and mixed information on retail sales. Differences across regions and products were noted. With the possible exception of commercial real estate in some cases, investment is not yet much affected by credit conditions. Improvements in inventory management were cited as a positive. Unemployment remains low, and wage pressures exist in some areas, but they were less cited, I think it’s fair to say, than in past meetings. Export demand related to the weaker dollar and strong foreign growth provides some help to the manufacturing sector, although it was noted that other countries might not be immune to a slowdown in U.S. growth. Overall, most participants saw slower growth, but there is greater agreement that the outlook is in any case more uncertain. On inflation, some took a relatively benign view noting the restraint from a slowing economy and less tightness in labor markets. Others noted some recent increases in core inflation and continuing pressures from energy, food, and the dollar. Many stressed that stable inflation expectations cannot be taken as a given. Any comments or questions? Let me just add a bit to the discussion because, as usual, it has already been very thorough. Again, if one looks at the incoming macro data, I think a fair judgment is that it was a little weaker than we expected. The economy has been a little slower than we expected. Housing data, consumption, and I would argue investment and production numbers were all somewhat lower than we thought was going to be the case at the end of October. I would also argue that, in particular, the consumer, who of course is crucial to the expansion, is facing somewhat weaker conditions— including higher oil prices, less wealth from lower stock and house prices, and perhaps tighter credit—than was the case a month and a half ago. I think it is noteworthy that the unexplained portion of consumer sentiment has declined considerably. There seem to be attitudes or, if you like, forecasts among consumers that are even weaker than would be suggested by some of the conditions they are currently seeing, and I think that is a concern. Now, there have certainly been positive developments in the data. The labor market has held up pretty well. The unemployment rate actually dropped a bit last week. Stocks have come back a bit from their so-called correction, although I should say that this is conditional on a lot of expected easing by the Federal Reserve. ISM surveys show manufacturing as flat, but manufacturing is still growing, and there was a bit of good news yesterday in housing, with some slight indications of improved pending sales. I think it’s interesting that the Michigan survey notes that prospective homebuyers are actually a bit upbeat because they see interest rates as low and prices as more favorable. So, again, the data suggest some weakness, but the story is not entirely unmixed. So how would we interpret this? I think you could take a more sanguine view that we are seeing the continuation of a zigzag pattern that we’ve seen for quite a while. We had very weak growth in the first quarter of this year, for example; but even with the zero growth projected for the fourth quarter, we will see 2.2 percent growth in the first half of ’07 and 2.5 percent growth in the second half of ’07. So it could be that we’re just seeing a zigzag pattern, and some of that is certainly true. It’s also still true that a lot of the weakness we’re seeing is in the housing sector. For example, for all of ’07, growth excluding housing is about 3½ percent—so again, not suggestive of great weakness. Now, all of that being noted, I don’t think I’d go quite as far as Governor Mishkin; I try to maintain an even keel here in my mood. [Laughter]" FOMC20070807meeting--94 92,MR. LACKER.," Thank you, Mr. Chairman. In the Fifth District we continue to see moderate economic growth, though it has been uneven across sectors in recent weeks. Manufacturing activity rebounded somewhat in June and July after several months of weakness, with our indexes showing increases in new orders and shipments. Activity at District services firms advanced at a steady pace, with solid revenue growth and a broader pickup in hiring. The retail sector, however, has lost much of the momentum reported last month, as softness in big-ticket categories continues to constrain revenue growth. On the employment front, District labor markets are increasingly taut, given steady hiring activity and slower labor force growth. In addition, in contrast to the Eighth Federal Reserve District, contacts continue to report rising wage pressures and difficulty finding qualified workers. Housing markets remain weak across much of the District. However, commercial real estate activity remains healthy, with steady demand reported for office and industrial space. Some contacts, however, have expressed concern about slower activity in the retail segment of that market. Turning to prices, our July surveys indicate increased inflation pressures. The average current rate of increase of manufacturers’ prices has moved up for both raw materials and finished goods over the past few months, reversing the decline seen earlier this year. Price pressures on the services side have picked up as well, though expectations for future prices eased somewhat in the July report. At the national level, we continued to receive fairly good news on inflation. After annualized rates of monthly core PCE inflation above 2 percent at the beginning of the year, we’ve now had four months of readings below 2. But there are still abundant reasons for caution, as President Moskow, for example, noted. I’ll mention the Greenbook, which cites transitory factors—apparel and owners’ equivalent rent, for instance—that have contributed to the recent moderation. The passing of these damping forces could well push core inflation back up in the near term. So although I think we have reason to take some comfort from recent inflation numbers, and I do, I want to wait to see more evidence, especially as growth moves back toward trend. I still think the prospects for a return to trend growth are reasonably good, and my assessment of trend is still a bit higher than the Greenbook’s, in part because I’ve not revised my estimate of productivity growth much in response to the GDP revisions. Obviously, there are downside risks to be concerned about, and financial market activity since the last meeting obviously raises some concerns. As far as we can tell at this point, the heightened turbulence of the past month is all pretty closely related to subprime and nontraditional mortgages and the leveraged financing of private equity buyouts in the corporate sector. These two market segments are relatively new, and they represent the latest manifestation of the broad, ongoing wave of financial innovation that we’ve been seeing over the past few decades. Because these two markets are so young, one would expect participants’ risk assessments to be more uncertain and thus be more sensitive to what is learned from market events and incoming news. That said, developments in the past month have certainly been quite dramatic, and it looks less like rapid learning than it does rapid unlearning of what was previously viewed as known—although that, too, is of course a form of learning. The implication of these revised risk assessments for the economic outlook and for policy depend on whether they affect business investment or household spending on consumption or new housing. At this point the answer to that question is not yet clear, but it’s worth noting that, by many measures, corporate credit quality seems to remain pretty good by historical standards, and the buyout movement, as President Poole just noted, seems to have been more about restructuring liabilities and governance arrangements and less about funding capital spending. So it’s not obvious why there should be dramatic effects on business investment. What about consumption? PCE was fairly soft last quarter, and this softness could be a harbinger of more-sustained weakness. The second-quarter softness may well be a one-time phenomenon, however, reflecting both the sharp rise in gasoline prices in the first five months of the year and some payback from the strong spending growth in Q4 and Q1. Moreover, the outlook for household income looks pretty good, with labor market conditions fairly firm and consumption gains showing no sign of slowing down. In addition, household net worth is coming off a relatively high base. Neither of these fundamentals seems likely to be seriously threatened by the repricing that’s in train. Housing, on the other hand, continues to be the predominant area of concern regarding real spending, and financial market developments have only heightened that concern. The Greenbook paints a fairly pessimistic picture. The decline in residential investment accelerates over the remainder of year and continues into next, and the inclusion of three “greater housing correction” alternative scenarios suggests that the staff is especially concerned, justifiably so in my view, with the downside risk to their outlook. But even though the housing market has definitely deteriorated, the outlook for housing is quite uncertain in my mind, and I continue to think that a more moderate decline is also possible and that housing could be somewhat less of a drag on growth than the Greenbook forecasts. At this point, however, the reassessment under way in secondary markets regarding housing-related credits still has a way to go, and until that process plays out, it’s going to be hard to gauge the resulting magnitude of repricing at the retail level. About all I conclude at this point is that the outlook for housing is still awfully uncertain right now. Thank you." CHRG-111hhrg51698--398 Mr. Masters," I think common sense says that is not the case. We have plenty of studies that we can show that say that index funds were in fact an issue, and excessive speculation was a driver in creating the commodity markets bubble. There are studies from MIT, from the World Bank, from the United Nations. I saw one a couple days ago from the Austrian Ministry of Finance. There is one from the Japanese Ministry of Trade. There have been a lot of studies that have come to the opposite conclusion. So I could submit those if you would like to see them. " FOMC20081216meeting--154 152,MR. LACKER.," Yes. So it is sort of a bummer that these go up in the recession if you are trying to measure what is happening to the NAIRU. But I always thought of the phrase ""sectoral reallocation"" as having to do with the theories of the business cycle in which cyclical downturns are caused by an unexpected decline in a given industry that causes resources to shift out of that industry and that it takes time for them to be absorbed into some other industry. From that point of view--if you are trying to measure that component as opposed to policy-induced, widespread declines in activity--I would think you would want not to take out the cyclical part. I am thinking about housing. We devoted a lot of resources to housing in 2005, much less now. Those resources thrown on the market, in fact, are the proximal cause of the initial downturn in employment growth. A lot of ancillary industries are related, so I would think that, if we didn't take out the usual housing cyclical thing, which is really sharp in the early periods, you would see a bigger rise here. " FOMC20061025meeting--12 10,MR. STOCKTON.," Thank you, Mr. Chairman. About a week ago, as we were closing the forecast, I was marveling at how little it had changed over the intermeeting period—both the broad strokes and the details. But the warm glow of accomplishment had barely been kindled when a glance at my desk calendar revealed the source of our success. The last FOMC meeting had been only five weeks ago, so we simply had not had time to accumulate our usual backlog of forecasting errors. [Laughter] I recognize that even this assertion is open to some challenge. Because of the incoming data, we have revised down our estimate of third-quarter growth of real GDP about ¾ percentage point, to an annual pace of just 1 percent. However, we don’t think this downward revision carries with it much, if any, macroeconomic signal about greater weakness going forward. Importantly, consumption, housing, and business fixed investment all came in very close to our September forecast. The downside surprises that we experienced last quarter were concentrated in motor vehicle production, defense spending, and net exports. In each case, we believe some good reasons exist for anticipating that these sources of restraint will abate or reverse in the fourth quarter. With regard to motor vehicles, the production cuts needed to deal with the inventory overhang that developed last spring have been larger and have come more quickly than we had expected. As a consequence, the drop in motor vehicle output took a bigger bite out of growth in the third quarter and is now expected to be a roughly neutral factor for growth in the current quarter, rather than being a small drag on growth in both quarters. Defense spending also fell far short of our expectations last quarter, but we expect these outlays to rebound in the fourth quarter to a level more in line with defense appropriations. Finally, imports are estimated to have surged in the third quarter more than seems warranted by the fundamentals and, as best we can tell, without a full offset in other components of spending. Karen and her team expect some of that import surprise to be unwound in the fourth quarter, providing a small plus to estimated growth. All told, we are projecting the growth of real GDP to rebound to a pace of 2¼ percent in the fourth quarter. For the second half, output is anticipated to grow at an annual rate of 1½ percent, a forecast not much different from the one in September. We also have made only minor adjustments to our longer-term GDP forecast. By our assessment, lower oil prices and a stronger stock market more than offset the effects of a slightly higher dollar and a bit weaker trajectory for house prices. All told, we revised up our forecast for the growth of real GDP 0.1 percent in both 2007 and 2008, to 2.2 and 2.5 percent respectively. Basically, the general contour of the forecast is the same as in September. As before, the very subdued pace of the expansion that is projected for the second half of this year results principally from a sharp contraction in residential investment that directly subtracts more than 1¼ percentage points from the growth of real GDP. Residential investment continues to contract next year, though that contraction gradually diminishes. In addition, the drag on spending and activity from the run-up in energy prices that has occurred, on net, over the past three years is expected to lessen considerably from this year to the next. The attenuation of the drags from housing and energy alone would result in a prompter return of growth to potential. However, we expect the housing slump to restrain the growth of real output this year and next through wealth effects and multiplier-accelerator influences. Most notably, house prices are projected to about flatten out; and as the impetus from past house appreciation wanes, consumption growth should slow, and the saving rate should begin to edge up. With its usual lag, the overall deceleration in output, income, and sales further damps consumption and business investment. As a consequence, growth remains slightly below potential in 2007, and the output gap edges up to roughly ½ percent of GDP by the end of the year. With the bulk of the direct and indirect effects of the housing slump expected to have largely played out by then, real GDP growth is expected to expand in line with its potential in 2008. Meanwhile, core PCE price inflation, which is currently running a bit less than 2½ percent, edges down to about 2 percent in 2008. The opening up of a small output gap helps to head off an intensification of inflation pressures. But by far the most potent influences are the diminishing upward pressures from prices for energy, non-energy imports, and other commodities. Because this basic story is virtually unchanged from the September Greenbook and because we had relatively few surprises to deal with in the forecast, I thought that I would dispense with a further explication of the contours of the forecast. Instead, I=ll offer you a scorecard of sorts to help you audit the plausibility of the forecast story in light of data that we will be receiving in coming months. Let me start with housing, because as I noted a moment ago, the recent and projected contraction in residential investment is the principal source of the below-trend growth that we are projecting over the next year. For that story to be on track, housing starts will need to drop sharply further by the end of the year. Single-family starts averaged about 1.4 million units in the third quarter, and in our forecast, we are anticipating a further 12 percent decline, to a pace of 1¼ million units this quarter. We read the incoming data as being consistent with that outlook. Although starts bounced up in September, permits—a less noisy indicator of housing activity—continued to plunge. Moreover, inventories of unsold homes remain at a very high level, and sales cancellations have continued to increase. But after a long period of what seemed to be unrelentingly bad news, the housing data received over the intermeeting period could be fairly characterized as more mixed. Sales of new and existing homes firmed a bit in late summer, the index of pending home sales moved up in August, and homebuying attitudes as measured in the Michigan survey jumped up in September and October. Although it is far too early to conclude that these indicators are pointing to stabilization in housing markets, they provide at least some encouragement to the view that the bottom may now be closer than the top. We will also be scrutinizing the information on house prices. Another reading on the OFHEO (Office of Federal Housing Enterprise Oversight) price index will become available in early December before the next meeting. Here we will be looking for another noticeable step-down in the rate of house-price appreciation, from the 5 percent pace posted in the second quarter to a projected 1¾ percent pace in the third. That forecast is roughly consistent with our near-term forecasting models that make use of the information in the Case-Shiller price indexes and other high-frequency measures of home prices. As you know, we are not forecasting the national average of house prices to drop, but our very low projected rate of house-price appreciation implies that a substantial fraction of households will be experiencing outright declines. Consumption will be the second major area that should be monitored, in part because we are expecting the slowing in house prices to show through here. In brief, we will be looking for a continuation in coming months of the moderate increases in consumer spending that we have observed since the spring. Over the past half year, consumer spending excluding motor vehicles has been increasing at a pace of roughly 2¾ to 3 percent, and we are expecting more of the same in coming months. That relatively steady expected growth reflects some crosscurrents that seem likely to be at work. Real income gains should be bolstered by the recent fall in energy prices and continuing, albeit modest, gains in employment. But the lagged effects of higher borrowing costs and an ebbing of positive wealth effects from housing are expected to hold spending below the gains in income and result in a slight upward tilt to the saving rate. Obviously, given the importance of consumption in overall aggregate demand, developments here will have a critical bearing on the probability of achieving our projected soft landing. A snap-back in consumer spending in coming months—an outcome that seems to underlie some of the outside forecasts that are stronger than ours—might lead to no landing rather than a soft landing. In contrast, any serious faltering of consumer spending is “buckle the seat belts and assume the crash position.” The third major development that we will be looking for is another sustained step- down in the pace of employment growth. Slower employment growth is a key link in the multiplier mechanism through which the housing-induced slowdown in aggregate output and spending propagates forward into below-trend growth next year. We correctly anticipated the first leg of that slowing earlier this year, when average gains in nonfarm payrolls dropped from the 200,000 per month pace of the preceding several years to the roughly 120,000 per month pace observed since the spring. But our projection anticipates a further slowing in the fourth quarter to an average pace of about 75,000 per month. To be sure, the increase in September was just 51,000, but that came on the heels of a gain in August of 188,000, so we wouldn’t want to lean too heavily on the September observation for support. Moreover, if asked to present just one piece of evidence that casts the greatest doubt on the staff projection at present, I would point to initial claims for unemployment insurance. Claims have basically been moving sideways in recent months and provide no indication that a further softening in labor markets is under way. Given the looseness of the relationship, our forecast of payroll employment is not inconsistent with the current level of initial claims, but right now this important piece of our forecast seems to have more upside risk than downside risk. The fourth element of our forecast that we will be looking for in coming months is some signs of slowing in business fixed investment. Of course, the accelerator consequences for equipment spending of the slowing we now think is under way in aggregate demand is really a story for 2007, and given the volatility in the data, it will take some time to detect that slowing when, or if, it occurs. But more immediately, we are expecting to see some slowing in nonresidential construction from the 20 percent pace that we’ve experienced over the past half year to something closer to a 10 percent pace in coming quarters, thus providing less offset to the weakness in residential construction than has been the case thus far this year. With energy prices leveling out, the upward impetus from drilling and mining activity seems likely to gradually abate. Outside drilling and mining, smaller employment gains, slower growth of manufacturing output, and still-high vacancy rates suggest to us that this sector will cool somewhat going forward. The final item on the scorecard is inflation. We are going to be looking for core PCE prices to continue to increase an average of about 0.2 percent per month for the remainder of the year, with core CPI running between 0.2 and 0.3 percent per month. Those increases would be higher than in most recent years but lower than the pace observed last spring. Moreover, some of the key factors that underlie our projection of a gradual slowing of core inflation over the projection period now seem to be falling into place. After nearly three years of persistent upside surprise, oil and other energy prices have dropped noticeably from the levels of late summer. If these recent developments hold, the cost pressures from rising energy prices should ease over time. Moreover, the sharp increases in residential rent that occurred in the spring appear to have simmered down of late, and we are expecting that pattern to continue in coming months. Meanwhile, most of the major measures of inflation expectations that we monitor have continued to fluctuate in a reasonably narrow range, and we expect that to remain the case going forward. I am tempted to say that, armed with this scorecard, you will arrive at the December meeting with a clear idea of how the staff forecast has stood up to the incoming data. But of course, we all know how the story goes. Much like the cliffhanger serial movies of the 1930s, the promise appears to be that, if you come back next time, all the current problems will be resolved. However, given rational expectations, you know that, to the extent any problems are resolved over the intermeeting period, they will simply be replaced by a new set of puzzles and perils. Karen will continue our presentation." FinancialCrisisInquiry--203 Yes. You know, what we’ve observed over time with traditionally underserved borrowers or people with lower or nontraditional credit histories is that we always had higher delinquency rates than was typical in the prime markets but our actual loss rates always ran under 1 percent. And part of that was because—part of how to run a successful operation, lending to these communities, includes understanding that there can be different kinds of income interruptions and vicissitudes of life and working with borrowers through those periods to keep the loan performing. And so, really, we—you know, now, of course, we’ve been impacted by the larger crisis. But just—then what’s become what we now talk about as subprime lending is loan products that had risky features and, as Professor Rosen’s discussed, lots of layers of risk. And these were not products, for the most part, except in the narrowest, narrowest sense—for the most part, these were never products that provided particular benefits to the consumers. They were products that were push-marketed to, you know, more vulnerable populations and then spread out as the bubble grew and housing became more unaffordable for most families. CHAIRMAN ANGELIDES: All right. Thank you very much. And, last question here, before we move on, which is that—do you have data on—and maybe, again, it’s contained. I’ve read a lot, but at 56, I don’t retain all. And that is, do you have data on the extent to which community banks engaged in subprime origination? CLOUTIER: Yes, we—we—I’m sure we have data on that, but it was very, very little. Let me—can I just add on to both of these comments... CHAIRMAN ANGELIDES: Can you—well, let me just say, can you get us some data on... CLOUTIER: CHRG-110shrg50418--78 Mr. Nardelli," So, Mr. Chairman, let me answer two or three points, please. First of all, having been there a year-and-a-half, let me share with you what we did find and what we did do. We immediately eliminated four vehicle nameplates because what we found is they were designed for Europe and being sold in the U.S. We immediately put in the first ever Chief Customer Officer. We have identified over 400 line items to improve performance, reliability, durability, and finish. So yes, we have made some mistakes in Chrysler and what we are trying to do is move expeditiously to remedy those. Our warranty costs as a result of that in the last 15 months has gone down 29 percent by focusing on customer first and quality, period. Your other point, and having spent a lot of time in the housing industry, I can share with you that there was this unbelievable bubble. As you know, people were extracting a tremendous amount of equity, trillions of dollars, and reinvesting and rolling up. The mistake the Chrysler probably made during that period is that we were responding to the customer who wanted bigger, more expensive, higher horsepower vehicles to go with their second homes, their boats, their trailers, and we chased that consumer demand up. Lesson learned for us, and we are moving as fast as we can to make sure our product portfolio is much more balanced, that we have smaller, more fuel efficient, more efficient cars to blend with those things that we are doing, both like Alan and Rick, in producing hybrids, producing electric vehicles, to make sure that we have the appropriate blend as we go forward. " FOMC20080130meeting--208 206,CHAIRMAN BERNANKE.," Thank you, and thank you all for succinct and very insightful comments. [Laughter] I'm going to try as usual to summarize what I've heard; but even more so than usual, no warranty is expressed or implied. Again, trying to bring together some of the comments, we noted that incoming data since the last meeting have been broadly weaker than expected, and anecdotes generally suggest slower growth, in some cases significantly slower growth. Housing demand, construction, and prices have continued to weaken, and inventories of unsold homes are little changed. Housing weakness has implications for employment, consumer spending, and credit conditions. With respect to households, consumption growth has slowed, reflecting falling house and equity prices and other factors, including generally greater pessimism about the labor market and economic prospects. The labor market has softened by a range of measures, with unemployment jumping in December. However, workers in some occupations remain in short supply. Together with financial indicators, weaker labor and consumption data suggest that the economy is at a risk of recession; in any case, it is likely to grow slowly for the first half of the year. The second half of the year may be better, the result of easier monetary policy, fiscal stimulus, and possible improvement in housing and credit markets. However, there are significant downside risks to growth, including the possibility of an adverse feedback loop between the economy and credit markets. Reports by firms are mixed. Investment may have slowed, reflecting uncertainty and slower growth in demand. Commercial real estate activity may be constrained by tighter credit conditions. Manufacturing is slow to mixed, though IT, energy, and some other sectors continue to be strong. Financial markets remain stressed. Credit conditions more generally appear to be worsening, and the problems may be spreading beyond housing. Additional risks are posed by the problems of the monoline insurers. Credit losses have induced tighter lending standards, and a key question is how severe those may become and how persistent they may be. One offset is the ability of banks to raise capital. Core inflation and headline inflation have remained stubbornly high and are a concern. One risk is the ability of some firms to pass through higher input costs. Inflation compensation has risen at long horizons, reflecting some combination of higher inflation expectations and inflation risk premiums. Going forward, a slowing economy, anchored inflation expectations, and possibly stabilizing food and energy prices should lead to more moderate core and total inflation. However, some see upside risks, especially the possibility that higher headline inflation might affect inflation expectations. So that's my attempt to summarize. There's a great deal more detail and a great deal more color in the conversations around the table. Let me try to add a few points. Again, much of what I'll say has been said. I do think that there has been a significant deterioration in the outlook for economic growth and an increase in the downside risks to growth. It was sufficiently severe as to prompt me to call the January 9 videoconference that we had, and I think that since then we have had further deterioration. A number of things have happened and are going on. Very important, perhaps most important, is the continued further deterioration in the prospects for the housing market. Housing, of course, feeds directly into the real economy through employment, income, and wealth, and I think there are some indications that spillover from the housing sector to the rest of the economy is increasing. However, the critical aspect of the housing outlook is the relationship to the financial system, which I'll come back to. Consumer spending has slowed. I think there's little doubt about that at this point. There are a lot of factors now that are acting as headwinds in the consumer sector. Let me just point out the basic fact that most households in the United States have very little in the way of liquid financial assets. Therefore, when they, on the one hand, are denied access to home equity if they see tighter credit conditions on cards, autos, and so on, and if at the same time they see greater uncertainty in the economy and the labor market, then their natural tendency would be to be much more conservative in their spending. I do note that fiscal action may be of some help, particularly for people in that kind of situation. Like President Yellen, I think the indicators of a weakening labor market are broader than just the payroll report. There are a number of other things as well. We may get a better report this week. The UI claims are a little encouraging, but I do think that the weakening economy is going to drag down the labor market to some extent. Certainly the financial markets have deteriorated, reflecting greater concern about recession. We see it in the equity markets but also in short-term interest rates and a variety of credit measures as well. Finally, just going through this list of items, we continue to see problems--credit issues, banks concerned about additional losses not just in mortgages but perhaps in other areas as well--with the potential implication of a further tightening of credit conditions. Those are some of the developments that we've seen since the last meeting. On our January 9 call, I talked about the regime-switch model and those ways of thinking about the business cycle. Others have talked about that today. I think many of those models would suggest that the probability of recession at this point is quite high, at least 50 percent or more. I don't think any of us would be happy to see a garden variety NBER recession; but if we had that, there would probably be a few benefits, including correction of some imbalances that we're seeing in the economy and perhaps some reduction at the edge in the inflation picture. But, like others, I am most concerned about what has been called the adverse feedback loop--the interaction between a slowing economy and the credit markets. A phrase you might have heard, which is getting great currency among bankers, is ""jingle mail."" Jingle mail is what happens when otherwise prime borrowers decide that the value of their house is worth so much less than the principal of their mortgage that they just mail their keys to the bank. (I wonder if that 140 percent is the right loan-tovalue number. Maybe it's less than that.) Even if prime mortgages hold up--and I think in some regions of the country there will be significant problems with prime mortgages--there is a lot of other potential trouble. We're just beginning to enter the period of maximum subprime ARM resets. Second lien piggybacks and home equity loans are all questionable at this point. We haven't begun to address the option ARM issue, which is about the same size as the subprime ARM category, and of course, we have the issues with the monolines and private mortgage insurers. Outside of mortgages, expectations for credit performance are worsening in a range of areas, including commercial real estate and corporate credit. So I think that even under the relatively benign scenario that the Greenbook foresees, we're going to see a lot of pressure in the credit markets and perhaps a long period of balance sheet repair, tight credit, and a drag on the economy. Again, our experience with financial drag or headwinds has been that it can be quite powerful and deceptively so, and I think that's a significant concern. Now, the central issue here, though, ultimately comes back to the housing market. Certainly by this point there must be some pent-up demand for housing. We've had obviously very low sales for a period. House prices are soft. Mortgage rates are low. Affordability is better. What's keeping people from buying houses is the fact that other people aren't buying houses. If there were some sense that a bottom was forming in the market or in house prices, we probably could actually see a pretty quick snap-back, an increase in housing demand, and that in turn would feed back into the credit markets, I think, in a very beneficial way. So there's the possibility that, if the housing market can get restarted, we could get a relatively benign outcome. " FOMC20050630meeting--35 33,CHAIRMAN GREENSPAN.," We do obviously have BEA [Bureau of Economic Analysis] data on transaction costs and, one would presume, profit margins, so that in a way we have at least one element of the markup over cost. The differences that we’re looking at here are so large that it’s not a minor question. Indeed, if you take Dick’s bubble—or lack thereof, I should say—you get the impression that deflation is probably going on. [Laughter] I’d be curious, frankly, to have Andreas, who has looked at this to a great extent, comment on Dick’s paper." CHRG-111shrg57322--1220 Mr. Blankfein," In the context of the chaos in the market, all the size positions, all the market making we were doing in that period of time, with all that was going on, getting within $500 million of flat during that year 2007, I think, reflects a desire and an accomplishment to get closer to home. We bought--OK, and I will just--so anyway, I just wanted to respond to you---- Senator Levin. You may not think a half-a-billion dollars is a lot, but the fact that you were able to get through 2007, when the bubble burst, was because you went with the big short. Those are your own---- " FOMC20070321meeting--120 118,CHAIRMAN BERNANKE.," Thank you. Thank you very much for the comments. I’m going to offer, as I always do, a brief summary and invite any comments and corrections, and then I’d like to add a few comments of my own. Most participants today agree that growth looks as though it’s going to be slower, but there is some diversity of opinion about how persistent the slowdown would be. Many people have marked down growth expectations for the remainder of the year, and there was a general sense that the uncertainty about growth prospects and downside risk have increased. However, some people saw the current slowdown as only a soft patch that would be reversed soon. Housing remains weak, and some participants noted the risk that problems in mortgage and credit markets and increased foreclosure rates might contribute to further weakness. However, others felt that the housing situation has not changed materially since the last meeting. The slowdown in capital investment drew more concern, in part because it has proved difficult to explain. An inventory correction continues, but automobile inventories have been brought into line. Some factors that will support growth include a booming global economy and stronger government spending at both the federal and the state and local levels. The labor market continues to be tight, with some noting increases in wages. Developments in the labor, housing, and credit markets will be important in determining the future course of consumption. Several participants pointed to potential financial risks, including possible knock-on effects of the subprime mortgage problems and the possibility of the drying up of currently abundant liquidity and financial markets. Corporate earnings are also likely to slow. If these risks materialize, they could add to downside pressures on output. However, some thought that financial conditions will remain supportive. Some, but not all, think that inflation will continue to moderate, albeit very slowly. There is general disappointment with recent inflation readings, and some were skeptical that any meaningful progress against inflation is being made. In particular, resource utilization pressures, particularly tight labor markets, pose a longer-term inflation threat. Import prices and slower productivity growth also add to inflation risk. The views of most participants were that upside inflation risks still outweigh downside risks to output, that uncertainty has increased, and that the tails of the distribution have become fatter. Are there comments? If not, let me just add a few thoughts. It’s very difficult to speak last—all the good ideas have already been presented. So I’ll say just a few things. I think the growth outlook is slightly worse. The housing market is, of course, central to near-term developments. The central scenario that housing will stabilize sometime during the middle of the year remains intact, but there have been a few negative innovations. We’ve noted the subprime issues and the possibility of foreclosures, reduced confidence, and tightened credit terms, and I’ve also noted that reports from builders about the spring selling season have not been particularly upbeat, in general. At the same time, we continue to see rough stability in sales, starts, and permits. The effects of the decline in subprime lending may have already been mostly seen, since that has slowed from last fall. Mortgage rates, of course, remain quite low, and the labor market is a key determinant of housing demand and of mortgage delinquencies, particularly cross- sectionally. Across the country, there’s a very close correlation between foreclosure rates and state unemployment rates. So long as the labor market remains strong, I would think that the general health of the housing market would be improving. The housing market, I think, will follow the same scenario, but there are a few negative innovations. There was a lot of discussion about capital investments, and I share the puzzlement about why that’s happening. Like Governor Mishkin, I am concerned that it might signal something about productivity. Another possibility in the current environment goes back to my Ph.D. thesis on the effects of uncertainty on investment, which found that greater uncertainty can make people delay their commitments. In our last meeting, we discussed the possible upside risk to consumption. I think that risk is much diminished now. Our retail sales have been quite flat, and the strong growth of consumption in the first quarter is almost entirely due to the December blip, which will carry through to the quarterly arithmetic. But consumption is very likely to slow. Gas prices are another reason that consumption is likely to slow. The labor market, again, remains strong. I agree with the Greenbook that there is some likelihood of softening going forward. In particular, I think Governor Kohn mentioned that the slowing productivity growth we’re seeing could be consistent with some labor hoarding in this late stage of the cycle. Again, I’ve marked down my growth expectations only a bit, but if we were handicapping recessions, I’m afraid that risk has probably gone up a bit. I would cite at least three reasons. First, there seems to be a pretty good chance that potential output growth is lower than in the past; and almost by definition, if growth is lower, then the chance of negative quarters is greater. Second, the Greenbook has a 60 basis point increase in unemployment occurring stably over the next two years. If that happens, it will be the first time it has ever happened. [Laughter] Generally speaking, increases in unemployment tend either not to occur or to be bigger than 60 basis points. Finally, we’ve discussed the financial market sensitivities, which are having an effect, so that changes in the outlook could have pretty substantial feedback effects onto the economy through the stock market, other financial markets, and credit markets. So I think, as President Fisher does, that the tail in that direction is unfortunately somewhat fatter. Likewise with inflation, the news was disappointing. We knew that there would be—and we have seen—month-to-month volatility. It is difficult, as President Pianalto noted, to make a firm conclusion based on the recent data about whether or not inflation is moderating. I would just note that rents and owners’ equivalent rent are still pretty important here. They have not yet slowed much, which may have to do with the nature of the uncertainties about the housing market. That possibility will be helpful going forward. At an earlier meeting I indicated that medical costs were a risk; and they have, indeed, proved to be a risk. Speaking about inflation makes me reflect on the difficulties of measuring aggregate supply in general. As we think about the economy going forward, we face two countervailing possibilities. One, which I and several others have already mentioned, is that potential output growth may well be lower than many outsiders and maybe even the Greenbook think. Obviously that will make it difficult to get economic slack and will make this situation much more challenging. At the same time, the lack of wage acceleration at least raises the possibility that the NAIRU might be somewhat lower than 5 percent, which would be helpful in the other direction. With respect to inflation, again, as I said, I’m disappointed by the recent numbers. I don’t get a sense from business people or from surveys and so on that the general public’s worry about inflation has increased very much, except insofar as they perceive that inflation is constraining the Fed from acting. So, again, I don’t think we’ve seen an adverse breakout by any means, but obviously we’re going to have to remain very vigilant and make sure that we maintain our credibility on the inflation front. As the last item, I would like Vincent to distribute table 1. We made a couple of changes in the description of the economy. He can make a few comments, and then everyone will have an opportunity to look at it overnight, and we can discuss the communication issues tomorrow." FinancialCrisisInquiry--755 ROSEN: So it’s a much smaller number. We have something called a mend and extend happening now where they are mending and extending loans. But the same bubble that happened in residential happened somewhat in commercial. Big value increase and now a 40 percent value decline. So there’s a—a lingering issue that’s going to be there. I—it - it doesn’t all hit at once. The good news is it’s stretched out over the next five years. So I think we’re OK. It’s not good. It—but I think the residential losses going forward for the next year and a half are going to be bigger still, than the commercial over five years. FOMC20070131meeting--174 172,MS. BIES.," Thank you, Mr. Chairman. Like several of you, I’m going to focus on housing and what we’re seeing in the banking sector and in mortgage performance. Since the last meeting, I am feeling better about the housing market in the aggregate. It looks as though home sales are stabilizing for the fourth quarter. On the whole, home sales actually did go up a bit. The inventory of new homes for sale has now fallen for five months through December, and mortgage applications for home purchases continue to move above the levels of last summer, when they hit bottom. The National Association of Realtors is estimating that existing home sales have already bottomed out, and homebuilder sentiment improved in three of the four past months. But even if sales really have stabilized, the inventory of homes for sale still must be worked down before construction and growth resume in this market. Given that some existing homes have likely been pulled off the market in light of slower sales and moderating housing prices, this inventory correction period will probably continue into 2008. I think this is particularly true in markets such as Florida, as First Vice President Barron mentioned, where a large amount of speculative investment occurred during the boom period—with three to five years of excess construction from the investor side. So those homes still have to be worked through. Asset quality in the consumer sector as a whole is very good. We have come through one of the most benign periods. The exception, as Bill mentioned in his presentation earlier today, is the subprime market. When you dissect it, you see that prime mortgage delinquencies are flat and subprime mortgages at a fixed rate are flat. The whole problem is in subprime ARMs, which are running into difficulties. The four federal regulatory agencies are looking harder at some of these subprime products. We started reviewing 2/28 mortgages, and now we’re looking at and testing some other products. We’re finding that the issues are getting more troublesome the further we dig into these products. To put the situation in perspective, subprime ARMs are a very small part of the whole mortgage market. As Vincent mentioned, subprime is about 13 percent, and the ARM piece of the subprime is about half to two-thirds, so we’re talking perhaps around 8 percent of the aggregate mortgages outstanding. We’re seeing that the borrowers who got into these during the teaser periods now are seeing tremendous payment shocks. For example, 2/28s that are going from the fixed two-year period to the adjustment period basically had their interest rates double, so they’re going from a 5 percent handle to a 10 percent handle, and the borrowers don’t have the discretionary income to absorb that. This type of mortgage was sold to a lot of subprime borrowers on the idea that they are lending vehicles to repair credit scores. You will show that you are going to pay during the early period, and then you can refinance and get a lower long-term rate, so you’ll never pay the jump. But we’re finding that some of these mortgages have significant prepayment penalties, and so to refinance and get the better terms, some borrowers are getting into difficulty. Because of the moderation in housing prices, these borrowers haven’t built up enough equity to absorb the prepayment penalty. So the problem stems from a combination of factors. There are a lot of spins on these products, but we’re trying to take an approach based on principles in looking at what’s really happening. I also want to mention that, although the ownership of the mortgages is very diffuse and so we’re not seeing any real concentrated risk, particularly in banking, we do need to pay more attention to where the mortgage-servicing exposures are. The servicing of these mortgages that are securitized is concentrated in certain institutions. Clearly, when you have such a high level of delinquencies and potential defaults, all profitability in servicing is gone. So there could be some charge-offs in these securitized mortgages. Also, I think all of you have noticed the number of mortgage brokers that have closed up shop in the past six months because they couldn’t get enough liquidity or capital to repurchase the early defaults of these recent pools. That is really shrinking the origination pocket. I should also say that, with the exception of the subprime ARM mortgages, we feel very good about overall credit quality. When I look at the economy as a whole, I also see that except for housing construction and autos, the rest of the economy is sound. The recent growth in employment and the strong wage growth give me comfort that the income growth of consumers is there to mitigate some of the wealth effects that we may have with moderating housing prices. But I also share the concerns that some of you mentioned here, and that President Yellen spoke of in a speech, about the issue regarding productivity trends and wage growth, and determining how fast the economy is growing. Productivity is going to have to grow faster to absorb the higher wage growth, particularly as employment growth continues strong, and I think the slack in the skilled labor force is getting very, very limited. When I think, in aggregate, about the data since our last meeting, I feel a little better about inflation because it appears to be moderating, but I’m not jumping for joy because we need a few more months. However, the growth information has been, instead of mixed as at the last meeting, generally stronger, and that does make me feel better. In net, then, based on the recent information, I’m even a bit further along on the side that the risks have moved higher for inflation than on the side of the risk of a slowdown in the economy. Thank you, Mr. Chairman." FinancialCrisisInquiry--128 I’d say innovation always outpaces regulation, but in this case, it was just much further ahead. And, you know, you certainly need more capital for newer activities or more risky activities or other activities without a long enough track record. And you saw that. And, as Mr. Solomon said, we’ve had a lot of once-in-a-lifetime events. And you—you know, whether it’s Enron and WorldCom or Russia and Asia and Mexico or, you know, the tech bubble and then the real estate bubble. It seems as though these once-in-a- lifetime events happen every couple of years. So the idea of more capital overall makes a lot of sense for these once-in-a-lifetime events for these new activities. And as far as additional disclosure, no question. It would have been very helpful during the crisis and would still be helpful now especially with regard to problem loans at U.S. banks. I would make one point, though. We can’t be too pro-cyclical. If you try to correct all at once, then you’re going to kill the economy. So you have to do this in a balanced way. VICE CHAIRMAN THOMAS: A question to all of you, and it’s just from my previous job on Ways and Means and the tax code. Would it make a big difference, not much difference, if we had in the time of all of these once-in-a-lifetime events, a better understanding between equity and debt and the way in which major American corporations and even international corporations can utilize debt versus equity? And had we recognized it in the tax code, that, to a certain extent, the old cash-on-the-barrel head is, perhaps, a good way to see what’s going on, notwithstanding the complexity of the world today? CHRG-110hhrg44901--67 Mr. Bernanke," Again, I think I would not put much weight on this technical terminology. I mean, I think it is clear that growth has been slow, and that the labor market is weak. And so conditions are tough on families. I have no doubt whether it is technically a recession or not, and I don't see how that makes a great deal of difference. As far as the projection is concerned, we see continued growth, positive growth but weak for the rest of the year. Looking at the housing market, it is beginning to stabilize, at some point around the end of the year, early next year. And with the hope that we can continue to strengthen the financial system, we would hope to see recovery back to more normal levels of growth in 2009. But like all economic forecasting, there are uncertainties in both directions. But with respect to the current situation, again, whether it is a recession or not doesn't really play in our policy decisions. " CHRG-110hhrg45625--119 Mr. Bernanke," Let me say that if the financial situation stays where it is, or doesn't improve, that we are going to see higher unemployment, fewer jobs, slower growth, more foreclosures, fewer people able to buy houses and cars, and a much slower economy. If you look at other countries, Japan had a decade of slow growth. We see other countries with very severe downturns. This is going to have real effects on people at the lunch bucket level because it is going to affect the way the economy and jobs can grow in this country. " fcic_final_report_full--243 COMMISSION CONCLUSIONS ON CHAPTER 11 The Commission concludes that the collapse of the housing bubble began the chain of events that led to the financial crisis. High leverage, inadequate capital, and short-term funding made many finan- cial institutions extraordinarily vulnerable to the downturn in the market in . The investment banks had leverage ratios, by one measure, of up to  to . This means that for every  of assets, they held only  of capital. Fannie Mae and Freddie Mac (the GSEs) had even greater leverage—with a combined  to  ratio. Leverage or capital inadequacy at many institutions was even greater than re- ported when one takes into account “window dressing,” off-balance-sheet expo- sures such as those of Citigroup, and derivatives positions such as those of AIG. The GSEs contributed to, but were not a primary cause of, the financial crisis. Their  trillion mortgage exposure and market position were significant, and they were without question dramatic failures. They participated in the expansion of risky mortgage lending and declining mortgage standards, adding significant demand for less-than-prime loans. However, they followed, rather than led, the Wall Street firms. The delinquency rates on the loans that they purchased or guar- anteed were significantly lower than those purchased and securitized by other fi- nancial institutions. The Community Reinvestment Act (CRA)—which requires regulated banks and thrifts to lend, invest, and provide services consistent with safety and sound- ness to the areas where they take deposits—was not a significant factor in sub- prime lending. However, community lending commitments not required by the CRA were clearly used by lending institutions for public relations purposes. FOMC20070509meeting--61 59,MR. LACKER.," Commercial real estate activity generally remains solid, although some observers expressed concern about the sustainability of the quite strong pace of office construction in Northern Virginia. Our survey measures of manufacturing-price trends seem to have moderated since the beginning of the year, consistent with sluggish demand in that sector. On the services side, price trends seem to have declined somewhat since the first half of last year, although measures of services prices have been choppy and trendless over the past few months as a whole. Turning to the national economy, housing news has been disappointing, but news about business investment and manufacturing has been encouraging. However, the overall outlook hasn’t changed terribly much since our last meeting. Housing begins to stabilize in the second half of this year, business investment in equipment and software picks up, and consumer spending remains relatively healthy. As a result, I expect real growth to return to trend in ’08. Although my outlook broadly agrees with that of the Greenbook, there are some minor differences—but I should emphasize that they are minor. First, I remain a tad more optimistic about trend growth. I’m expecting something closer to 2¾ than to 2½. Second, I still think that residential investment will bottom out in the middle of the year rather than continue to slide into ’08. Of course, it is quite difficult to have a lot of confidence in any one scenario for the housing market, in part because the recent data have been fairly choppy. The figures for homes sales, which late last year suggested that housing demand had stabilized, now suggest that demand may be taking another step downward. If so, this would increase the size of the cumulative reduction in starts relative to new-home sales that will be needed to work off the inventory overhang. It’s very hard to know, however, just how far housing activity needs to fall before it comes back into stable alignment with income and preferences. But my hunch is that the drag on growth will not last quite as long as the Greenbook says, and I still see reasonably good prospects for stability in the housing sector in the second half of this year. I also think that the housing correction will have only limited effects on spending outside residential investment. In particular, I’m a bit more optimistic than the Greenbook about household spending. As for inflation, the Greenbook now has us waiting until the third quarter of ’08 before we see a moderation in core inflation. Even then, we get only 0.1 percent. I would view this outcome as fairly disappointing. But if I had been asked for an unconditional forecast, I probably would have submitted something a lot like that. Instead, we were asked for a projection conditional on what, in our judgment, would be an appropriate monetary policy. So the projection I submitted has core PCE inflation at 1.8 percent next year and 1.6 percent in 2009. Under what, in my judgment, would be an appropriate monetary policy, we use the Chairman’s July testimony to announce that the FOMC’s objective is for PCE inflation to average 1½ percent and that the Committee intends to reduce inflation to that level within two years. While such an announcement would not necessarily shift inflation expectations immediately downward, I project that consistent communications from Committee members accompanied by further rate increases when downside growth risks abate later this year would bring expectations into line with our objective by early next year. Although growth would be weaker this year than in my unconditional forecast, it would ultimately return to trend in 2008, and the properly measured sacrifice ratio would turn out to be significantly smaller than is often assumed or inferred from standard Phillips curve estimates. I mention this scenario simply to reiterate that I believe that there’s a feasible alternative to the hypothesis that inflation will settle in around 2 percent or higher unless we engineer a substantial output gap." fcic_final_report_full--188 As late as July , Citigroup and others were still increasing their leveraged loan business.  Citigroup CEO Charles Prince then said of the business, “When the mu- sic stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Prince later explained to the FCIC, “At that point in time, because interest rates had been so low for so long, the private equity firms were driving very hard bargains with the banks. And at that point in time the banks individually had no credibility to stop participating in this lending business. It was not credible for one institution to unilaterally back away from this leveraged lending business. It was in that context that I suggested that all of us, we were all regulated entities, that the regulators had an interest in tightening up lending standards in the leveraged lending area.”  The CLO market would seize up in the summer of  during the financial cri- sis, just as the much-larger mortgage-related CDO market seized. At the time this would be roughly  billion in outstanding commitments for new loans; as de- mand in the secondary market dried up, these loans ended up on the banks’ balance sheets.  Commercial real estate—multifamily apartment buildings, office buildings, ho- tels, retail establishments, and industrial properties—went through a bubble similar to that in the housing market. Investment banks created commercial mortgage– backed securities and even CDOs out of commercial real estate loans, just as they did with residential mortgages. And, just as houses appreciated from  on, so too did commercial real estate values. Office prices rose by nearly  between  and  in the central business districts of the  markets for which data are available. The increase was  in Phoenix,  in Tampa,  in Manhattan, and  in Los Angeles.  Issuance of commercial mortgage–backed securities rose from  billion in  to  billion in , reaching  billion in . When securitization markets contracted, issuance fell to  billion in  and  billion in . When about one-fourth of commercial real estate mortgages were securitized in , securitizers issued  billion of commercial mortgage CDOs, a number that again dropped pre- cipitously in .  FOMC20060920meeting--144 142,MS. BIES.," Thank you, Mr. Chairman. I want to start my remarks today by reflecting on some results of the latest Duke University CFO survey. This survey is only about six or seven years old, but the one that was just concluded on September 10 has CFOs’ optimism at the lowest levels in five years, and so it’s continuing to show an erosion of their confidence. I found the CFOs’ number 1 worry—weak consumer demand—interesting because it wasn’t there before, and that uncertainty is part of what the CFOs are worrying about. Their second biggest concern is rising labor costs, which they attribute primarily to the scarcity of labor. They are anticipating that the scarcity is going to continue to drive labor costs higher. In terms of their hiring plans, they are planning now to hire fewer people than they hired last quarter. They are expecting to increase employment over the next twelve months 0.8 percent; last quarter’s survey showed 1.3 percent, so that’s quite a slowdown. However, they’re going to increase outsourced employment 4.3 percent. Thus what is showing up is the uncertainty—wanting to use an adjustable labor force to get the flexibility because of the uncertainty. They are also trimming their capital spending plans over the next twelve months to 5.1 percent, compared with 7.5 percent last quarter. Thus the survey indicates that CFOs have growing concern; they are still optimistic overall, but I think that caution is there. Now, in looking at the numbers myself, I’m perhaps not quite as pessimistic. Again, as several of you have said—and Dave commented in his remarks—except for housing, the economy really does look good. As you know, I’ve been worried about the mortgage market and housing for quite a while. In an endeavor to find something good to say, I have noticed that, in the past couple of months, the Mortgage Bankers Association index of new loan applications for purchase mortgages looks as though it’s starting to level off. Very often that could be a leading indicator, so that could be a positive sign. However, as some of you have remarked, there’s a lot of speculation in the housing markets that has to unwind. All the folks who bought housing for investment have to do something as they see housing prices slowing and the financing costs to carry their investments going up. How that unwinding will occur, given the substantial size of the speculative positions in some markets, is something that will need very close monitoring. I know that our supervisory staff is focusing on that, too. People are focusing on the fact that delinquency rates in mortgages still look good. However, we’ve seen a very rapid increase in debt service ratios since 2004. I’m concerned, again, with the amount of adjustable-rate mortgages out there that will reprice in the months ahead. If, as we think, some of these loans, particularly subprime loans, were made mainly on the collateral value of the house and not on the affordability of the mortgage, we could see more distress in the borrowers’ markets coming forward. If that’s the case, it could have spillover effects on consumer spending more broadly. On the positive side, payroll growth has been good in the past three months—128,000. It has picked up a bit, and it is significantly above the Greenbook forecast, and that gives me some optimism. It’s putting more income in people’s pockets to spend, and the unemployment rate has been stable. Hourly earnings, however, are rising faster. While that acceleration can support consumer spending, it contributes to my concern about where we’re going in the long run on inflation. As I look at the Greenbook forecasts since May, we’ve been continuing to project more and more inflation going forward. The private sector has basically been doing that in their forecasts as well. When I look at those forecasts, I’m concerned that for various reasons we have reduced our estimates of the trend rate of growth. As we bring down the trend rate of growth— and I realize that, as several have said, we’re at the lower end of the private-sector growth forecasts—I worry about the disconnect. Are we seeing a slowdown in potential that others aren’t? Or if we’re right that potential growth is lower and the private forecasters are right that real growth is going to be faster, then we could have more inflation pressures going forward. For the first time, we are also looking at prices in 2008, and they continue to rise at over 2 percent. They’ve been over 2 percent for two years. I worry, from the standpoint of our credibility, about what having such a long period above 2 percent means. So I believe we will see moderation of inflation, but I think it’s important to preserve our flexibility and be able to respond if these worst-case scenarios that I laid out become more troubling to us going forward." FOMC20060328meeting--142 140,MS. BIES.," Thank you, Mr. Chairman. Overall, I agree with many of you around the table and with the Greenbook. I see that you have solid growth going forward. I want first to talk about the corporate sector and then to talk a bit about the household sector. I have talked with several corporate CFOs in the past couple of weeks, and I also just received a copy of the Duke quarterly CFO survey. I found the comments from the CFOs and the survey results to be similar, and so I thought I would just use the Duke survey to make my comments here. The CFOs are expecting to be able to raise prices more over this coming year than they did last year. On average, they are expecting an increase in prices of about 3.3 percent. A year ago at this time, the quarterly survey showed a 2 percent increase. So the increase is slight. And they are also expecting to raise wages and salaries faster, 4.2 percent this coming year. Their biggest concerns continue to be global competition and health care costs—that has not changed at all. What I find really amazing is how much these CFOs continue to be focused on cash levels. Right now, as you know, the liquid assets on the balance sheets of corporations are at the highest level in at least forty-five years. Corporate profit margins relative to GDP are running at 11 percent, and that is again a record level. If you look at the survey results, the CFOs are saying that they plan to increase cash even more in 2006. How are they going to do that? One of the things this group is forecasting this year is for earnings to grow 13.1 percent. Last March the survey said 11.4. So the projection for earnings growth is up about 2 points. They are not expecting top line revenue growth of 13 percent—they are expecting to be able to widen their operating margins. So the trends we have been seeing are what everybody is just building on. This inertia and this new focus on cost management seem to be central to what is going on in corporate America. Partly, too, they are worried about top-line revenue growth, and I am hearing more of them talking about using mergers to widen their operating margins: Grow market share through acquisition, get immediate revenue pops, pull out the extra costs, and get the bottom line growth at 13 percent that way. They also are planning to spend more on capital expenditures this year, up 6.5 percent versus 4.7 percent, and also much more employment growth, 2 percent versus 0.6. So they are optimistic; but again, the focus on widening operating margins from already historically wide levels and on building liquid assets shows that a real focus on the fundamentals in corporate America is continuing. If you look at the survey of small businesses, you can read the same kinds of trends in the responses. The optimism of small business remains at a very high level. So, in summary, I think corporate America is going to continue to push earnings growth and production but is clearly focused on cost containment. And while they may be looking at raising prices a bit, I think overall prices will be contained. Now, a look at the household sector. What I have been noticing in the past few months is that job growth, as many of you have mentioned, has clearly gotten a lot stronger and also that wages are growing much faster—in the last three months, they have gone up at an annual rate of 4.8 percent, which is pretty strong. I think we have to go back about four or five years to get that kind of increase. So the real question, as many of you have said, is what is really happening to productivity. The last time we had this kind of wage growth was in the late ’90s, and we saw the pop in productivity. So unit labor costs were there and helped modify inflation. I heard from the CFOs that this is exactly what they are trying to do—to find ways to improve productivity just so they can handle the higher wage cost because they are finding that skills are short in some areas. But the highly skilled people are probably also more productive, on average, than other folks who may be looking for jobs, and hiring the more-productive workers could also help in that way. I think that the good job growth and the faster wage increases will also help put a floor on housing sales. You know I have been concerned about where we are in terms of the mortgage markets going forward in support of housing. We know that the fixed obligation ratio that our staff constructs has been at record levels; last quarter it showed a tick down in the fourth quarter, but it still is relatively high. Mortgage rates on the long end have not really moved very much in the last couple of years. But to the extent that so many new mortgages were financed with adjustable-rate mortgages in the last year and the ARM rate spread now has really moved up as we have moved short rates up, there is less than a point difference now between one-year ARMs and the term rates. So affordability, I think, is going to continue to come under more pressure going forward. Housing inventories are increasing. Again, I talked to a CFO at a large builder. They clearly are managing inventory much better than they did years ago, but even so, backouts on sales and such things are increasing. The number of housing starts that they have in train and starts going forward are going to be slowing down, and they are giving guidance to the Street that they’re not going to get the sales that they had. But even if it slows down, housing is still going to be very strong in relation to historical standards, but it will be off the peak that we have been seeing. Finally, to follow up on the comments that some of you made, I see that we still have a tremendous amount of liquidity in the financial markets. Again, corporations are sitting on all this liquidity. We do not hear anything from corporations about difficulty in financing big or small business. We know the bankers clearly are looking for loan growth and trying to find it, and the housing market is able to attract all the liquidity it needs. So in terms of how effective our rate increases have been, I see that the lag effect is still there and that plenty of liquidity is still out there, which keeps me focused on where core inflation will be." CHRG-111hhrg51698--116 Mr. Gooch," The entire world was over-leveraged and went through a credit bubble that may have significant causes other than the various instruments that we used to transact the risk. Yes, I completely support the concept of centralized clearing, but I agree with Mr. Duffy, not all products could be put into centralized clearing. Regulation, transparency and limits, limits on positions relative to capital and things like that, those things all make sense. Certainly, AIG should not have been selling credit default swaps and pocketing the premiums and treating it as if it was income. They should have been far more conservative. But there is always, throughout history, the case of either individuals or corporations or governments that overspeculate, and they should be held to some kind of limits. " CHRG-110shrg50415--25 Chairman Dodd," Thank you very, very much, Mayor. And let me just on that point, before turning to Mr. Stein, I am somewhat reluctant to quote the Wall Street Journal on this point, but the Wall Street Journal noted that between 60 and 65 percent of subprime borrowers actually would have qualified for conventional mortgages; 60 to 65 percent of those borrowers would have qualified for less costly mortgages. As you may recall, for those who were here, we had the first hearings and had the representatives from the Brokers Association. We put up the Web page, and the first instruction to brokers from their association was, ``Convince the borrower that you are their financial adviser.'' The most deceptive of practices. They were anything but the financial adviser to the borrower. And as a result, literally thousands and thousands of people ended up with mortgages vastly more expensive than ones they qualified for. That is criminal, in my view. And to make your point, let me just quote on the last point--or the first point you made in your testimony, just to make your point, this is a commentator that wrote an article called ``They Gave Your Mortgage to a Less Qualified Minority.'' And let me quote, if there is any doubt about what you just said. Listen to this quote: ``Instead of looking at outdated criteria, such as the mortgage applicant's credit history and ability to make a downpayment, banks were encouraged to consider non-traditional measures of creditworthiness, such as having a good jump shot or having a missing child named Caylee.'' The article goes on to say that, and I quote, ``Ultimately, the housing bubble burst and, as predicted, food stamp-backed mortgages collapsed.'' The article goes on and refers to this kind of mortgage crisis ``as an affirmative action time bomb that has gone off.'' If there is any doubt about what Mayor Morial just said, that is the kind of articles that are appearing all across the country, and the data is, of course, entirely the opposite. The facts are entirely the opposite. And so I appreciate immensely you testifying this morning about this theory that is being promulgated. I remember Paul Sarbanes, who chaired this Committee--he is a great friend of mine, a great Chairman of this Committee. Chuck Schumer and I--he was a House member in those days, in 1999, we sat up all night on that 1999 law to fight those on this Committee and elsewhere who did everything in their power to get rid of the Community Reinvestment Act, and we prevailed. I think, Bob, you may have been in the House that year, maybe on the Banking Committee. But I will never forget staying up until 5 and 6 o'clock in the morning to fight to keep the CRA. And so I appreciate very much your testimony. " fcic_final_report_full--227 The summer of  also saw a near halt in many securitization markets, includ- ing the market for non-agency mortgage securitizations. For example, a total of  billion in subprime securitizations were issued in the second quarter of  (already down from prior quarters). That figure dropped precipitously to  billion in the third quarter and to only  billion in the fourth quarter of . Alt-A issuance topped  billion in the second quarter, but fell to  billion in the fourth quarter of . Once-booming markets were now gone—only  billion in subprime or Alt- A mortgage-backed securities were issued in the first half of , and almost none after that.  CDOs followed suit. From a high of more than  billion in the first quarter of , worldwide issuance of CDOs with mortgage-backed securities as collateral plummeted to  billion in the third quarter of  and only  billion in the fourth quarter. And as the CDO market ground to a halt, investors no longer trusted other structured products.  Over  billion of collateralized loan obligations (CLOs), or securitized leveraged loans, were issued in ; only  billion were is- sued in . The issuance of commercial real estate mortgage–backed securities plummeted from  billion in  to  billion in .  Those securitization markets that held up during the turmoil in  eventually suffered in  as the crisis deepened. Securitization of auto loans, credit cards, small business loans, and equipment leases all nearly ceased in the third and fourth quarters of . DELINQUENCIES: “THE TURN OF THE HOUSING MARKET ” Home prices rose  nationally in , their third year of double-digit growth. But by the spring of , as the sales pace slowed, the number of months it would take to sell off all the homes on the market rose to its highest level in  years. Nationwide, home prices peaked in April . Members of the Federal Reserve’s Federal Open Market Committee (FOMC) dis- cussed housing prices in the spring of . Chairman Ben Bernanke and other members predicted a decline in home prices but were uncertain whether the decline would be slow or fast. Bernanke believed some correction in the housing market would be healthy and that the goal of the FOMC should be to ensure the correction did not overly affect the growth of the rest of the economy.  In October , with the housing market downturn under way, Moody’s Econ- omy.com, a business unit separate from Moody’s Investors Service, issued a report authored by Chief Economist Mark Zandi titled “Housing at the Tipping Point: The Outlook for the U.S. Residential Real Estate Market.” He came to the following conclusion: Nearly  of the nation’s metro areas will experience a crash in house prices; a double-digit peak-to-trough decline in house prices. . . . These sharp declines in house prices are expected along the Southwest coast of Florida, in the metro areas of Arizona and Nevada, in a number of Cali- fornia areas, throughout the broad Washington, D.C. area, and in and around Detroit. Many more metro areas are expected to experience only house-price corrections in which peak-to-trough price declines remain in the single digits. . . . It is important to note that price declines in vari- ous markets are expected to extend into  and even . CHRG-110hhrg46596--365 Mr. Feeney," I bet it is many multiples of the $20 billion. So, again, this is not GAO's fault. I think Congress and the Administration have led Americans in a direction that may be very difficult long term to recover from. There are things that we can do like managing a monetary supply not to create bubbles. There are things that we simply cannot do. Micromanaging the decisions of 300 million Americans and businesses and institutions is not something that Washington will ever do successfully, in my view. God bless you on your mission. I don't think it will work. I hope it does. It never has in history. With that, I yield back. " CHRG-109hhrg31539--217 Mr. Baca," Okay. Well, the spending of gas prices growing faster than spending for other basic items such as healthcare, housing and college, what impact will this have on long-term economic growth? And do you believe that there should be a greater sense of urgency for Congress and this Administration to do something to stop the rising gas prices? " FOMC20061212meeting--61 59,MS. YELLEN.," Thank you, Mr. Chairman. I have to admit that this time around I found it pretty challenging to read the tea leaves on economic activity. The data are providing distinctly contradictory signals. For example, several key indicators of aggregate spending have come in below expectations, and the Greenbook now sees real GDP growth this quarter and the next averaging a mere 1½ percent. At the same time, the labor market continues to be strong and shows no clear signs of weakening, as evidenced by the November employment report. The latest information on inflation has been fairly favorable; but even with some signs of easing, the underlying trend in core consumer price inflation remains above my comfort zone. The last time we met I described the situation as a bimodal economy with strength in most sectors and weakness limited to just two sectors, housing and domestic auto production. This description by and large remains apt. The correction in the housing sector has continued, even sharpening somewhat compared with our expectations. Still, there are some encouraging signs that the demand for housing may be stabilizing, probably assisted by recent declines in mortgage rates. After a precipitous fall, home sales appear to have leveled off. In addition, equity valuations for homebuilders have continued to rise in the past couple of months, suggesting that the outlook for these businesses may be improving. Finally, the gap between housing prices and fundamentals may not be as large as some calculations suggest because real long-term interest rates have fallen quite a bit recently, raising the fundamental value of housing. That said, the housing sector on balance is a source of downside risk, and the risk could be magnified if mortgage rates were to rise again as foreseen by the Greenbook. Outside residential investment, GDP growth has remained solid. Consumption has continued to be strong; indeed, I think there are upside risks to consumer spending, given the Greenbook’s forecast of a significant rise in the saving rate. But recent indicators of nonresidential investment and activity in the manufacturing sector have come in below expectations. The key question is whether these data hint at a crack in the economy’s armor that could widen. It’s obviously too early to tell, but these weaknesses bear careful monitoring. Overall, the data on spending paint a clear picture of an economy growing well below trend, but it seems as though the BEA hasn’t delivered this message to the BLS. [Laughter] The very latest data show payroll employment growing steadily. The household data are even more alarming. The unemployment rate has declined ½ percentage point over the past year and now stands at 4½ percent, ½ percentage point below our estimate of the NAIRU. My business contacts tell me the same thing. Labor markets are tight, and jobs are hard to fill, especially for skilled positions. But some other indicators suggest that labor markets may have softened a bit. In particular, the Conference Board index of job market perceptions, based on a survey of households, declined in both October and November. This index is historically very highly correlated with the unemployment rate, but now it’s sending a different signal, suggesting that labor markets are roughly in balance. Similarly, in November fewer firms reported openings that are hard to fill. The fall in the unemployment rate this year is hard to square with Okun’s law. Over the past four quarters, GDP growth has averaged 3 percent, just 0.3 above the Board’s estimate of potential GDP growth. A standard Okun’s law calculation suggests that this should have led to a decline in the unemployment rate of only about 0.1 percentage point. In fact, however, it declined 0.5 percentage point. Of course, labor markets do adjust with a lag, so we may just need to be patient and wait for Okun’s law to reassert itself as assumed in the Greenbook forecast. An alternative possibility is that the output gap is more positive than assumed in the Greenbook because of lower growth in potential output or more-rapid growth in actual output. In his presentation, David noted the possibility that the growth rate of potential output may be lower than even the downwardly revised estimate in the Greenbook. It is also possible—and, in fact, there are indications—that actual output growth may have been faster than the pace reflected in measured GDP. Growth in domestic income has outpaced GDP growth by ¾ percentage point over the past year. Now I know that when someone mentions the statistical discrepancy, eyes start to glaze over. But I raise this issue because it could have important implications for the outlook. If the gross domestic income measure ends up being more accurate, then the decline in the unemployment rate this year would not be surprising. Going forward, more-rapid output growth would imply a lower path for unemployment, potentially adding to inflation pressures. Turning to inflation itself, the news has been pretty good on balance since our last meeting. We expect core PCE price inflation to edge down from just under 2½ percent this year to about 2 percent in 2008. We came to this forecast balancing two main pieces of news. On the one hand, recent labor market data point to a lower path for the unemployment rate than before, and all else being equal, this boosts our inflation forecast a bit. Offsetting this effect, on the other hand, is the huge downward revision in compensation per hour. When these data came out, I let out a big sigh of relief. The revised data are more consistent with the indications we were getting from the employment cost index and suggest that wage growth has remained contained. In contrast, my contacts report intensifying wage pressures, resulting in part from more-frequent employee quits and outside offers. Even so, my contacts do not report that these developments are exerting significant pressure on their profit margins or prices, suggesting continued strong productivity growth. But that, in turn, conflicts with the data on productivity growth in the nonfarm business sector, which have been weak, not strong. Output per hour in the nonfarm business sector increased only about 1½ percent over the past year, well below its trend. But there is reason to believe that this decline may overstate the slowing in productivity growth, given continued strong growth in productivity in the nonfinancial corporate sector. At least part of this discrepancy between nonfinancial corporate and nonfarm productivity growth reflects the gap I mentioned before between gross domestic income and gross domestic product. If the GDI numbers are, in fact, more accurate, that alone could add nearly 1 percentage point to nonfarm business productivity growth, perhaps reconciling the reports by my contacts of intensifying wage pressure along with an absence of pressure on prices and margins. In summary, I continue to view a soft landing with moderating inflation as my best-guess forecast, conditional on maintaining the current stance of policy. But there are sizable risks on both sides to the outlook for growth, and the downside risks are now more palpable. There is, likewise, a great deal of uncertainty about inflation going forward; in this case, the risks remain biased to the high side." FOMC20051101meeting--88 86,MR. MOSKOW.," David, I had a question for you about the forecast that activity is going to slow in the second half of ’06 and ’07. You talked about the reasons for the slowdown, which were tighter monetary policy, a slowing in house price appreciation, and diminishing fiscal stimulus. In the Monday morning briefing, you threw in the stock market as well—waning impetus from household wealth in terms of both the stock market and the housing components. I thought the Greenbook had an assumption of 6 percent growth in the stock market per year. I wonder if you could talk about that." FOMC20060328meeting--138 136,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Like all of you, we think the underlying trajectory of demand and inflation seems quite favorable, perhaps a bit more so than it did in January. We expect real GDP to grow at a rate slightly above the rate of increasing potential in ’06 and to slow to the range of potential in ’07. We expect the core PCE to rise at a rate in the neighborhood of 2 percent over the forecast period. Differences between our forecast and the Greenbook’s are minor. In our forecast, we assume that inflation expectations remain anchored and the term premium remains low and that we are now at a point where little or no resource slack is left in the domestic economy. The monetary policy assumption we adopt is the path currently priced into the futures markets. The major sources of uncertainty in our forecast are the size of the wealth effect we might see accompanying any slowdown of housing, the flexibility of profit margins, and the sustainability of this present configuration of low risk premiums. We view the risk to the growth forecast as roughly balanced, although the usual suspects provide a source of concern. The risk to our inflation forecast, in contrast, still seems slightly tilted to the upside. On the growth front, as I said, we think the underlying pace of demand growth is pretty strong, and we don’t see any signs yet that would point to evidence of a significant slowdown relative to potential in prospect. We think productivity growth is likely to remain quite high, rising perhaps a bit faster this year than in ’05. With the labor market growing on trend and some increase in labor’s share of national income, we expect consumption growth to remain reasonably strong. Stronger income growth offsets the expected deceleration in housing-price appreciation and the effect that might have on consumption. We expect a slight increase in the contribution of business fixed investment to demand growth, due principally to a rise in spending on equipment and software. We expect, of course, the contribution of residential investment to slow with the forecast period. World GDP growth seems stronger and more broadly based. We expect net exports to be a persistent drag, shaving about ½ percentage point off growth for each of the next two years. Despite this forecast of pretty strong spending growth and high levels of resource utilization, we believe core inflation is likely to remain moderate. Under the assumption of a relatively stable dollar and with the energy-price assumption taken from the futures curve, we expect headline inflation to slow to a rate closer to the core over the forecast period. But this forecast rests on three important foundations. The first is that we succeed in keeping inflation expectations reasonably well anchored. The second is that demand growth not only does not accelerate to a rate substantially above trend but also slows to potential over the forecast period. And the third is that the expected rise in compensation and unit labor costs results in a rise in labor share of income—in other words, that compensation growth accelerates but the increase is absorbed by some compression of profit margins and does not lead to a significant acceleration in core inflation. Now, the sources of potential upside risk to the inflation forecast are several. One, of course, comes from the interaction between our views about productivity growth, compensation, and profit margins. If the pace of productivity growth slows significantly relative to our assumption and if, at the same time, conditions in labor markets continue to improve, unit labor costs are then likely to accelerate. A rise in compensation, however, would not by itself portend a troubling increase in core inflation. The extent of this risk, as I said, depends on the degree to which rising unit labor costs are absorbed in shrinking profit margins rather than triggering output price increases as firms attempt to defend existing margins. And because the labor share of income seems somewhat low and, as historical averages suggest, there’s room for unit labor cost growth to be absorbed in profit margins rather than causing price increases, we need to be attentive to the risk that this process may produce a short-term increase in core inflation, perhaps also in inflation expectations. A second potential risk comes from what we think we know about the pace of demand relative to potential supply globally. A continued increase in commodity prices around the globe and, more recently, some modest increase in capital goods prices may suggest that global pressures on resource constraints are pushing up prices. This raises the risk that the recent weakness in core goods prices in the United States may not be sustained. Service price inflation in the United States has shown signs of slowing. Our central forecast, as I said, is conditioned on little movement in the dollar over the forecast period, but any sizable depreciation of the dollar would still carry the risk of some acceleration in core goods prices. For nearly two years, overall inflation, as what is measured by the PCE or the CPI would suggest, has been running substantially above core, and this is true for a range of alternative measures of underlying inflation. If the underlying inflation rate were closer to 1.5 percent than to 2 percent, we might view these potential sources of upward pressure with more equanimity. Although the probability seems low that these forces will act to produce a significant acceleration of core inflation or a significant deterioration in inflation expectations, we need to be careful about those risks. So with underlying inflation at the upper end of the inferred inflation preference of the Committee, we need to be more attentive to these risks. On the growth side, the most obvious sources of downside risk to growth are a substantial rise in energy prices from current levels, a slowdown in productivity growth, a sharp rise in risk premiums, and a more-adverse effect on saving and consumption from the expected adjustment in housing markets and prices. Like the staff forecast, we think it’s reasonable to expect household saving to rise a bit and consumption growth to slow, in part because of changing expectations about the pace of future appreciation in the value of home equity. But we believe that, absent some large, negative shock to perceptions about employment and earned income, the effects of the expected cooling in housing prices are going to be modest. Of course, this view may prove optimistic. We take some reassurance from the fact that the average growth forecast in the private sector probably anticipates a significant cooling in housing and a significant effect of that cooling on saving and consumption. Developments in asset prices and risk premiums over the past several months seem to support this picture of stronger confidence in the growth and inflation outlook because real rates seem to have risen. Equity prices and credit spreads suggest considerable confidence in the prospect for growth. Implied volatilities remain quite low. We don’t know how much of this is fundamental and how much will prove ephemeral. At the moment, though, overall financial conditions seem pretty supportive of the expansion. So with this forecast of growth in the vicinity of potential, core inflation at around 2 percent, and the risk somewhat to the upside for inflation, we think the principal responsibility of monetary policy remains to preserve the sense that we will act to keep long-term inflation expectations contained at levels consistent with price stability." CHRG-111hhrg48867--231 Mr. Silvers," I really appreciate that this is my friend Peter Wallison's religion, but I think that the facts are that when we had well-regulated financial markets they channelled capital to productive activity, they were a reasonable portion of our economy and they were not overleveraged and we did not suffer from financial bubbles. And that describes the period from the New Deal until roughly 1980. And then we started deregulating, and the result was financial markets that grew to unsustainable size, excessive leverage in our economy, an inability to invest capital in long-term productive purposes, an inability to solve fundamental economic problems, and escalating financial bubbles. That is the history of our country. When we had thoughtful, proportionate financial regulation, it was good for our economy. Now we are in a position, pursuant to your question, where we have global financial markets and where a global financial regulatory floor is an absolute necessity if we are going to have a stable global economy. If we choose to be the drag on that process, it is not only going to impair our ability to have a well-functioning global financial system, it will damage the United States's reputation in the world. This question is immediately before us. And I would submit to you that while systemic risk regulation is important here, underneath that are a series of substantive policy choices which will define whether or not we are serious about real reregulation of the shadow markets or not. And if we choose to be once again the defender of unregulated, irresponsible financial practices and institutions, that the world will not look kindly upon us for doing so, as they did not look kindly upon us for essentially bringing these practices to the fore in the first place. " FOMC20070509meeting--49 47,MS. YELLEN.," Thank you, Mr. Chairman. My assessment of the economic outlook and the risks to it is largely unchanged since our last meeting. The data since that meeting have been mixed. On the one hand, the very sluggish real GDP growth in the first quarter gives me pause concerning potential downside risks. Much of the first-quarter weakness, of course, was due to housing, and I really don’t see that sector starting to turn around at this point. My homebuilder and banking contacts report stricter underwriting standards for all mortgages, not just subprime ones, so residential investment could remain a significant drag on the economy over the near term as the Greenbook now envisions. Indeed, whereas the Greenbook assumes that national house prices are flat going forward, I am worried that they may actually fall. On the other hand, the improved picture of auto inventories along with some positive glimmers on manufacturing and business investment suggests that those sectors may prove to be less of a drag on the economy going forward. With respect to inflation, the recent news has also been somewhat mixed with lower-than- expected readings on core consumer prices and labor compensation offset by higher prices for energy, other commodities, and imports. Taking a longer view, I anticipate real GDP growth over the next two and a half years of about 2.6 percent, just a bit below my assessment of potential. My forecasts of both actual and potential growth are a tenth or two stronger than the Greenbook forecasts; but the basic story is very similar, and the underlying assumptions, including the path for the nominal funds rate, are essentially the same. I view the stance of monetary policy as remaining somewhat restrictive throughout the entire forecast period. The key factors shaping the longer-term outlook include continued fallout from the housing sector, with housing wealth projected to be roughly flat through 2008. Given the reduced impetus from housing wealth, household spending should advance at a more moderate pace going forward than over the past few years. This slowdown in consumption is reinforced by more-moderate gains in personal income, as the unemployment rate gradually rises, reaching 5 percent in 2009. Although I anticipate that the labor market will remain fairly tight over the next year, I do not expect faster compensation growth to exert significant upward pressure on prices. I expect it instead to restrain profits, given that labor’s share of income is now at an exceptionally low level. I also anticipate that various temporary factors that have been boosting inflation, such as the run-up in owners’ equivalent rent and the pass-through of energy prices, should dissipate, while inflation expectations remain well anchored. Overall, I’m more optimistic regarding inflation than the Greenbook and anticipate that core PCE price inflation will edge down below 2 percent after next year. One of the more interesting questions about the outlook, as David noted in the questions to him, is how to reconcile the strong labor market performance with the weak growth in output or, equivalently, how much of the recent slowdown in productivity growth is likely to persist. And that is something that we have been thinking about, too. Over the four quarters of 2006, nonfarm business productivity rose 1.6 percent, about half as fast as the average pace set from 2000 through 2005. Whether these recent lower numbers reflect a transitory drop in growth or a downshift in the trend rate is an important issue. A lot of excellent research has been done on this topic by staff at the Board and elsewhere in the System. My reading of the evidence at this point is that the recent decline in productivity growth does largely reflect cyclical factors. I think productivity growth has fallen significantly below trend because of labor hoarding and lags in the adjustment of employment to output. We have also been giving close scrutiny to the behavior of the residential construction sector and productivity in that sector. My staff has done some work on estimating what productivity growth has been over the past year or so in residential investment and in the nonfarm business sector outside residential investment. They estimate that essentially all of last year’s slowdown in labor productivity growth is due to the behavior of productivity in residential construction. We estimate that residential construction productivity dropped 10 to 15 percent in 2006, whereas productivity in the nonfarm business sector outside residential investment was well maintained. Exactly why those lags exist, again, is a mystery to me as well as to David and others. But going forward, it seems to us that, as the adjustment lags work themselves out, residential construction employment will likely post significant declines, and productivity in that sector and the economy as a whole will rebound. That said, the pace of structural productivity growth may also have declined slightly as the Greenbook hypothesizes. Relative to the second half of the 1990s, both the pace of productivity growth in the IT sector and the pace of investment in equipment and software have slowed, and these factors have probably depressed trend productivity growth slightly in recent years and are likely to continue depressing it somewhat going forward. But the hypothesis that the recent decline in productivity growth is mainly structural does not seem to me to square well with the broad range of available evidence. Recall that in the 1990s there was a whole constellation of evidence—including a booming stock market, robust consumption, and rapid business investment—that was consistent with a hypothesis of a lasting increase in the rate of productivity growth. In contrast, over the past year or so, business investment in equipment has been very sluggish and more so than seems warranted by the deceleration in business output. So such weakness could reflect lower assessments by companies of their ability to improve productivity through the installation of new capital, and that is, I think, consistent with the lower trend of productivity growth. But you would think that a marked slowdown in secular productivity growth would also result in downward revisions to the expected paths of future profits and real wages, weakening equity market valuations and crimping consumption growth. I have seen no signs over the past year that household perceptions of their future wealth accumulation have been downgraded. In sum, the data seem consistent with the view that the recent slowdown in nonfarm business productivity represents a temporary cyclical drop that is concentrated in residential construction combined with a modest decline in the trend. So I remain optimistic that the underlying productivity trend is at or only slightly below 2½ percent." FOMC20061025meeting--87 85,MS. BIES.," Thank you, Mr. Chairman. Well, again, as some of you have said, in five weeks we don’t have a whole lot of new information. But I’m coming back and starting with housing again. As you know, that continues to be something I watch. Let me just make a few comments and give you recent feedback from some exams and dialogues with brokers that I’d like to share with you. Looking at both starts and permits, we all know that housing is continuing to soften in terms of construction, and we have also identified the increasing number of contract cancellations for new housing. Someone mentioned earlier the noise that we may be having around housing data, and I get this through some of the anecdotal conversations that I’ve had with folks. One topic was the inventory of existing housing for sale. I’m hearing from a couple of real estate brokers that people who may have wanted to sell their homes or may have put them up for sale are withdrawing them from the market. They don’t need to move, and it isn’t worthwhile for them to move if they don’t get the price they want. I think the supply was possibly bigger than what we’re really measuring, and so we’re seeing some understating of what desired house sales would be in terms of inventory. That’s continuing; it is just beginning at this stage, at least in a couple of regions, according to folks with whom I’ve talked. One of the challenges that we’re faced with here is that—again, I try to look for the good news—in the housing purchase process, people file applications for mortgages very often before they qualify to buy the house. When you look at the Mortgage Bankers Association data on purchase mortgage applications, as I mentioned before, they dropped 20 percent from their peak of last summer, but in the past few months they have been leveling off. So if applications are a leading indicator, we may begin to see some moderation in housing purchases. However, the 20 percent drop in purchase mortgage applications means that mortgage brokers are earning a lot less income. If they don’t close a transaction, most of them get no paycheck because three out of four mortgages are originated not in financial institutions but by independent brokers. We’re beginning to see increasing evidence of this in terms of the quality of mortgages that are out there. We continue to track the mortgages that have vintages—in other words, that were originated—in 2005, and we are continuing to see that, as these mortgages age, the early delinquencies for these are greater than early delinquencies for similar-aged mortgages of earlier vintages, which implies a loosening of underwriting standards and more stress on the borrowers. We are also seeing in a small way increased predatory activity with loans. Certain practices have been described to me lately with new products, such as the 2-28 mortgage, which is fixed for two years and then escalates and becomes an ARM tied to LIBOR in the third year. But don’t worry—you can refinance it with the broker and bring your payment down and do it all over again. We’re seeing those kinds of things—mortgages for which people are being qualified by brokers with no escrow account; all of a sudden taxes are due, and borrowers don’t have the money for them. So predatory lending is rearing its head at the lower end of the scale, and it’s something we have to continue to watch for. However, before I leave housing, let me just say that the bottom line is that overall mortgage credit quality is still very, very strong. We’re seeing predatory lending only in pockets of the market. I continue to believe that the rest of the economy—except for autos, I should add—is still very strong. Consumer spending is good, and business fixed investment is very sound. The moderation in energy prices and the growth in consumer income will continue to add support to the economy going forward. Jobless claims have been low and moving in a very narrow range the past few months. As several of you have mentioned, I’m hearing more concern by corporate executives about the inability to hire the talent they need to meet their business plans, and so I’m seeing more indication of tightness in labor markets. Turning to inflation, as many of you have said, core inflation has moderated from the pace in the third quarter. But going forward in the Greenbook forecast, it is still showing significant persistence even though we think we will be growing, at least for a period, below potential. That concerns me because that level is higher than I’m comfortable with in the long run. We might have had some spillover effects from rising commodity and energy prices earlier on, but I was hoping at this point that, with the reversing, we would see more-positive spillover effects that would mitigate inflation. So I am very worried about inflation. At the same time, I know that negative spillover effects on growth due to the rapid decline in housing construction and the moderating house-price appreciation are risks, which we cannot dismiss, to growth; but on net I am still much more concerned about the persistence of inflation. Thank you, Mr. Chairman." FOMC20061025meeting--81 79,MR. LACKER.," Thank you, Mr. Chairman. The Fifth District survey for October just released today shows manufacturing flattening out after a run-up last month, though expectations remain upbeat. Services firms note solid increases in revenues, and overall District job growth remains strong. Among retailers, big-ticket sales were softer, and housing-related sales slowed further; but with other retailers, the picture brightened, with sales and traffic notably stronger. The housing sector continues to slow, with sales weakening further in the D.C. area and modest price reductions occurring in other large markets. Some cities in the Carolinas, however, continue to report modest increases in home sales prices and even permits, and in many locations, activity varies significantly across different price ranges. District labor markets remain tight, and our surveys indicate that expectations are for some additional wage pressures in the next six months. This commentary includes the now-usual reports of shortages of particular skills. Our price measures moderated some, but they remain elevated. The national outlook has changed only marginally in the past five weeks. At our last few meetings, we have seen the staff mark down their forecast for second-half growth as the pace of the contraction in housing activity has become clear. The information that has come in over the past several weeks does not suggest any steepening in the rate of decline, and if anything, there are scattered signs suggesting that we might be getting close to the bottom. Except for housing, the economy still appears to be in good shape. Consumer spending is holding up well. Employment is tracking labor force growth. Commercial construction is fairly robust, and business investment spending continues to grow. So we’re still not seeing any major spillovers from the housing market to other economic sectors. Housing is certainly going to subtract from headline growth over the next couple of quarters, but I expect GDP growth to return to close to potential at some point next year, and I remain more optimistic than the staff about when that will occur. There is a risk that output growth will come in lower than I anticipate because of a more severe deterioration of the housing markets or more substantial spillover effects on other spending categories. Although it’s certainly too early to rule this out, I think the probability of such an outcome has receded in recent weeks. So my outlook for real growth is about the same as it was in September with, if anything, a tad less downside risk. The inflation outlook has not improved since our last meeting. The September core CPI reading was 2.9 at an annual rate, identical to the August reading, and core PCE inflation for September is estimated at an annual rate of about 2.1 percent, I think. I grant that three-month core PCE inflation has come down off its May peak of close to 3 percent. I do take some comfort in the fact that core inflation did not remain so high, but that measure of inflation has been right about 2¼ percent for three straight months. The Greenbook forecast has it stepping up to 2.4 percent for the next six months and falling below 2.2 percent only in the second quarter of 2008. So three-month core PCE inflation is now as low as it gets for the next year and a half in the Greenbook forecast, and at the end of 2008, core inflation will have been above 2 percent for five straight years. I have my doubts about the prospects for even the modest decline described in the Greenbook. The notion that slowing real growth will bring inflation down much has already been heavily discounted around this table—and rightly so, in my view, given the tenuous status of the relationship between real gaps and inflation. The recent fall in energy prices may help, but relying on tame energy prices is problematic, I think. It would encourage the public to believe that we will allow core inflation to rise whenever energy prices surge. That belief is, for me, the leading hypothesis explaining the run-ups in core inflation that we saw last fall and earlier this year. We are likely to see some significant swings in energy prices in the years ahead. So help from this direction is by no means certain. More broadly, I believe we should be leery of letting a relative price move core inflation around. There was a lot of discussion at our last meeting about the state of inflation expectations, and a number of people pointed to evidence that market participants did not seem to believe we intend to bring inflation down to the center of the 1 to 2 percent range. This is confirmed by the Bluebook, which provides a very useful compilation this time from various sources of market expectations for core PCE inflation, and they are all clustered around 2¼ percent. If the Greenbook forecast is realized and core inflation gradually comes down to 2.1 percent over the next two years, it’s hard to believe these expectations would fall much. So with core inflation running around 2¼ percent and not likely to come down much soon and with expectations apparently settled at about the same rate, I’m deeply concerned about inflation. Thank you." CHRG-110shrg46629--127 Chairman Dodd," Have they done that? That is good to hear. Let me turn to Senator Shelby for one question. I have one additional one after his and then we will complete the hearing. Senator Shelby. Thank you. Chairman Bernanke, GSE reform. We have talked about this before. This Committee has been interested in strengthening the regulatory system for the housing related Government Sponsored Enterprises for a number of years. The House recently, as you are probably aware, considered language giving the new proposed regulator the ability to regulate the size and the growth of the enterprise portfolios and charged the regulator to consider risk of the portfolios. However the language, which was amended on the House floor, I understand, which passed in the House, limited the risk consideration to only risk to the enterprises. Would you view this language, as it was passed by the House as amended on the floor, with what bank regulators have over financial institutions? That is do you consider, as a regulator, only the risk to a particular financial institution? Or do you look at the portfolio? Do you look at other things? The portfolio your predecessor, Chairman Greenspan, says right here in this Committee and I believe you have reiterated that there is risk there in that portfolio, possibly to the taxpayer. Would you comment on this? " FinancialCrisisInquiry--448 BASS: Sure. First of all, I’ll—in the interest of full disclosure, I was a senior managing director at Bear Stearns for five and-a-half years from 1996 to 2001. So a lot of the people at that firm are very good friends of mine. And a lot of the people that ran the firm are very good friends of mine. In—in September of 2006, I went to Bear Stearns to meet with a guy named Bobby Steinberg, who at the time was their chief risk manager at the firm. He congregated a meeting in a conference room at their headquarters for me with the head of mortgage trading, the head of fixed income trading, the head of mortgage risk, fixed income risk and himself. And I went through my entire presentation as to what I saw building in the housing market where I— where I thought mortgage credit was going to go. And—and—and, you know, a couple points that I’ll make. Someone—someone in this morning’s hearing said did you ever contemplate housing prices ever dropping. They didn’t even have to drop for losses to show up. OK? If housing prices just went flat, they would have lost 9 or 10 percent on these securitizations, which would have wiped out everything up to close to the AAs. So to put it into perspective, I—I went through my presentation with their risk committee and said do you realize that if I’m right—and— and by the way, I’m one data point from Dallas, so I realize that they can discount what I had to say. But the presentation’s fairly compelling. If I’m right, do you realize what’s going to happen to this firm, knowing how—the firm’s position? And he said-- he said, Kyle, you worry about your risk management, and we’ll worry about ours. And that was the last time I spoke with them. Again, it’s—it’s one data point. And with regard to the Federal Reserve, I met one of President Bush’s staffers and—and went through it with him. And he suggested I go talk with the Federal Reserve here in D.C. And I met with one of the Federal Reserve board members and went through my— my presentation again, just a data point from Dallas—meeting at the Federal January 13, 2010 Reserve here in D.C. It’s—it’s not a large data point. However, their answer at the time was—and—and this was—this was also the thought that was—that was homogeneous throughout Wall Street’s analysts—was home prices always track income growth and jobs growth. And they showed me income growth on one chart and jobs growth on another, and said, “We don’t see what you’re talking about because incomes are still growing and jobs are still growing.” And I said, well, you obviously don’t realize where the dog is and where the tail is, and what’s moving what. But again, it was my opinion which, you know, they intended—or they—disregarded. CHRG-111hhrg56766--10 The Chairman," I thank the gentleman from North Carolina. The gentleman from North Carolina will have 2 minutes and 10 seconds. The gentleman from Texas is now recognized, the ranking member of the Subcommittee on Domestic and International Monetary Policy, for 3 minutes. Dr. Paul. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. I am interested in the suggestion that Mr. Volcker has made recently about curtailing some of the investment banking risk they are taking. In many ways, I think he brings up a very important subject and touches on it, but I think it is much bigger than what he has addressed. Back when we repealed Glass-Steagall, I voted against this, even though as a free market person, I endorse the concept that banks ought to be allowed to do commercial and investment banking. The real culprit, of course, is the insurance, the guarantee behind this, and the system of money that we have. In a free market, of course, the insurance would not be guaranteed by the taxpayers or by the Federal Reserve creating more money. The FDIC is an encouragement of moral hazard as well. I think the Congress contributes to this by pushing loans on individuals who do not qualify, and I think the Congress has some responsibility there, too. I also think there has been a moral hazard caused by the tradition of a line of credit to Fannie Mae and Freddie Mac and this expectation of artificially low interest rates helped form the housing bubble, but also the concept still persists, even though it has been talked about, that it is too-big-to-fail. It exists and nobody is going to walk away. There is always this guarantee that the government will be there along with the Federal Reserve, the Treasury, and the taxpayers to bail out anybody that looks like it is going to shake it up. It does not matter that the bad debt and the burden is dumped on the American taxpayer and on the value of the dollar, but it is still there. ``Too-big-to-fail'' creates a tremendous moral hazard. Of course, the real moral hazard over the many decades has been the deception put into the markets by the Federal Reserve creating artificially low interest rates, pretending there has been savings, pretending there is actually capital out there, and this is what causes the financial bubbles, and this is the moral hazard because people believe something that is not true, and it leads to the problems we have today because it is unsustainable. It works for a while, but eventually, we have to pay the price. The moral hazard catches up with us and then we see the disintegration of the system that we have artificially created. We are in a situation coming up soon, even though we have been already in a financial crisis, we are going to see this get much worse and we are going to have to address this subject of the monetary system and whether we want to have a system that does not guarantee that we will always bail out all the banks and dump these bad debts on the people, and that it is filled with moral hazard, the whole system is. When that time comes, I hope we come to our senses and decide that the free market works pretty well. It gets rid of these problems much sooner and much smoother than when it becomes politicized that some firms get bailed out and others get punished. It is an endless battle. Hopefully, we will see the light and do a better job in the future. " FOMC20070509meeting--80 78,MR. KOHN.," Thank you, Mr. Chairman. My outlook, like most of the rest of yours, was basically the same as the one in the Greenbook, and it hasn’t changed all that much over the past few weeks. Like the rest of you, I see income growing at less than the growth rate of potential for several quarters, the pace held down by housing and the slower growth of consumption that has become evident in recent data and confirmed by President Poole’s reports. This is offset over time by a strengthening of business spending, the end to the inventory correction that we see in IP and ISM statements, and a pickup in capital expenditures as businesses feel more comfortable that the expansion will continue and that any overbuilding they did when income growth was higher in those three or four years that President Stern was talking about has been absorbed. Like the rest of you, I see a pickup in demand to something like the growth rate of potential some time next year as housing activity adjusts to the lower level of demand and as inventory is worked off. Several favorable factors support this eventual return to potential: supportive financial conditions, especially for businesses; credit availability, which we’ve just been talking about; narrow credit spreads; low long-term rates; and good foreign demand— another upward adjustment in this Greenbook to rest-of-the-world economic growth; and the decline in the dollar—which will support exports. I used the staff structural growth of 2½ percent. It seemed to me that the adjustments the staff made were small, offsetting in participation and productivity, and looked reasonable given the recent data. There is still a tension between the labor data and having potential growth as high as it is, and it leaves the staff in a position in which labor force participation is slightly above the trend, which strikes me as where it ought to be when the unemployment rate is slightly below the NAIRU. Also, productivity is slightly below the trend, so they need faster-than-trend productivity growth just to get back to their now lower trend, which strikes me as where it ought to be after three or four quarters of below-trend growth and presumably some labor hoarding, but not that much below trend. So that looked like a reasonable assumption to me, and that’s what I used in my projection. I differ from the Greenbook in a couple of respects. One is that I had softer equity and house prices than the staff did. On the equity front—I think I said this last time—I expected equity prices to be soft, and they’re up 6 percent. [Laughter] Fortunately, I don’t back my predictions with my personal wealth. But—I’m going to hold to that prediction—[laughter] the market still seems to be building in a more rapid increase in profits than seems consistent with moderate nominal GDP growth and some rebalancing of the labor-capital share, which we may be beginning to see. Certainly, there is practically no growth at all in domestic profits in the Greenbook for ’08. Now, the market may get more from the foreign profits, as people have been saying, but I think there is potential for disappointment there. On house prices, inventories are large, and the price-to-rent ratio is still extremely high. On the demand side, I think demand is being damped by tightening in subprime and alt-A markets. On the supply side, there will be some more foreclosures, particularly as rates adjust up this year. So I presume that prices will need to drop somewhat, rather than just stay level as in the staff forecast, even to get the housing stabilization and eventual slight rebound that the staff and I included in our real GDP forecast. Now, to offset the effects of weakness in wealth from these prices, I had a slight easing of monetary policy this year, next year, and the following year—¼ percentage point each year—to get that same output. This was only a slight easing in real rates given that inflation is edging down and inflation expectations aren’t presumed to change very much. I did this in the context of what I would have as an interim inflation target of 2 percent. I think 2 percent is achievable without significant output loss: It is low by historical standards and broadly consistent with price stability and minimal welfare distortions relative to 1½ percent. I agree that a little lower might be nice eventually, but I would get there opportunistically by leaning against any increases and accepting decreases rather than deliberately going to 1½ percent. I’m skeptical about the expectations effect that might accrue from the announcement of a 1½ percent commitment. A second difference with the Greenbook is that I assumed a slightly lower NAIRU— 4¾ percent. Any point estimate is silly—we really have only the vaguest idea—but it seemed to me that the compensation data, the price data, of the past few years were more consistent with a NAIRU that was a bit below 5—and so I assumed 4¾ percent. As a consequence, I had slightly less inflation than the staff forecast—0.1 in ’07 and in ’08. So I had 2.2 in ’07 and 2.0 in ’08 and had it staying there in ’09. In some sense I thought the more interesting part of the forecast was thinking about the second moments—the skews and the probabilities around the central tendencies. I confess that for ’07 I committed the sin of thinking things were more uncertain than usual, Mr. Chairman. [Laughter] I hate it when I hear people say that." CHRG-111shrg50814--20 Mr. Bernanke," Well, we have seen a very broad-based weakness. Housing is very central. At this point, the housing market has reversed the boom that we saw earlier in the decade. In fact, we are now at levels of construction and price declines that we have not seen for a very long time, if ever, and so I would anticipate some stabilization in the housing market going forward and eventually demographic trends, household formation, economic growth will begin to create recovery in the housing market. Likewise, people are very reluctant right now to make commitments to consumer durables like automobiles. I think the current rates of auto sales are below what we will see once the economy begins to normalize. So I think those sectors will be part of the recovery. But in general, as we see confidence coming back, particularly consumer spending on discretionary items, those areas will begin to strengthen and we will see a broad-based recovery. " CHRG-111shrg57709--47 Mr. Volcker," If they get in trouble, they are going to fail, and that will make their own financing more difficult, or less easy, and presumably in itself tend to contain their leverage. So between the oversight and their natural self-protective instincts, hopefully, knowing that they are not going to be saved, we reduce the chance of crisis. Senator Shelby. Dr. Volcker, one of the President's recent proposals is a limit on consolidation in the financial sector. In particular, the President proposal would, to quote from a White House press release, quote, place limits on the excessive growth of the market share of liabilities at the largest financial firms to supplement existing caps on the market share of deposits. Along those lines, I have three questions. First, could you elaborate on what constitutes excessive growth and on what particular liabilities restrictions will be imposed there? In other words, what would excessive growth be? This is important. " CHRG-110hhrg34673--142 Mr. Bernanke," I would like to see a bill. I think we need to have a strong regulator in this arena, and we need to find some way that we can limit the growth of the portfolios. As a practical matter, I think that restricting portfolios to mortgages related to affordable housing might be an appropriate compromise and an appropriate approach that would provide some limitation, but the Federal Reserve has always been concerned about the size of portfolios. It never has found a substantial benefit to homeowners from large portfolios. " CHRG-111shrg55117--71 Mr. Bernanke," Well, from the Federal Reserve's perspective, we have basically a two-pronged approach. One is to work with banks to work out commercial real estate projects which are no longer performing, in very much the same spirit as we have work-outs for residential mortgages that are not performing. There, as with residential mortgages, there is an incentive to do that if the costs of foreclosure are sufficiently high. I think one slightly positive thing is that I don't think that commercial real estate experienced quite the increase in prices or the bubble component that housing did, but nevertheless it is still under a lot of pressure. The second element of our program is the TALF, which now also will allow borrowing from the Treasury's PPIF program also to come in and buy CMBS through the TALF. Whether Congress wants to take additional steps, you know, you could intervene with guarantees or other kinds of support that would have fiscal implications. It would mean the Government was bearing risk. So I haven't really seen a full-fledged proposal and I would be somewhat reluctant to strongly endorse one. I think really the Congress has to make those tradeoffs between the fiscal cost, the fiscal risk, and what is, I will agree, a very real risk on the side of foreclosures and problems in commercial real estate---- Senator Menendez. As I talk to this industry, Mr. Chairman, they tell me that at least presently, there isn't--they seek the private marketplace. They are not really seeking the Government. But there isn't a private marketplace, certainly not in a sustainable way, for what is coming down the road. And so the question is, do we wait again for the crisis to happen, or do we anticipate where it is headed and seek to stem it because otherwise we have significant risk to our economy. I am just wondering, do you think that what you have today as tools is sufficient to meet that challenge in the days ahead or not? " FinancialCrisisReport--246 CDO securities, delaying thousands of rating downgrades and allowing those securities to carry inflated ratings that could mislead investors. 4. Failure to Factor in Fraud, Laxity, or Housing Bubble. From 2004 to 2007, Moody’s and S&P knew of increased credit risks due to mortgage fraud, lax underwriting standards, and unsustainable housing price appreciation, but failed adequately to incorporate those factors into their credit rating models. 5. Inadequate Resources. Despite record profits from 2004 to 2007, Moody’s and S&P failed to assign sufficient resources to adequately rate new products and test the accuracy of existing ratings. 6. Mass Downgrades Shocked Market. Mass downgrades by Moody’s and S&P, including downgrades of hundreds of subprime RMBS over a few days in July 2007, downgrades by Moody’s of CDOs in October 2007, and actions taken (including downgrading and placing securities on credit watch with negative implications) by S&P on over 6,300 RMBS and 1,900 CDOs on one day in January 2008, shocked the financial markets, helped cause the collapse of the subprime secondary market, triggered sales of assets that had lost investment grade status, and damaged holdings of financial firms worldwide, contributing to the financial crisis. 7. Failed Ratings. Moody’s and S&P each rated more than 10,000 RMBS securities from 2006 to 2007, downgraded a substantial number within a year, and, by 2010, had downgraded many AAA ratings to junk status. 8. Statutory Bar. The SEC is barred by statute from conducting needed oversight into the substance, procedures, and methodologies of the credit rating models. 9. Legal Pressure for AAA Ratings. Legal requirements that some regulated entities, such as banks, broker-dealers, insurance companies, pension funds, and others, hold assets with AAA or investment grade credit ratings, created pressure on credit rating agencies to issue inflated ratings making assets eligible for purchase by those entities. FOMC20051213meeting--38 36,MR. SANTOMERO.," David, could you give us a risk assessment on your consumer spending forecast? In 2006 and 2007, you have consumer spending growth of 3½ percent, while the housing December 13, 2005 18 of 100 with that forecast? You made reference to it in the formal comments, but I wonder if you are quite comfortable with the forecast or a little uncertain about it." CHRG-110shrg50409--97 Mr. Bernanke," There have been similar episodes in the U.K. and Australia, for example. But it is hard to draw strict analogies. One reason is that the financing systems are different in the different countries. Clearly, in this case, the high loan-to-value subprime adjustable rate mortgages, those sorts of instruments were particularly sensitive to the decline in house prices that we saw, and the effects, therefore, on credit quality and on bank balance sheets were stronger. So there are other examples, and we have looked at those. Most of them suggest, which is something which I am sure we are all happy to hear, that eventually the new equilibriums is established, the housing market comes back into balance, and the negative effects of that are ended, and you begin to see more stable growth again. I am sure that will happen here, but there is not an exact analogy. Senator Bayh. Well, along those lines--and I know you are reluctant to offer advice to the legislative branch of Government, but I am sure you have followed the bill that passed out of the Senate last week. Going over to the House, there may be some marginal adjustments, but probably not more than that. Is there anything else we should be looking at doing here in a timely fashion to address the housing challenge that has not been included in this legislation? " FOMC20061212meeting--96 94,MS. BIES.," Thank you, Mr. Chairman. I thought I’d start today talking a bit about housing markets and the condition of banks right now. As many of you have noticed, some of us are optimistic that we may be approaching a bottom in the housing market. I think we’ll see that bottom in housing sales long before we see it on the construction side because there’s a large amount of inventory still to work through. But as we’ve noted, the applications for purchasing mortgages have been level since midyear. The growth in mortgage credit has slowed significantly from where it was in the past two years, dropping to only 10 percent growth this past quarter, a growth rate that is significantly above the growth of personal income and that most of us in the past would have considered to be alarming. Part of what’s amazing in all of this is that in 2004 and 2006, particularly toward the end of that period, purchase money seconds, by which people borrowed the downpayments for homes, were a big part of mortgage financing. Banks are still getting some of this business and putting it on their balance sheets, and it is part of the growth of what you’re seeing the banks funding. But it is at a pace that I think needs to be adjusted. I’m saying that, although the number of applications may have bottomed out, the amount of leverage in each housing deal may still need some correction going forward, and so we may see some slowdown in the volume of dollars that are funded through mortgage lending. Delinquency rates are really, really low by historical standards. The one sector that has had a jump in delinquencies is subprime ARMs, and clearly the jump is related to rates that have already reset. We’ve got more to come. Even though these have jumped, they’re still not at alarming levels. But it’s something that I think the banks are watching very, very carefully. One thing I’m hearing more from some folks who have been investing in mortgage- backed securities and maybe in some CDOs (collateralized debt obligations), where they’ve been tranched into riskier positions through economic leverage, is the realization that 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. I’m hearing this from folks who understand that the quality of what goes into those pools varies tremendously when you don’t have the Fannie Mae and Freddie Mac framework for the underwriting. When a mortgage is originated through a bank, we do a lot through safety and soundness supervision to make sure, if a bank is buying loans from brokers, that the loans are underwritten in a sound manner and are therefore affordable to the borrower when they’re undertaken. We’re seeing that some of the private-label mortgage-backed securities are having very high early default rates or delinquencies in the mortgages, which usually means that the originator has to buy them back out of the pools. There isn’t a whole lot of transparency in the disclosures around some of these bonds, and some of the brokers are underwriting products that have very high early default rates, which is something that investors are starting to focus on. As more products are generated outside the banking sector, they get funneled to pools through broker-dealers as opposed to the banks. I think that we’re missing a level of due diligence regarding brokers, who may not be doing a good job. As you all know, the fraud rate on mortgages has tripled in the past two years. So I think we could see noise in some of the mortgage-backed private deals and some of the riskier CDO economic leverage positions. Bank earnings are really, really strong overall, especially by historical standards. Banks are making a lot of layoffs connected with the mortgage business. They are taking steps to get costs—whether related to originations, post-loan closings, or payoff administration—under control. Net interest margins, however, continue to be under significant pressure. I’m hearing more from banks that, since we’ve stopped raising rates, they’ve lost the nice little lag effect— the ability to wait for us to move before lagging along. In other words, they have lost that lagniappe in their liability cost that has helped them with their margin pressures. So those pressures are going to be more of a challenge for them, especially with a flat or inverted yield curve, depending on where they’re funding and lending. Loan-loss provision continues to be the best in many, many years. No one really expects it to jump, but clearly it can’t get a whole lot better than it is, and so that will also present challenges going forward. As for the economy as a whole, I, too, want to compliment President Yellen because I think she did a fantastic job of helping us think about the different signals we’re getting. When I looked again at the graph that I love in the Greenbook that shows where our forecast has been, I was struck that we’ve seen the forecast of GDP growth continuing to moderate in the past several months but our expectations of inflation are actually flat to up a bit. To me that raises questions about the tradeoff that we really have when we are running below capacity and below potential growth rates. The bit of softness that I’m hearing about from some of my contacts in sectors outside housing and mortgages warns me that we need to be a little more vigilant than I had been expecting about growth maybe softening in a broader sense. But the fact that inflation continues to be above 2 percent in the forecast period is something that does concern me, and I think part of my concern relates to the tremendous amount of liquidity that sits out there in the banking sector, in the U.S. financial markets, and clearly globally. The presence of this liquidity is something that we really need to think about. It’s not back to where it was in my money supply days, when I started my career at the St. Louis Fed; but I do worry that liquidity is, as some of you have said, causing a lot of transactions to occur that economically perhaps wouldn’t otherwise occur. That is also something we need to watch very carefully." CHRG-110shrg50415--64 Mr. Levitt," Sometime over the course of the past 2 years, 3 years. I will get back to you with the specific time of that. But so much of what the SEC does, as I said in my statement, is the sending of signals, the speeches given, not the rules that are passed. And those signals simply have not been sent. Shareholder access to the proxy, a terribly important issue. It has been bubbling around for 10 years now, and the Commission failed to act. A non-binding shareholder vote on executive pay, again, bubbling around for some years. The Commission did not act. Over and over and over again, the message was sent that this Commission is not an investor-friendly Commission. I do not think this is a question of authority except with respect to such issues as derivatives. There clearly we are in an unregulated area, and a lot of us were responsible for not calling attention to this early on. There is more I could have done while I was there, and the condition grew worse and worse and worse. I do not believe this is a question of giving the SEC authority that they lack. I think it is a question of the SEC properly utilizing that authority, reinvigorating their Enforcement Division, which has been demoralized by a variety of factors. Giving them more cops on the beat, allowing them to send a message which only they can send that they truly are the investor's protector. Senator Brown. Thank you, Mr. Levitt. One last question, Mr. Chairman, if I could. The 40,000 angry e-mails and letters and calls I received told me--and they have said it repeatedly--that this is not a natural disaster, this is a man-made one. I would guess, I would say likely, that most of the 40,000 believe that some of this behavior was illegal. There seems to be certainly no self-imposed accountability. Mr. Ludwig, while we do not really know the facts yet, do you think the architects of this disaster might be held accountable by the law? " FOMC20070509meeting--82 80,MR. KOHN.," So here is my reasoning. I thought that the average includes lots of episodes of more or less steady growth in steady state and then other episodes of cyclical adjustments. In my mind, we were in the middle of a kind of mini-cycle, which was an adjustment from greater-than-sustainable growth to growth that we hope is sustainable. We’ve seen that the adjustment had already created some inventory overhangs and some changes in capital spending plans. So I thought that, because we’re not at a steady state, things might be a little more uncertain than usual. But I compensated for that by narrowing my confidence bands in ’08 and ’09 [laughter] when I think we’ll be close to a kind of a steady state. On the skews part, like President Geithner, I had downside skews on output. It wasn’t so much housing because I think that, with the adjustment to demand or activity that’s in the staff forecast and my own adjustment to prices, the risks around that are approximately balanced. Nor was it a spreading of problems in the subprime market to other credit markets; I think we’ve seen enough since the subprime problems started to be pretty sure that the risk is no more than the normal kind. Rather, the risk I saw was from concerns about the financial position and the psychology of the household sector and the interaction of those with housing. So it was a spillover in some sense from housing to consumption. The financial obligations ratio is very high. Households, as President Geithner noted, are highly leveraged. One of the surprises to me in the development of subprime markets was apparently how many borrowers and lenders were counting on the future appreciation in houses just to support the debt service, to say nothing of the consumption that must be going on at the same time. I suspect that this is more widespread than just the subprime market. How many households were expecting price appreciation to continue more as it did before rather than to slow down or even for prices to decline (as I think they will), it’s hard to say. But I suspect there are a lot of these households, and I think we could get some feedback there. The staff has the saving rate actually declining in the second and third quarters, and there might be some technical reasons for that. Even to get modest consumption growth, we see a very gradual uptrend in the saving rate over time. That might be the most likely outcome, but it did suggest to me that there is at least some fatter tail on the possibility that households, seeing what’s happening in the housing market and to their financial obligations, will draw back more quickly from spending. When President Geithner and I were in Basel, the most popular question to us was whether capital spending would really pick up again. A number of central bankers doubted that that could happen as long as consumption wasn’t growing more rapidly. But I’m comfortable with the capital spending pattern so long as the consumption pattern looks something like the pattern in the Greenbook and like the one that I have as my most likely outcome. More generally, as you pointed out at one point last fall, Mr. Chairman, I think we’re in a very unusual situation of below-potential growth for an extended period—a situation that is pretty much unprecedented without breaking out one way or another. Some nonlinearity is going to come up and bite us here, and, as I see it, the nonlinearity is most likely in the household sector. Now, if income proceeds along the expected path, it seems to me that there are upside risks to inflation moving down to 2 percent and staying there in our forecast. I think that overall we’re facing a more difficult inflation environment than we have for the past ten years or so: the high level of resource utilization; rising import prices from the decline in the dollar and the high level of demand relative to potential supply globally, including in the emerging-market economies—one thing we heard in Basel was that increasing numbers of these economies are having trouble sterilizing their reserve accumulation and are running into inflation pressures from that happening—higher prices for energy, food, and other commodities; higher headline inflation; and possibly even slower trend productivity growth. I didn’t see a downside skew to any of these things. But, as I thought about the whole picture with all these things seeming to tilt a bit on one side and their interaction, it seemed to me that there was some upside risk to the possibility that inflation expectations would rise rather than stay where they are as assumed in my most likely outcome. Now, for policy purposes, I would weight the upside risk to inflation more than the downside risk to growth, but we’ll get to that later in the day. Thank you, Mr. Chairman." FOMC20050630meeting--134 132,MS. BIES.," May I say something here? I don’t have any quantitative studies on this, but based on talking to the folks who lived through it, I’d make a couple of observations. If we look at the 1980s—the most recent housing bubble that was nationwide. We saw the bubble bursting nationally as opposed to the pockets we’ve had with the California breakdown or the Boston breakdown, which really related to the local economies and local employment developments. I think the local economic employment situations were the drivers of delinquencies, and the regulators generally missed that because they missed the local economic impact. And I think people focus on the fact that those cycles were driven by local economic conditions. I think the period of the 1980s involved a broader failure on the part of supervisors. If we compare the 1980s experience with what is happening now, in the earlier period a lot of financial institutions were on an exam cycle that went five or six years. So, nobody on the supervisory side was in there looking at what was going on. And that period was before the time when securitization became a prevalent practice, so most of the risk was carried on the books of the banks. Also, many of the banks that were hit very badly were following developers—going out of their footprint and June 29-30, 2005 46 of 234 banks is that while we say they are diversified geographically, many of their loans are to investors or purchasers of second-home resort properties. So, the lenders again are following their customers out of the local area, and in the location of the new property the local lenders aren’t looking at it; the customer’s lender is handling the transaction. So, we still may have that risk embedded within the financial institutions. It’s one of the things we’re focusing on. What is new about it this time, though, is that a lot of these nonconforming products are being securitized by the private sector. So the real question is: Where does the market discipline kick in? And as supervisors, can we fault an institution for responding to a market need when it is offloading the loans and the risk into these types of mortgage structures that Andreas has been describing? We clearly could if the financial institutions were buying the equity or mezzanine risk tranches and the risks were back on the institutions’ books. But in many cases that clearly isn’t what is happening. So, we have some different aspects this time around. Just to let everybody know, the OCC [Office of the Comptroller of the Currency] and the Fed currently are putting together a horizontal review to look at the fringe kind of lending activities where we do need to send some signals. We wrote the HELOC [home equity line of credit] guidance that came out last month. We’re working on this other one and hope to have it out in a couple of months. We don’t want to turn off safe loans or the traditional types of lending activities, but we need to figure out where to go on some of these practices that are on the fringes. But we haven’t done a sterling job. I think that’s why we’re trying to send out some guidance. We sent out the appraisal guidance a year or so ago. But some of the risky practices of the past are starting to be repeated, and it may be that the generation of lenders now didn’t live through the problems before." FOMC20060629meeting--95 93,MS. YELLEN.," Thank you, Mr. Chairman. The staff presentations make abundantly clear that most of the data we have received since we met in May have been disappointing in one way or another. Recent economic activity appears to have been quite a bit weaker than expected, as exemplified by the Greenbook, which shows a significant downward revision to 2 percent growth in the current quarter and a noticeable downward adjustment to 2¾ percent in the second half of this year. However, in view of the possibility that labor and product markets may have moved a bit beyond full utilization, as well as the recent high readings on core inflation, a period of growth a bit below potential could be seen as necessary to prevent a buildup of underlying inflationary pressures. Under the assumption of one more funds rate increase at this meeting, it seems reasonable to me that growth will remain somewhat below its potential rate, that the unemployment rate will gradually trend upward to slightly above the NAIRU by the end of next year, and that core inflation will gradually move down toward my comfort zone. If things work out that way, I suppose the outcome would be nearly optimal, given that we are starting from an undesirably high inflation figure in the second quarter. My concern is that it is very difficult at this stage to rule out a much less desirable scenario in which the lagged effects of our earlier reactions restrain activity more strongly and more persistently than we now expect. We might also see further financial disruptions as a consequence of investors’ increased risk aversion, which is the bearish possibility that Dino described earlier. In other words, the question is whether the large surprise in the second quarter will be followed by a series of similar surprises later this year. I am concerned about downside risks to the real outlook, especially until we can better gauge the magnitude of the repercussions from the weakening in housing markets that now clearly is under way. The data on core inflation in recent months present the opposite concern, having been higher than expected and pushing core inflation slightly above my comfort zone over the past year. This raises the possibility that we are making systematic errors in our understanding of the fundamental forces driving inflation. The key question is whether the necessary decline in inflation requires more action from us or whether inflation is being pushed up by temporary factors that will dissipate on their own. The Greenbook, I think quite reasonably, shows core inflation edging down over the next year and a half as the effects of several temporary factors abate. One possibility in this regard is that there has been a modest pass-through from energy-price increases to core inflation and that these effects will dissipate if energy prices stabilize at today’s elevated levels. Moreover, part of the recent uptick traces to large increases in housing costs that are finally showing up in the CPI just as the housing market is slowing. As David noted in his briefing, the CPI measure of changes in housing prices for owner-occupied housing reflects movements in market rental rates rather than house prices and interest rates. After long being stagnant or even falling, rents are finally moving up. Perhaps with higher mortgage interest rates and lower expectations of house-price appreciation, speculative properties are being dumped into the market, and families in the market for housing are now more inclined to rent rather than buy, driving rents up and housing prices down. It certainly would not be surprising to see a return to a more normal relationship between rents and house prices. Such a phenomenon, if it is now playing out, would most likely be transitory rather than permanent, although it could play out for quite some time. Unfortunately, at this point it is difficult to tell how much of the recent rise in core inflation is temporary and how much is due to underlying inflation pressures like tight labor and product markets, which would suggest a more persistent problem for policy. I would feel more concerned were it not for the largely reassuring data on productivity, labor compensation, and profit margins. That said, the good news is all in the forecast, whereas the bad news is in the data. So I certainly can’t rule out the possibility that the increase in core inflation in the second quarter is the leading edge of a developing trend. In summary, I think the most likely scenario is a relatively benign one. However, we have had some rather large surprises in both output and inflation since we last met. It seems to me that, in the policy round coming up, the more important matters are the risks that growth could slow much more than now seems likely or that inflation could prove to be a more serious problem than I currently expect it to be or, for that matter, that both factors could come into play. It is unlikely that we will be able to sharpen our assessment of these risks very much until more time passes and more data become available." FinancialCrisisReport--197 Resisting FDIC Advice. During the period 2004-2008, internal FDIC evaluations of Washington Mutual were consistently more negative than those of OTS, at times creating friction between the two agencies. OTS also resisted the FDIC’s advice to subject WaMu to stronger enforcement actions, downgrade its CAMELS rating, and solicit buyers for the bank. As early as 2005, the FDIC examination team expressed concerns about WaMu’s high risk lending strategy, even though the bank’s management expressed confidence that the risks were manageable. In an internal memorandum, for example, the FDIC team identified multiple negative impacts on WaMu’s loan portfolio if housing prices were to stop climbing. The memorandum stated in part: “Washington Mutual Bank’s (WMB) single-family residential (SRF) loan portfolio has embedded risk factors that increase exposure to a widespread decline in housing prices. The overall level of risk is moderate, but increasing. … A general decline in housing prices would adversely impact: a) The SRF loan portfolio; b) The home equity loan portfolio; and c) Mortgage banking revenue. … In January 2005, management developed a higher-risk lending (HRL) strategy and defined company-wide higher-risk loans as … sub prime loans … SFR loans with FICO scores below 620, … consumer loans with FICO scores below 660, and … [the] Long Beach … portfolio. Management intends to expand the HRL definition and layer additional risk characteristics in the future. … Management acknowledges the risks posed by current market conditions and recognizes that a potential decline in housing prices is a distinct possibility. Management believes, however that the impact on WMB would be manageable, since the riskiest segments of production are sold to investors, and that these investors will bear the brunt of a bursting housing bubble.” 752 751 See, e.g., April 16, 2010 Subcommittee Hearing at 61 (testimony of OTS Director Reich: “[F]irst of all, the primary regulator is the primary Federal regulator, and when another regulator enters the premises, when the FDIC enters the premises, confusion develops about who is the primary regulator, who really is calling the shots, and who do we report to, which agency.”) 752 Undated draft memorandum from the WaMu examination team at the FDIC to the FDIC Section Chief for Large Banks, FDIC-EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005). In an interview, when shown the draft memorandum, FDIC Assistant Regional Director George Doerr, who was a member of the WaMu examination team, told the Subcommittee that this type of analysis was prepared for a select group of mortgage lenders, including WaMu, to understand where the mortgage market was headed and how it would affect those insured thrifts. He did not have a copy of the final version of the memorandum, but said the FDIC’s analysis was discussed with OTS. Subcommittee interview of George Doerr (3/30/2010). FOMC20070807meeting--67 65,MR. HOENIG.," Mr. Chairman, the Tenth District economy overall continues to perform well, with strength in energy and agriculture partially offset by the weaknesses in residential construction. Developments since the last meeting include some softening in District manufacturing activity similar to that shown in the July ISM survey numbers and in other regional Reserve Bank indexes. We have also seen a slowing in overall employment growth. In contrast, consumer spending seems to be holding well in spite of higher gasoline prices. Indeed, reports from District directors and business contacts indicate a strong summer tourism season with increased air traffic and higher hotel occupancy rates throughout the western part of our region. The recent slowing in District employment growth has been somewhat surprising to us, given the activity in much of our region. Since the beginning of 2004, District employment growth has been running around 2 percent, and in the past few months has slowed to about 1½ percent. Geographically, the slowdown has been most notable in Wyoming, New Mexico, Colorado, and Oklahoma, and anecdotal information suggests that the slower growth is due more to a shortage of skilled and semi-skilled labor than to any weakening in demand. This anecdotal information is supported by new regional information on employment costs by the BLS. According to them, recent employment cost increases in these states have been well above increases nationally and in other parts of our region. Construction activity remains mixed, with weakness in residential construction offset to some extent by strength in commercial construction. Just an aside, when you talk about things that are on the horizon, we are a little concerned about commercial real estate because it is very hot right now and there is a fairly large portion of it on the books of the banks in our region. On the residential side, there is considerable variation across our region. In some areas where energy and agriculture are strong, housing activity is actually above normal. In other parts of the District, however, both national and local developers are experiencing the most difficult conditions in some time. In most District metro areas, inventories of unsold homes continue to rise, but the rate of increase has diminished somewhat in recent months. Turning to the national outlook, data released since the last meeting support the view that growth will pick up over the year. Compared with the Greenbook, I am more optimistic about both the near-term outlook and longer-run growth. Specifically, I think second-half growth is likely to be around 2½ percent. Growth in 2008 and 2009 is likely to be near potential, which we estimate to be around 2¾ percent. Housing obviously constitutes the major downside risk to growth over the next few quarters. I am not yet convinced, however, that recent financial market volatility and repricing of credit risk will have significant implications for the growth outlook. It is still reasonable at this point to think that the recent volatility will prove transitory, and the repricing of credit risk is, in that sense, desirable. I am also encouraged by the results of the July senior loan officer survey, which suggests no general tightening of bank credit conditions. Like the Bluebook, I think that Treasury yields are likely to move back up once the markets feel more comfortable about the state of the economy and credit conditions and realize that policy easing is not likely to be forthcoming. Although weakness in housing and tighter credit conditions have increased the downside risk to output, I believe that strength in consumer spending, exports, and government spending will help maintain moderate growth in the period ahead. With regard to the inflation outlook, recent data on core CPI and PCE continue to be favorable. However, I am expecting some pass-through of higher energy prices to temporarily boost core measures over the second half of this year. In addition, pressures from resource utilization and slow productivity growth remain. Thus, despite recent improvements, I continue to believe that some upside risk to inflation remains. Thank you." CHRG-111hhrg53240--105 Chairman Watt," Press that button and pull it close to you. Ms. McCoy. Chairman Watt, Ranking Member Paul, and members of the subcommittee, thank you for inviting me here today to discuss restructuring financial regulation. Today I will testify in support of the Consumer Financial Protection Agency Act of 2009. This bill would transfer consumer protection and financial services from Federal banking regulators to one agency dedicated to consumer protection. We need this to fix two problems: first, during the housing bubble, fragmented regulation encouraged lenders to shop for the easiest regulators and laws; and second, banking regulators often dismiss consumer protection in favor of the short-term profitability of banks. Under our fragmented system of credit regulation, lenders could and did shop for the easiest laws and regulators. One set of laws applies to federally chartered banks and thrifts and their operating subsidiaries. Another set of laws applies to independent nonbank lenders and mortgage brokers. Because lenders could threaten to change charters, they were able to play regulators off one another. This put pressure on regulators, both State and Federal, to relax their standards and enforcement. Countrywide, for example, turned in its charters in early 2007 in order to drop the OCC and Federal Reserve regulators and to switch to the OTS. The result was a regulatory race to the bottom that only the Fed had the power to stop. During the housing bubble, three of the four Federal banking regulators--the Federal Reserve, the OCC, and the OTS--succumbed to pressure to loosen loan underwriting standards and safeguards for consumers. Today I will focus on the Fed. Under Chairman Alan Greenspan, the Federal Reserve Board failed to stop the mortgage crisis in thee crucial ways: First, the Federal Reserve was the only agency that could have stopped the race to the bottom. That was because it had the ability to prohibit unfair and deceptive lending for all lenders nationwide under the Home Ownership Equity Protection Act. But Chairman Greenspan refused to exercise that authority. The Fed did not change its mind until last summer when it finally issued such a rule. At that point, the horse was out of the barn. Second, the Fed as a matter of policy did not do regular examinations of the nonbank subprime lenders under its jurisdiction. These included the biggest subprime lender in 2006, HSBC Finance, and Countrywide ranked number three. Finally, the last time the Fed did a major overhaul of its Truth in Lending Act mortgage disclosures was 28 years ago, in 1981. With the rise in subprime loans and nontraditional ARMs, those disclosures became solely obsolete. Nevertheless, the Fed did not even open a full review of its mortgage disclosure rules until 2007, and it still has not completed that review. So why did the Federal Reserve drop the ball? One reason was its overriding belief in deregulation. Another, however, was an attitude that a good way to improve bank safety and soundness was to bolster fee income at banks. We still see that today with respect to rate hikes with credit cards still going on. This focus on short-term profits not only hurt consumers, it undermined our Nation's financial system. The Act would fix these problems in three ways: first, it would stop shopping by providing one set of consumer protection rules for all providers nationwide; second, the Act puts the authority for administering those standards in one Federal agency whose sole mission is consumer protection. We are asking the Fed to do too much when we ask it to excel at four things: monetary policy; systemic risk regulation; bank safety and soundness; and consumer protection. Housing consumer protection in a separate agency in fact will provide a healthy check on the tendency of Federal banking regulators to underestimate risk at the top of the business cycle. Finally, to avoid any risk of future inaction by the new agency, the Act gives backup enforcement authority to the Fed and other Federal banking regulators in the States. My time is up. Thank you and I will welcome any questions. [The prepared statement of Professor McCoy can be found on page 161 of the appendix.] " FOMC20060808meeting--50 48,MS. YELLEN.," Thank you, Mr. Chairman. So far the economy has stuck pretty close to the script of the soft landing sketched out in the June Greenbook. Real GDP growth slowed markedly in the second quarter. Housing construction has declined sharply, and house prices have decelerated; this situation suggests that our policy actions have taken hold in this interest-sensitive sector. The recent sharp rise in oil prices should also put a damper on growth of real income and consumer spending. Most forecasters now expect below-trend growth in the current quarter. Nonfarm payroll employment has shifted down to a more-sustainable pace, and the unemployment rate has risen to 4.8 percent, just a bit below standard estimates of the NAIRU. Core inflation, although uncomfortably high, came in 0.2 percentage point below the June Greenbook’s forecast in the second quarter. In addition, despite further large increases in the price of oil, inflation expectations held firm. In light of these developments, a reasonable forecast is for growth to continue to run slightly below its potential rate, the unemployment rate to edge up, and core inflation to recede gradually. At our last meeting, I laid out some of my concerns about downside risks to the outlook for growth and upside risks to inflation. Quite honestly, I cannot say that the recent data have done much to assuage my angst on either account. The recent falloff in housing activity and the deceleration in house prices have been faster than expected. The current Greenbook has residential investment falling at an annual rate of 14 percent in the second half of this year, nearly twice as fast as projected in June. These surprises intensify the risk of a sharper slowdown as the lagged effects of our past policy actions come fully into effect. For example, the housing slowdown could become an unwelcome housing slump as envisioned in one of the Greenbook alternative scenarios. A large homebuilder in our District summarized the views of many of our contacts when he recently commented that “the housing market has not yet popped, but a hissing sound is now clearly audible.” [Laughter] He pointed to rapidly rising cancellations as a particularly ominous sign. I will be watching the incoming data closely for signs as to whether the housing slowdown remains orderly as hoped or takes a steeper downward slide, posing a greater risk to the economy. My concerns about inflation have also been somewhat heightened by the recent data or, more precisely, revisions to past data. Core measures of inflation continue to be well above my comfort zone. Of course, after the experience of last year, when core inflation was revised up by a considerable amount, I approached this year’s annual NIPA revision with some considerable trepidation. I was relieved to see that the core PCE price inflation data came out of the revision relatively unscathed, revised up just 0.1 percentage point for 2005; but other aspects of the report were somewhat less reassuring for the inflation outlook. First, the rate of labor productivity growth over the past three years has been a bit slower than we thought, primarily because of downward revisions to the rate of capital accumulation, so that the Greenbook now projects structural productivity growth of 2.7 percent, about ¼ percentage point slower than we thought back in June. This revision suggests somewhat less downward pressure on inflation emanating from cost reductions and, therefore, greater upside risks to inflation. But that wasn’t the only surprise tucked away in the annual revision. The upward revision to compensation growth over the past four quarters implies that growth in unit labor costs over the past year has been more rapid than we had believed. I had thought that there was a good chance that compensation per hour and unit labor costs would increase relatively moderately going forward, helping to contain inflationary pressures. The data revision was thus a bit of a wake-up call for me, and I have revised upward my views on the outlook for compensation and unit labor costs. My reading of the report is that the revised data provide a clearer and less sanguine picture of the trend in this measure of compensation. However, the employment cost index was in line with expectations in June and continues to show moderate growth. Moreover, even with revisions to productivity and compensation, the markup in the nonfarm business sector remains very high by historical standards, suggesting that firms do have room to absorb costs. Overall, I view the inflation outlook as highly uncertain, with a pronounced upside risk. As I mentioned at the last meeting, we just don’t have a good handle on why core inflation has risen of late or how persistent this rise will be. While it is comforting to attribute the increase to energy and commodity-price pass-through, empirical evidence suggests that pass-through effects have been quite modest since the mid-1980s. If so, the door is open for other explanations that may have a more lasting influence and require a more aggressive policy response. Something that makes me even more uncertain about the inflation outlook is that standard backward-looking Phillips curve models of inflation appear to be breaking down. It has been widely noted that the estimated effect of resource utilization on inflation in such models has become much smaller over time. But equally striking is the finding that the sum of coefficients on lagged inflation when freely estimated appears to have fallen as well, suggesting that inflation has become far less persistent. In fact, our staff finds that, in looking over the past ten years, it is better to assume that core inflation will return to its sample average over the next four quarters than that it will remain in its recent range or follow a standard Phillips curve model. Interestingly, this decline in the persistence of core inflation has occurred at roughly the same time that long-run inflation expectations, as measured by the Survey of Professional Forecasters, appear to have become well anchored, and this may not be a coincidence. Economic models with forward-looking inflation expectations tell us that, if the central bank has credibility and holds to a fixed long-run inflation target, then inflation will be less persistent than is implied by the standard backward-looking Phillips curve model. Indeed, the puzzle for macroeconomists has been why we see so much inflation persistence. Perhaps we no longer do. If that is true, inflation may decline faster than the Greenbook expects. Admittedly, the past ten years form a relatively small sample from which to draw definitive conclusions. But the inflation process may have changed in a fundamental way, and we should be open to that possibility. I would like to stress that this evidence and the analysis concern the simple correlations of the inflation data that are used for forecasting. The evidence does not relate to structural relationships, and therefore it does not necessarily inform us about how our policy decisions affect the economy or about the best course for policy. In summary, although my modal forecast is relatively benign, I remain very concerned about risks to both growth and inflation." FOMC20080625meeting--82 80,MR. BULLARD.," Thank you, Mr. Chairman. The District economy continues to be sluggish. Severe weather, combined with a very wet spring, is hampering agriculture in some areas. Major flooding has caused significant damage already, and the situation continues to develop. Many business contacts in the District emphasize energy costs along with some other high commodity prices as an overriding concern. Most of the descriptions I have encountered concern businesses and consumers scrambling to adjust to new pricing realities. Many contacts are reporting skittishness over the inflation outlook, fueled by dramatic increases in key commodity prices. Many contacts with deep experience in the commodities markets remain convinced that market manipulation or speculation is behind the run-up in commodity prices across the board over the past several years. This belief is widespread and deeply held. Many predict a crash in market prices of these commodities once the bubble bursts. My assessment is that this very strong belief may, by itself, have important macroeconomic implications. Businesses and households may be reacting very differently to price increases that they see as temporary, as opposed to their reaction if they view price increases as permanent and unlikely to reverse. Reports on the level of economic activity are decidedly mixed. The housing sector remains in a deep slump and subject to a widespread shakeup. Business in the energy sector continues to boom. High energy prices are affecting the logistics business, which has to try to be profitable at higher prices with reduced demand. Still, a very large retailer reports brisk activity, and a large technology firm is essentially unaffected by the macroeconomic slowdown. Recent data on the U.S. economy have been stronger than forecast, keeping economic performance weak but avoiding a particularly sharp contraction. The worst outcomes stemming from financial market turmoil have failed to materialize thus far. There is, to be sure, still some potential for additional upheaval, depending in part on the managerial agility among key financial firms. However, the U.S. economy is now much better positioned to handle financial market turmoil than it was six months ago. This is due to the lending facilities now in place and to the environment of low interest rates that has been created. Renewed financial market turmoil, should it occur during the summer or fall, would not now be as worrisome from a systemic risk perspective. In addition to this lessened risk from financial markets, I see the drag from housing dissipating during the second half of the year. Most likely we will also see a moderation in energy price increases. Output growth is, therefore, likely to be moderately stronger going forward. Policy was very aggressive during January and March of this year. This was, in part, a preemptive action, insurance against a particularly severe downturn brought on by financial contagion. This was a very real possibility, but it did not materialize. This has created a situation with more stimulus in train than would have been intended had we known the outcome in advance. This is putting upward pressure on inflation and inflation expectations in the second half of this year. Policy has to turn now to face this situation. On the long-term projections, I think it is a good idea to put down long-term projections. I am happy with any of the options. I have a slight preference for option 3. I think a trial run would be good. If the objective is to name these numbers, such as an inflation target or the potential growth of the economy, another way to do it would just be to name those numbers and not have it tied to any projection or any particular year. We could just say, ""This is what I think the inflation objectives should be. This is how fast I think the economy could grow in the absence of shocks. And this is what I think the unemployment rate would be if output were growing at potential and inflation were at target."" You could just name those numbers. You wouldn't have to say five years away or ten years away, which kind of brings in new long-run factors that you might not want to get into. Thank you. " CHRG-111hhrg51698--166 Mr. Damgard," The answer to that is certainly yes, to the full extent of the law. And my only point was don't confuse speculation with manipulation. I think speculation doesn't have to be as demonized as it has been. Speculators have been pretty important to the market. I believe the CFTC has done an excellent job in determining when there is manipulation in the market. Frankly, that is why you created the agency; and that is one of its foremost goals. In my judgment, there is no evidence, credible evidence to suggest that any manipulation was taking place. They looked at it long and hard, and they looked at the speculators, and there were more shorts than there were longs in the first half of last year when we saw the bubble. " FOMC20060808meeting--138 136,MR. KROSZNER.," I think it would be odd to take out the reference to housing, given that we have mentioned it a number of times in the past. The rationale clearly says that it’s “partly reflecting” and then gives a number of factors. It is not saying that those factors are the only ones. Also, I don’t interpret this language as being simply about what happened in the past; “has moderated” is also talking about where we are—that growth is not as strong as it was. I see that language as having a forward-looking aspect to it. I think it would be very odd to take housing out, partly because it’s factually accurate, even if you take the historical view, and partly because, given our discussions around the table, we are concerned about “gradual cooling.” It is appropriate to leave the reference in." FOMC20070321meeting--214 212,VICE CHAIRMAN GEITHNER.," It is what we think. The problem with it is that, as Don said, the reference to gains in income itself is empty, and putting so much emphasis on housing as part of our forecast for growth being basically fine going forward is a little awkward. My view is the corner solutions are more attractive than the intermediate, and they are either some modified version of what we have now or a return to minimalism with a stop after “quarters.”" FOMC20060131meeting--118 116,MS. BIES.," Thank you, Mr. Chairman. When I was preparing for this meeting early last week, I was feeling very comfortable with the forecast of good growth in 2006, in the mid-3 percent range near potential, and a modest uptick in core inflation above 2 percent. As many of you have already remarked, the GDP numbers on Friday made me slightly more pessimistic, both on growth and on inflation. The surprise drop in government spending, I have full confidence will turn around. Final sales fell, however, so that all the growth that occurred in the fourth quarter came from inventory growth. Given that inventory–sales ratios continue to run at historically low levels, though, inventories should continue to be a source of growth going forward. As many of you also have noted, other indicators show much stronger performance. Initial unemployment claims, goods orders, capacity utilization, and strong corporate balance sheets—all of them effectively say that we have a strong foundation underneath this growth. The inflation numbers ticking up to 2.2 percent gave me a bit of pause. We came through two good quarters, the second and third quarters, with very low inflation; but again, the uptick shows how much variability we see around the inflation numbers quarter to quarter and warrants attention. The one area—and I want to second Dave Stockton’s remark—of main concern is the housing market. Let me talk about it a little differently from some previous comments today. When we look at the aggregate levels of debt that households have and relative prices, one of the things as an old lender I worry about is the ability to service the debt and the discretionary spending that households have. While 80 percent of mortgages are fixed rate, 20 percent are variable. Starting in 2002, we saw a jump in ARMs, taking advantage of the very steep yield curve at the time. We now are in a period when not only the fancy option ARMs, the exotic products of the past eighteen months, but also the 3/1 ARMs and the five-year ARMS that became very popular in 2002 and 2003 are repricing. If interest rates just hold where they are right now, we estimate that the monthly debt service cost is going to go up by at least 50 percent on that 20 percent of mortgage portfolios. If you look at the Greenbook, you’ll notice that the financial obligation ratio rose quite substantially in the past six months. It is now back to the peaks of 2001 and 2002, and we have a lot of mortgages still to reprice. We also know that some of these exotic mortgages don’t amortize, but they will kick in and start amortization and that will also pull cash out of discretionary spending. In an overall look at consumers, with housing and the cost of heating this winter rising, you’re beginning to see a little caution in the borrowing numbers. The drop in home equity lines of credit that I mentioned a meeting or two ago now has been sustained through the whole quarter. So we have actually seen that home equity lines outstanding that have been drawn on have dropped. Consumer credit as a whole dropped, excluding mortgage credit, and mortgage growth as a whole slowed to just over 10 percent. So households are signaling that they’re pulling back on new borrowing, not just in housing but in general. When you look at the ability of consumers to spend discretionarily out of their monthly take-home pay, these are signals we need to look at. And the rising fixed payments that they have is something, in looking at the tail of the distribution on housing market risk, that I think is important for that segment of the population going forward. The other sad thing is that this is our last meeting with the Chairman, and I just personally also want to echo some of the comments of my colleagues around the table to thank you for your leadership. I’ve been very impressed with the kind of atmosphere that I found when I joined during your tenure as leader of this institution. The integrity with which everything is done, your emphasis on the quality of ideas, and your continuing to search for new ways to look at information—because the economy is dynamic—remind us that we have to watch for new things always evolving. The collegiality with which you have led this organization has made it enjoyable for all of us to be here. And finally, as an old risk manager, I was glad to feel right at home with your approach to monetary policy. [Laughter] So thank you for your leadership. It has been a pleasure to have served with you." CHRG-111shrg57923--30 Mr. Liechty," Well, I think that for the large--when people approach the financial markets, they typically approach from the statistical perspective. Even though it is a whole bunch of individual agents interacting with each other, it is too complicated typically to really model effectively. There are some folks at Los Alamos and there is a really big simulation study over in Tokyo. I know there are IBMs involved with where they are trying to do Asian-based modeling. But typically, you have to sit back and look at aggregate summaries and model it from that perspective. Now, we have a lot of information that is already about the financial markets that is widely disseminated and we would be talking about adding additional information on top of that. I think where you start to begin to have problems or people begin to influence is if you have people all doing the same type of behaviors, so lots of people are making mortgage-backed securities and securitizing them and selling them off to pension fund, and there are lots of similar behaviors happening and then a shock comes through and everybody has to respond in a similar fashion. Then, in some sense, the model collapses down to a much simpler system because everyone is forced into a corner in the way they are going to have to behave. For the most part, I think giving more information and trying to model it is not going to have an impact, because I don't know that anybody is going to really have the ability to nudge the system one way or another. But what you hope you will find is when the system gets to a point where there, in essence, are bubbles that could be collapsing and what might trigger those bubbles, how you respond to that is going to be very carefully thought about, and is going to have to be very carefully thought about by the systemic regulator and the other regulators when they have that information. Do they want to talk to banks quietly? Do they want to make a public announcement? These are things that you are going to have to think very carefully about, and I am not prepared to lay the guidelines out right now. Senator Corker. So you are not really thinking about creating a world full of elevator music or anything. We would still have some degree of chaos in the marketplace. " CHRG-111hhrg53248--200 Mr. Meeks," Thank you, Mr. Chairman. It is good to see all of you again. My first question would be to Chairman Bernanke. It seems that every time you look at reports, we seem to be getting some early signs that if not recovering, at least the recession is bottoming out. But most of the data that we looked at is based on domestic economic trends and housing, employment, etc. But we have also seen that our economy has become increasingly dependent on a broader global economy, and in particular developing countries, which have accounted for some 75 percent of global economic growth this decade and over 60 percent of growth in U.S. exports. So my question is, how do you see trends and risk in the recovery in developing countries impacting our own recovery here at home, going back and forth? " FOMC20060328meeting--107 105,MS. MINEHAN.," Next meeting, okay. [Laughter] We’ve had a wide range of contacts in New England since our last meeting, so what I’m going to do is try to summarize five or six different things that came out as a result of this range of contacts. The first point is basically driven by the data. New England continues to grow more slowly than the nation. Actually, employment growth year over year is about a third of the pace of the nation as a whole—sort of normal, in a way. New England tends to have a slower-growing population and labor force than the rest of the nation. But the recent pace of job growth is decidedly slower than the long-run average. Nonetheless, regional businesses seem to be broadly participating in the growth of the overall economy, and even the pace of losses in manufacturing jobs seems to be slowing. Indeed, merchandise exports for the region were quite strong despite continuing manufacturing job losses, suggesting that regional manufacturers have figured out a way to enjoy some productivity growth and to keep their output relatively high. Almost all contacts have been quite upbeat about sales and revenue expectations for this year. Most state corporate tax collections have been booming, and retail sales and state sales tax revenues are at or above budget almost everywhere except Rhode Island. Rhode Island seems to be going through a kind of flattening of growth. I’m not exactly sure why. At a recent conference of regionwide Realtors, optimism was expressed by heads of state Realtor groups that, so far, home sales and prices, although they are certainly moderating, have held up fairly well. And that’s even considering the fact that in the fourth quarter of last year, sales in the Northeast, unlike for the nation, declined for both new and existing homes. But ’06 was viewed by this group as proceeding fairly well. There is some evidence of tight labor markets for certain skilled jobs. We have in one of our advisory groups a CEO of a software firm that does software and consulting services oriented toward recruitment for Global 2000 customers. She reported that their clients around the world are having difficulty hiring health care, technology, finance, and professional-level sales personnel. So she was seeing some real uptick in labor market tightness at the high end. And I must say that when you look at commercial vacancy rates, which have declined for Class A downtown and suburban space, not just in Boston but elsewhere, you seem to get the impression that maybe businesses haven’t started to hire yet but they do have plans to hire and they do have plans to hire at the high end. Finally, local measures of price growth remain quite contained, though headline CPI data indicate that the region has suffered more than the nation from high energy and utility costs, even with the quite mild winter. In assessing the reaction of contacts about cost increases, we heard a bit less complaining this time around. Maybe people have just given up complaining, or perhaps they have found ways—and I think this is probably more true than not—to offset high commodity and energy costs through rising productivity. The picture for the nation is even better than it is for New England. We, like the Greenbook authors, have been a bit surprised and pleased at the strength of the incoming data after the bump in the fourth quarter. David mentioned all the good reasons to be pleased—strong employment, solid consumer spending, not much evidence yet of a large drag from housing, solid business investment and production, very favorable financing conditions, faster growth than the rest of the world, and through it all, moderating headline and rather flat core inflation, whether you look at the CPI or the PCE, reflecting a leveling-out of energy prices and continued strong productivity growth. True, some luck has been involved, particularly the rather temperate winter weather in the Northeast, with its good news for overall energy and electricity costs. And the drop in new home sales may be a harbinger of worse to come. But the first quarter is over, and it was stronger than we expected, even allowing for a bounceback from Q4. Looking ahead, we agree with the general trajectory of the Greenbook forecast, as we have for some time. However, we have penciled in a somewhat greater effect in ’06 on growth from the expected falloff in housing—that is, an actual small decline in residential investment in every quarter this year and a related effect on consumption from a flattening of the growth in household wealth. So our GDP forecast for ’06 is somewhere between three- and four-tenths lower than the Greenbook’s, though ’07 is just about the same. We also see a smaller uptick in core inflation this year, largely because we see labor markets as having a bit more capacity than does the Greenbook, which we believe accounts for some of the moderation in wage and salary growth, at least by some measures. It may be splitting hairs to mention what in the end are small differences between Boston’s forecast and the Greenbook’s. After all, we don’t have the same number of resources in Boston focusing on making a forecast as you do here for the Greenbook. But I think we are at a point where small differences in outlook really do affect how each of us sees the policy choices. Now, what are the risks around this benign, if not rosy, outlook? Will they continue to revolve around growth that is higher than expected, prompted by a continuation of consumer strength—if, for example, housing takes less of a bite out of growth than we expect—and by financial conditions that could remain more stimulative as well? Indeed, when we look both at where we’ve been off in evaluating the outlook over the past couple of years and at our own Boston forecast, the surprises have mostly been the result of rising household wealth and a related set of very favorable financial market conditions. If these conditions continue, greater inflationary pressure than we expect could well result, given where we are in terms of resource utilization. And of course, new energy shocks are possible, given the possible geopolitical unrest and tight supply conditions. Alternatively, looking at risks on the other side, a greater-than-expected slowdown in housing, with a related larger pickup in saving rates, could put an unexpected damper on growth. Absent new energy shocks, this would act to moderate both growth and inflationary pressures more than expected. So we see housing as integral to both upside risks and downside risks. As I see it right now, the risks to the forecast appear relatively well balanced, maybe a touch to the side of inflation. That’s mostly because we’ve had a lot of recent experiences with surprises on the upside relative to growth, with rising energy and commodity prices, and overall resource capacity is hard to be very precise about. However, I really don’t see large upside inflation risks, mostly because of what we’ve seen in terms of ongoing productivity growth. It remains solid, and it continues to act as a powerful buffer. Indeed, despite the temporary drop-off in Q4, I have not seen or heard anything from my contacts that suggests the underlying business drive to be ever more productive will slow, or slow anytime soon. So although my assessment of risks has a small upside tilt and I am concerned about how expensive being very wrong on the inflation side would be, I don’t see the situation as significantly unbalanced." FOMC20070918meeting--109 107,MR. LACKER.," Thank you, Mr. Chairman. Recent information from the Fifth District, both from contacts and from our survey responses, suggests that growth in economic activity in our District has slowed in recent weeks. The survey indicates that retail sales have weakened, with big-ticket categories such as automobiles and building materials leading the way. Shopper traffic has trailed off somewhat as well. Services firms report slower revenue growth and less optimism about demand going forward. Activity in some District housing markets has slowed markedly in the past two to three weeks, and some formerly healthy markets are now showing signs of weakness. One contact in Charlotte, for example, says that sales agents there are saying the same things they were saying in Atlanta several months ago. Residential foreclosures are more widespread, though they appear to be concentrated or overrepresented among investors rather than owner-occupants. Mortgage activity has fallen off in the past several weeks, according to our contacts. While standards have tightened for marginally qualified applicants, it is reported that mortgages remain readily available for creditworthy borrowers. The CEO of a nationwide title insurance company reports that their open orders have been trending down in recent weeks. He also says that they are seeing an increase in cancellations of title insurance orders because people are applying for more than one mortgage in the current climate. In contrast, commercial real estate conditions appear generally healthy, although recent reports suggest that closer scrutiny is being given to marginal project proposals. Conditions in manufacturing also look positive, shipments and new orders continue to expand, and hiring indicators for this sector have edged higher. District price pressures remain at about the same level they have been in recent months. Let me say that, broadly speaking across our contacts, we have heard in the past week or two more reports mentioning a sense of gloom. This echoes what Presidents Pianalto and Lockhart said. On the other hand, one contact in Charlotte, who has had a lot of successful experience in real estate markets, said that compared with past crises this is a walk in the park. Maybe that is just because he has made his. It may be particular to this situation, so I don’t want to make too much of that. The national economic data that we have received since our last meeting point pretty clearly to a weaker economic outlook for real growth. The employment report is a prominent example. Slower growth in the months ahead would weigh on income growth and consumption, although the Greenbook’s outlook for income remains pretty healthy. Recent reports on housing activity have also been quite disappointing. I think the key question is the effect on the housing market and broader economic activity of the recent financial market turmoil. I won’t survey what has happened; Presidents Yellen and Rosengren and Mr. Dudley did an excellent job on that. I will just comment that it seems, broadly speaking, as if we are on a traverse from a configuration of intermediation that placed a fairly heavy reliance on fairly complicated and structured products and rating agencies’ assessments of those. It is a traverse that is obviously going more rapidly and is fraught with more peril than the path that took us to the configuration we are coming from. So it is hard to know how much of an effect this turmoil will have on housing. I suspect that a lot of the slowdown was already in train before the middle of August. I base that thought on the fact that many mortgage rates rose earlier in the summer than August, though the jumbo market is an obvious exception to that. Beyond housing, any projections of real effects from events in financial markets seem like guesswork at this point. My sense is that, while we may see some marginal slowing in business investment, the effects are likely to be small because I don’t think the marginal cost of funding for most businesses has gone up much and we aren’t hearing reports of wholesale tightening of lending standards in the corporate sector. I haven’t heard that from around the country either. I expect consumer spending to grow more slowly than in recent years, but not too dramatically so. I think that there is a fair amount of uncertainty about the size of the housing wealth effect and that household net worth overall remains fairly high relative to income at this point. As I noted earlier, the Greenbook’s projection for disposable income isn’t too bad, so that would support consumption growth at least at a moderate pace going forward. Overall, then, I come out a touch above the Greenbook, with real growth about 2 percent in the second half and then gradually returning to trend. Of course, I have been expecting less of a slowdown than the Greenbook for about a year now. It turns out that, although we have both been too optimistic, the Greenbook has been closer to reality, so my confidence in my forecasting ability is waning here. The inflation numbers have been encouraging. Core PCE inflation averaged under 1.4 percent for the past five months, and overall PCE inflation was under 2 percent for both June and July. I am particularly pleased that TIPS inflation compensation has not increased even as market participants have marked down their expected funds rate path in the midst of the recent turmoil. That said, it still looks as though market participants expect inflation to settle near 2 percent rather than lower, as I would prefer. That concludes my remarks." CHRG-111shrg57319--113 Mr. Cathcart," It depended very much on the business unit and on the individual who was put in that double situation. I would say that in the case of home loans, it was not satisfactory because the Chief Risk Officer of that business favored the reporting relationship to the business rather than to risk. Senator Coburn. And this is a hard question to answer, but I hope you will make an attempt to do it. Was there a point in time when you recognized the writing on the wall in terms of the fraudulent activity? Mr. Vanasek, you saw a bubble coming, and Mr. Cathcart, I am not sure that we have any comments from you. But was there a point in time when you knew that things were going to come unwound? " CHRG-111hhrg56766--162 Mr. Meeks," Thank you, Mr. Chairman. It is good to see you, Chairman Bernanke, and congratulations on your reappointment, and thank you for your service. My question--and I'm trying to focus more around real estate and the housing industry, I know some of which you deal with and some of which you do not based upon some of the questions, but it is to me--most Americans, it is their largest investment that they will ever make--is in their home. And in listening to some of your testimony earlier, and I know that by, I guess, March 31st, you are scheduled to end the Fed's program to buy more mortgage-backed securities from Fannie Mae and Freddie Mac-backed debt, and I guess there is pressure to tighten up. And the last time the tightening took place, I think it was about 33 months ago, after the recession began and foreclosure rates were 4 times lower than they currently are. And there are signs, from what you are saying now, of growth. But my first question is, is it a little premature to consider tightening today because--will that kill the incipient housing recovery by tightening today and then hurting the housing market? " fcic_final_report_full--171 All along the assembly line, from the origination of the mortgages to the creation and marketing of the mortgage-backed securities and collateralized debt obligations (CDOs), many understood and the regulators at least suspected that every cog was reliant on the mortgages themselves, which would not perform as advertised. THE BUBBLE: “A CREDITINDUCED BOOM ” Irvine, California–based New Century—once the nation’s second-largest subprime lender—ignored early warnings that its own loan quality was deteriorating and stripped power from two risk-control departments that had noted the evidence. In a June  presentation, the Quality Assurance staff reported they had found severe underwriting errors, including evidence of predatory lending, legal and state viola- tions, and credit issues, in  of the loans they audited in November and December . In , Chief Operating Officer and later CEO Brad Morrice recommended these results be removed from the statistical tools used to track loan performance, and in , the department was dissolved and its personnel terminated. The same year, the Internal Audit department identified numerous deficiencies in loan files; out of nine reviews it conducted in , it gave the company’s loan production depart- ment “unsatisfactory” ratings seven times. Patrick Flanagan, president of New Cen- tury’s mortgage-originating subsidiary, cut the department’s budget, saying in a memo that the “group was out of control and tries to dictate business practices in- stead of audit.”  This happened as the company struggled with increasing requests that it buy back soured loans from investors. By December , almost  of its loans were going into default within the first three months after origination. “New Century had a brazen obsession with increasing loan originations, without due regard to the risks associated with that business strategy,” New Century’s bankruptcy examiner reported.  In September —seven months before the housing market peaked—thou- sands of originators, securitizers, and investors met at the ABS East  conference in Boca Raton, Florida, to play golf, do deals, and talk about the market. The asset- backed security business was still good, but even the most optimistic could read the signs. Panelists had three concerns: Were housing prices overheated, or just driven by “fundamentals” such as increased demand? Would rising interest rates halt the market? And was the CDO, because of its ratings-driven investors, distorting the mortgage market?  CHRG-109hhrg31539--205 Mr. Baca," Thank you very much, Mr. Chairman, and Ranking Member Frank, for having this hearing. And thank you, Mr. Bernanke, for being here as well. First, I want to start on the housing crisis. As the housing crisis market slows, areas like California, the Inland Empire where I have quite a few people moving in from L.A., Orange County, into the area, have been heavily dependent on real-estate-related employment will suffer the most. If prices start to drop in San Bernardino County, and homes stay on the market for 5 months instead of the 5 days, it hurts more than just the sellers. It also leads to less work for people, and I state less work for people who build new homes and those who help sell, finance, or insure them. Thousands of people's jobs are at stake, including home construction, real estate agents, mortgage brokers, inspectors, and more. Question number one is what industries of the economy have enough strength to pick up the slack as the housing market continues to cool? And question number two is what will the cooling housing market mean for job growth and unemployment numbers? " FOMC20080625meeting--84 82,MS. PIANALTO.," Thank you, Mr. Chairman. The last two months have brought an interesting shift in my conversations with my business contacts. Their concerns have shifted from problems in financial markets to the rapid increase in input prices. Energy prices are the focus nationwide, but steel prices are also capturing the attention of the business people in my District. Several manufacturers and builders noted that the price they pay for steel has almost doubled since the beginning of this year. Clearly, businesses are worried about signs of growing price pressures, but their reactions to these price shocks tell a more complicated story. Many manufacturers have not been able to pass on price increases, resulting in a clear loss to profit margins. These businesses often report cost-containment or efficiency programs that will affect their hiring and capital decisions for months to come. Interestingly, the consumer price data show a similar dichotomy. My staff noted that our primary measures of core inflation are not providing a consistent story about the path of underlying inflation. In the May CPI report, roughly one-third of the weighted price changes increased at rates above 5 percent, and roughly one-third of prices changed by rates less than 1 percent. For example, while energy costs were up strongly and prices for a number of general service components have been drifting higher, large declines in apparel and vehicle expenses are imparting significant offsets. The 16 percent trimmed mean indicator showed an alarming 4 percent rise in prices, while the median rose just at 2.2 percent. The weight of price changes in the 1 percent to 5 percent range was unusually small, making it difficult to estimate the central tendency of the price change distribution with much confidence. So this makes it difficult to get a good read on where future prices are headed. My District business contacts remain pessimistic about growth prospects. District retail reports focused extensively on the likely effects of gasoline and food prices on the purchasing decisions of consumers. Many manufacturers, builders, and distributors are facing complicated output and investment decisions in the context of input price growth and weaker markets. Overall, most of the business people that I talk with are still quite cautious about their business plans, despite the fact that most of them have found sources of credit and terms that are not too elevated from what they have seen in previous years. In the economic projections that I submitted for this meeting, I raised my near-term forecast for output growth slightly and for headline inflation slightly more. Over the medium term, my outlook continues to be for modest growth because the housing market, in my forecast, recovers slowly, actually more slowly than in the Greenbook. My staff estimated a model for national housing starts that takes into account what has happened in the past in states that have seen major increases in foreclosures. The real estate difficulties that these states faced were much more persistent than anything that we have yet seen in the national data. The bottom line of this analysis is that, if the patterns of past housing cycles from the states that experienced the boom�bust cycles are repeated at the national level, then housing starts should remain relatively weak over the next couple of years. Supporting this analysis, three of the large regional banking organizations in my District are increasing their loan-loss provisions significantly in the second quarter based on the continued deterioration in the housing sector. Based on current projections, these institutions are projecting housing sector credit losses to accelerate in the second half of 2008 and to continue into 2009. Currently, the weak output growth contributes to my forecast of declining inflation rates, especially the core rate, but I also see evidence supporting that view in the ""less worker bargaining power"" scenario that is in the Greenbook. My contacts see very little price pressures coming from labor costs now or in the near future. Finally, implicit in my forecast for output growth and inflation is a fed funds rate path that includes increases later this year and into next year. Although additional risks to growth remain, the primary risk to my forecast concerns input prices and inflation expectations. If commodity prices continue to accelerate, they are going to put upward pressure on both headline and core inflation and downward pressure on output. That environment could lead to a highly undesirable increase in inflation expectations. On the positive side of risk to the outlook, I think that the fed funds rate actions that we have taken, in conjunction with the actions that we took in August to bolster market liquidity, have improved confidence, and I have substantially lowered the odds I had placed on financial market meltdown and on a severe recession. In that sense, since our meeting in April the downside risks to my outlook for economic growth have lessened somewhat, and the risks to my inflation outlook have moved up somewhat. Regarding the issue of providing longer-term forecasts, I have long supported efforts to clarify the underlying objectives of FOMC participants by providing our longer-term economic projections. Of the proposals that were offered by the Subcommittee on Communications, I favor reporting the average values for output growth, unemployment, and total inflation expected over a five-to-ten-year period--option 3. The features of these five-to-ten-year projections that I find attractive are that they indicate where the economy might converge and don't imply too much knowledge of the path to the long run. Thank you, Mr. Chairman. " FOMC20051213meeting--27 25,MR. STOCKTON.," Thank you, Mr. Chairman. In the spirit of the season, I am tempted to report that I bring you great tidings of comfort and joy. However, this is, after all, the Federal Reserve, so it is probably more appropriate to simply note that tidings have improved modestly over the intermeeting period. While not quite in the miracle category, we have raised our projection for the growth of real GDP over the next two years and lowered our projection of price inflation. As you know, we revised up our estimate of the growth in real GDP in the third quarter by more than a percentage point and left fourth-quarter growth unchanged. As a consequence, real output is now projected to expand at an annual rate of nearly 4 percent in the second half of this year—about ½ percentage point faster than we were forecasting in October. The surprising strength in recent months has been widespread. But clearly, one of the standout areas of strength has been consumer spending. To be sure, sales of light motor vehicles were a bit softer than we had expected, but that was more than offset by considerably stronger consumer outlays in other areas. This morning=s retail sales report for November provided further evidence of the underlying strength in consumption. Although spending in the retail control category, which excludes sales at auto dealers and building supply stores, dropped 0.6 percent last month, that decline was more than accounted for by lower gasoline prices. In real terms, we estimate that spending was up more than 1 percent for the month. That figure is somewhat stronger than we had expected and would likely cause us to revise up the growth of consumption nearly ½ percentage point at an annual rate in the fourth quarter. December 13, 2005 10 of 100 In light of the 1 percentage point upward revision that we made to real GDP growth in third quarter, it may appear a bit surprising that we only carried the higher level, and not a higher growth rate, into the fourth quarter. But part of our upward surprise in the third quarter was in non-auto inventory investment. With stocks appearing reasonably well aligned with sales in most sectors, we didn=t see the need to make any further upward adjustment to this aspect of the forecast. Moreover, some of the third-quarter strength in GDP reflected defense spending that seemed likely to have been pulled forward from the fourth quarter. Both of these judgments appear to have been supported, and then some, by incoming data in the past two days. Yesterday=s Monthly Treasury Statement and this morning’s reading on retail inventories suggest that both defense spending and inventory investment are likely to be even weaker in the fourth quarter than we had written down. Balancing these softer readings against the stronger retail sales data would leave our forecast for real GDP growth in the fourth quarter unchanged at about 3½ percent. In contemplating the forecast for 2006 and 2007, we had to make some assessment of the sources of the strength in activity in the second half of this year. As we had anticipated would be the case back in September, we are now in the position of having to interpret whether the errors in our forecast of aggregate activity reflect misestimates on our part of either the hurricane effects or of the underlying behavior of the economy. We do believe that some of the surprising strength of activity is probably attributable to smaller negative effects from hurricanes than we had previously penciled in. To be sure, production in the energy sector is coming back a bit more slowly than we had expected, especially production from the off-shore platforms in the Gulf of Mexico. But outside of energy, production appears to be recovering more quickly. Output of chemicals, paper, rubber and plastics, and some areas of food processing improved noticeably in October and November. And we look to be getting a bigger plus from the production of construction supplies. On the spending side, the hits to consumption of housing services, food, and gasoline—areas that we had thought would be affected by hurricane-related disruptions—appear to have been smaller over the past few months than we had incorporated in our previous couple of forecasts. Of course, most of this remains educated guesswork and needs to be taken with a grain of salt. But all in all, we are inclined to attribute a few tenths of the surprising strength in second-half growth to smaller hurricane effects. December 13, 2005 11 of 100 However, the information that we have received over the past six weeks has not been confined solely to aggregate demand. Developments on the supply-side of the economy also appear to have been more favorable than we had expected. The surge in output growth last quarter was accomplished with almost no increase in hours worked. Consequently, output per hour in the nonfarm business sector rose at a 4½ percent annual rate in the third quarter and is now estimated to have been up more than 3 percent over the past four quarters. As optimistic as we have been, the data have continued to outflank us on the upside in recent quarters. In response to this continued good news, we revised up our estimates of structural labor productivity. In addition to an upward adjustment to the level this year, we boosted the growth of structural labor productivity about ¼ percentage point to a bit above 3 percent in both 2006 and 2007. Capital deepening is making a slightly larger contribution to this estimate, but most of the upward revision has occurred in multifactor productivity. Despite being nearly a decade into this favorable productivity wave, there are few signs that the efforts or abilities of businesses to implement greater technical and organizational efficiencies are flagging. On balance, the revisions that we made to aggregate demand were a touch larger than those we made to aggregate supply, and we estimate the output gap to be slightly narrower, on average, over the next two years than in the previous forecast. In response to these developments, we raised our path for the funds rate another 25 basis points, to 4½ percent by early next year. Despite these modest adjustments, the basic contour of our forecast remains unchanged. After increasing 3¾ percent this year, the rise in real GDP slows to 3½ percent in 2006 and 3 percent in 2007. That pattern reflects several powerful crosscurrents. We expect activity to be boosted early next year by rebuilding efforts in the Gulf Coast region. Moreover, with energy prices projected to level out after increasing sharply over the past two years, the drag on aggregate demand from the earlier run-up in prices should begin to ebb. But these positives are more than offset by fading fiscal stimulus, the lagged effects of tighter monetary policy, and a gradually diminishing impetus to consumer spending from equity and housing wealth. In sorting through the details of our forecast, it should be pretty obvious that a flattening out of activity in the housing sector is one of the principal sources of slower aggregate growth. After contributing about ½ percentage point to growth in real GDP per annum over the past four years, we are projecting residential investment to be a roughly neutral factor over the next two years. But that is still all forecast. To date, the hard data on housing have remained solid. Housing starts have remained at elevated levels, new home sales hit a record high in October, and house prices as measured by the OFHEO purchase index continued to increase at a double-digit pace through the third quarter. December 13, 2005 12 of 100 Board briefing, a variety of indicators of housing activity have turned down in recent months. Household attitudes toward home buying have dropped sharply; builder ratings of new home sales have deteriorated; the index of mortgage applications for home purchase has fallen off; and the inventory of unsold homes has moved up. Taken in isolation, none of these measures has an especially reliable statistical relationship to housing activity. But taken together, they could be indicating that we are at the front edge of some cooling in these markets. I offer one more piece of evidence that I think almost surely suggests that the end is near in this sector. While channel surfing the other night, to the annoyance of my otherwise very patient wife, I came across a new television series on the Discovery Channel entitled “Flip That House.” [Laughter] As far as I could tell, the gist of the show was that with some spackling, a few strategically placed azaleas, and access to a bank, you too could tap into the great real estate wealth machine. It was enough to put even the most ardent believer in market efficiency into existential crisis. [Laughter] Only time will tell if these indicators are giving us a head fake or are the start of our long-awaited slowdown in this sector. For now, we are sticking with our call that housing activity will level off next year. Moreover, we continue to anticipate that a more visible deceleration in house prices will be in evidence by the middle of next year, and the associated slower growth of household net worth contributes to the projected up-tilt in the personal saving rate. In our view, both of these developments are critical for damping growth by enough to prevent the economy from overheating. To date, the news on inflation does not suggest that we have overshot the mark on potential, though our ability to make that assertion with any confidence in real time is admittedly very tenuous. To begin, measures of core consumer prices came in a bit below our expectations. We also had a faster unwinding of the earlier hurricane-related increase in retail energy prices. Survey measures of inflation expectations have retraced virtually all of this autumn=s run-up, and TIPS [Treasury inflation-protected securities] -based measures of inflation compensation have retreated as well. On the cost side, lower hourly compensation and faster growth in structural productivity imply less pressure from labor costs, and the markup of prices over unit labor costs has risen further, pointing to a somewhat larger cushion between costs and prices. December 13, 2005 13 of 100 Obviously, there are some very important risks on both sides of our forecasts for real activity and inflation, and we tried to highlight some of the more prominent ones in the Greenbook. I recognize that our baseline forecast, in which the economy=s growth slows to about trend, output settles out at a level very close to potential, and inflation pressures ease a bit, all with just a little more tightening of policy, seems too good to be true. No doubt, events will conspire to force adjustments, both major and minor, on the staff projection. Perhaps I=ve just written the “flexibility and resilience” speech for the Chairman so often over the past few years that I=m suffering from something akin to the Stockholm syndrome—the tendency of hostages over time to sympathize with the views of their keepers. [Laughter] But as I look back over the past year and observe how well the economy performed in the face of some pretty substantial shocks, I don=t think our optimistic outlook is unwarranted. Karen will continue our presentation." FOMC20061025meeting--76 74,MS. YELLEN.," Thank you, Mr. Chairman. Five weeks have passed since our last FOMC meeting, and not surprisingly the outlook does not appear to have changed in any fundamental way. Recent data bearing on the near-term situation point to noticeably slower growth in the third quarter than we anticipated at our last meeting. However, the Greenbook has revised up its projection for growth during the current and next few quarters so that the overall effect on slack next year is roughly neutral. This forecast strikes me as plausible, but there are few data thus far to bear it out. Meanwhile, measures of consumer price inflation remain uncomfortably high, although the latest readings have been very slightly better. With regard to the pace of economic activity, there’s uncertainty in all directions. In fact, we seem to have a bimodal economy with a couple of weak sectors, and the rest of the economy doing just fine. Those two weak sectors are, of course, housing and domestic auto production. Autos seem likely to have only a short-lived effect. In the case of housing, we agree with the Greenbook assessment of housing activity and find it quite consistent with the reports of our contacts in this sector. Besides the falloff in activity, house-price increases have also slowed markedly. The Case-Shiller house-price index has been flat in recent months, and futures on this index show outright declines next year. However, equity valuations for homebuilders, as Cathy mentioned, have risen moderately in the past couple of months, following large declines over the previous year, and we interpret that as providing some indication that the expected future path of home prices has at least stopped deteriorating. Of course, housing is a relatively small sector of the economy, and its decline should be self-correcting. So the bigger danger is that weakness in house prices could spread to overall consumption through wealth effects. This development would deepen and extend economic weakness, potentially touching off a nonlinear type of downward dynamic that could trigger a recession. But so far at least, there are no signs of such spillovers. Consumption spending seems on track for healthy growth. Nonetheless, the growth estimate for the third quarter begins with a 1 and just barely. Any time a forecast is that low, it’s reasonable to consider the possibility that the economy could enter recession. So for this reason, we, like the Board’s staff, took a careful look at various approaches to assess this issue, including yield-curve-based models, past forecast errors, leading indicator models, and surveys. Our bottom line is that we agree with the basic results reported in Monday’s nonfinancial briefing. The highest probability of recession that we found, around 40 percent, was obtained from a model developed by a Board staff member. The model includes the slope of the yield curve and the level of the funds rate. An issue with this result is that long-term rates may currently be low, hence the yield curve inverted, for unusual and not very well understood reasons having to do with the risk premium. Estimates from the other approaches came in with lower probabilities. Finally, other financial developments that could presage future economic performance, like stock market movements and risk spreads, suggest some optimism on the part of financial market participants. So our sense is that, except for housing and autos, the economy appears to be doing quite well. Indeed, the recent rather sharp drop in energy prices could boost consumption spending even more than assumed in the Greenbook. While this is a possibility, it seems more likely to me that households ran down their savings to fill their gas tanks when gas prices rose and are, therefore, likely to use their recent savings at the pump to bolster their finances, at least partly. Overall, under the assumption of an unchanged funds rate, our forecast shows a beautiful soft landing, with real GDP growing at a moderately below-trend pace for a few more quarters and homing in near trend thereafter. But I must admit that we got this forecast essentially by averaging the strong and weak sides of the economy. I think that way of proceeding is reasonable, and I hope the landing happens that way. But I acknowledge there is plenty of risk. We may end up instead with either the strong or the weak side dominating the outcome. For example, if the housing market decline does not spread significantly to consumption, we could end up with a strong economy in fairly short order. However, if it does spread, the slowdown could last quite a while. Scenarios like this are nicely spelled out in the alternative simulations in the Greenbook. Which way things go is a key issue, given that we’re in the vicinity of full employment. The desired soft landing depends on growth remaining below trend long enough to offset the moderate amount of excess demand that appears to be in the economy so that inflation can trend gradually lower. The slight drop in unemployment, to 4.6 percent, in September did not help in that regard, and I should note that recent comments by our head office directors almost uniformly supported the idea that labor markets, especially for skilled workers, are tight. However, we do expect the unemployment rate to edge higher over the next year in response to sluggish growth. Our forecast for core consumer inflation comes down a bit faster than foreseen by the Greenbook. We have core PCE price inflation edging down from just under 2½ percent this year to just over 2 percent in 2007 and see a good chance that it may fall a bit below 2 percent in the following year. We see the relief on energy prices as helpful, although we keep trying to resist any temptation to overestimate the extent to which past energy price pass-through has been boosting core inflation. Inflation also may benefit from an unwinding of the earlier strong pressures on rents. Finally, as in the discussion we had earlier about the alternative Greenbook scenario, we think inflation may have become less persistent over the past decade, and this is one reason that we’re a bit more optimistic than the Greenbook about the possible degree of disinflation over the next couple of years. But on balance, I have to admit we don’t have a perfect understanding of why inflation has been so high over the past few years, and so I try to remain humble, as always, in my predictions. My bottom line is this. I see a non-negligible chance that the downside risks to the economy, emanating especially from housing, could produce a recession in coming quarters, but there’s a very good chance that the spillovers will be sufficiently modest that the economy will avoid a recession. I also see a significant chance that growth could modestly exceed potential. In that sense, the overall risks to the outlook for real GDP growth could be characterized as balanced. In addition, I see quite a bit of uncertainty about inflation going forward with the risks to my forecast probably being a bit to the high side." FOMC20060328meeting--164 162,CHAIRMAN BERNANKE.," Thank you. I would like now to summarize these views and add a few comments of my own. At that point, if there are additional comments or questions, they will be welcome. We have had, I think, a fairly upbeat group here the last couple of days, which is of course good, both in terms of views of economic activity and in terms of keeping inflation well controlled. The economy appears to be quite strong, but my sense is that most people feel that risks on that score are relatively balanced, which I take to imply that, after being strong in this quarter, growth will slow to something closer to a more-sustainable pace in the remainder of the year. Perhaps the leading source of uncertainty on the output side is the housing market, but I was reassured to hear that most participants think that a decline in housing will be cushioned by strong fundamentals in terms of income, jobs, and continuing low interest rates. The labor market is clearly continuing to strengthen, but I heard not too many concerns about increasing wage pressures. There was some discussion about shortages of more highly skilled workers, which presumably might affect wages at some point but apparently has not so far; and there was additional discussion of productivity gains, which are helping to keep unit labor costs down and to support growth. On the inflation side, I have not been in this conversation for a while, but I was impressed at least relative to a year ago that the angst about inflation seems to have declined. Clearly, inflation expectations are well anchored. Margins are high, and the sense of the group was that pass-through to consumer inflation was likely to be limited. Still, I took from the group some sense of at least a slight upside risk to inflation, reflecting the increasing resource utilization; the fact that inflation is somewhat on the high side of what many people describe as their comfort zone; and the fact that, if inflation does rise, there will be costs to bringing it back down and maintaining our credibility. So that is my overall summary of the Committee discussion. My own views, you will probably not be surprised to hear, are not radically different from what we have heard around the table. I would point out, first, that except for housing, the economy continues to be very strong. One might be tempted to average the expected rate of growth of the first quarter at about 4½ percent with the 1½ percent of the fourth quarter and say we’re at a pace of about 3 percent, but then I would remind you that we had 4.1 percent in the third quarter despite Katrina and about 3.7 percent average growth in the first three quarters of ’05. We have a strengthening world economy. We have consumption that looks likely to be well supported by income and jobs. Several people have talked about the strength of investment in nonresidential construction. Job creation at about 200,000 a month is clearly above the long-run sustainable rate. So except for housing—and that is, of course, a critical sector—it looks as though the economy is, if anything, growing more quickly than potential. Housing is the crucial issue. To get a soft landing, we need some cooling in housing. So far there is a good bit of evidence that there has been a peak, but we do not know a great deal more than that. So obviously we are going to have to watch carefully. The range of possible outcomes is quite wide. I agree with most of the commentary that the strong fundamentals support a relatively soft landing in housing. A pessimist might point out that the expectation of future price increases is itself an important part of the user cost of housing. A sea change in people’s views about what is going to happen to house prices in the future might significantly affect their perceived cost of owning a house and lead to lower prices and to weaker activity. On the other side, residential investment is, of course, only about 6 percent of GDP, and so long as consumption is well maintained by incomes, jobs, and other factors, I think it would take a very strong decline in the housing market to substantially derail the strong momentum for growth that we are currently seeing in the economy. What we might see in the next few quarters is some quarter-to-quarter variation. We may not have the stability of growth that we have had the last couple of years. If that happens, we should be willing to accept it. I might offer a very rough analogy to the way we think about energy prices and core inflation. With core inflation, our goal is to accommodate energy prices but to make sure that they do not get into the underlying rate of inflation. Again, this might be a rough analogy, but if the housing market moves significantly, we should perhaps not try to upset that movement but rather just try to ensure that the resources that are released are deployed in the rest of the economy and that the rest of the economy remains on a stable path. Again, I think we are unlikely to see growth being derailed by the housing market, but I do want us to be prepared for some quarter-to- quarter fluctuations. So, broadly speaking, I agree with the Committee that we should see some cooling for the remainder of the year and that we should approach a more-sustainable pace of growth. But I think there is some upside volatility risk, if you will, because of the fluctuations in residential investment. On inflation, like most of you, I am struck by how well behaved core inflation has been. Indeed, in 2005, core inflation was even slightly lower than it was in 2004, and we have all pointed to a number of explanations, including well-anchored inflation expectations, international competition, productivity growth, and since I wasn’t here, I can say good Fed policy. [Laughter] One area of uncertainty in trying to look forward is unit labor costs. Remarkably, unit labor costs in the nonfarm business sector grew only 1.3 percent in 2005, but as was already mentioned in the staff presentation, I think that understates the trend because it is coming off the surge in the fourth quarter of ’04 in bonuses, stock options, and other types of one-time compensation. If you smooth through that bulge, it looks as though the underlying trend of unit labor costs is more like 1.7 percent, and perhaps that may have some upward bias. There is certainly a lot of uncertainty about that, though. We have seen some indicators, such as average hourly earnings, rising. Other indicators, such as the employment cost index, are slowing. I just point this out as a significant source of uncertainty, given how difficult it is to forecast both compensation and productivity going forward. So, again, the stability of inflation in the last couple of years is very reassuring. I would note, however, that over the past three years, since 2003, we have seen a pickup in inflation. That was, of course, by design, but I think it is important for us to think about why that happened. There’s something of an identification problem here. To the extent that the increase in inflation over the last two to three years reflected the pass-through of energy costs and commodity prices, that is actually good news in a sense because, to the extent that those factors soften and flatten in the coming year, we should see some reduction in inflation in ’06 and ’07. To the extent that inflation increases in the last two and a half years reflected increased resource utilization, the strength in the economy, and the return of pricing power, however, there is a bit of concern that we may see some additional updrift of inflation in the next few quarters. Like most of you, I am not at all alarmist about inflation. I think the worst that is likely to happen would be 20 or 30 basis points over the next year. But even that amount is a little disconcerting for me. I think it is very important for us to maintain our credibility on inflation and it would be somewhat expensive to bring that additional inflation back down. So my bottom line on inflation is that there is a very modest upside risk. Again, I think it’s not a large risk but one that we probably should pay attention to. Are there any comments or questions to close our round on the economic outlook? If not, we can move to the policy round. In a moment I’m going to turn to Vincent to introduce the policy options in the statement. Before I do that, I just want to note that we have left unresolved the discussion about the ownership of the statement—in particular, what we are voting on when we vote at the end of the meeting. Currently we vote on the action, on the directive, and on the risk assessment but not on the rationale. The rationale has, however, been largely a consensus paragraph worked out by the Committee. My sense is that this decision is not entirely separable from a wide range of other issues we may want to talk about over the next few quarters concerning the content of the statement, its structure, whether we use forward-looking language, and whether we consider adopting some kind of numerical guidepost for inflation. And so what I would like to do, if it is okay with the Committee, is to maintain the status quo for today in terms of our voting in this statement. By the next meeting, in May, I will come back to the Committee with a proposal for a process by which we can address this whole range of issues over a period of time, and on the top of the agenda for that process will be the ownership of the statement. Is that acceptable? All right. Seeing assent, we will maintain the status quo on the statement just for today. Vincent, whenever you are ready." FOMC20070321meeting--111 109,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Our view of the outlook has changed since our last meeting, but more in the balance of risks and the sources of uncertainty than in our actual forecast for growth. But just to go through the changes quickly, we’ve reduced our forecast for growth in ’07 a bit, to something less than 3 percent, and we see more downside risks to that forecast. We’ve moved up the expected path of core PCE inflation just a bit in light of recent numbers, but we have maintained essentially the same view as before—that inflation will moderate to around 2 percent by the end of this year and a bit below that in ’08. We see the risk to this forecast still to the upside. We face greater uncertainty about the near-term outlook than we have over the past few meetings. Looking to the medium term, although we haven’t yet reduced our estimate of potential growth, we’re a bit more concerned than we’ve been about the strength of underlying structural productivity growth going forward. We have also changed our view of the appropriate path of policy a bit, introducing a gentle move down now in the fed funds rate beginning around the middle of the year. So this puts us a bit below the assumed path in the Greenbook, but we assume a slower, smaller reduction in the nominal fed funds rate than the market does today. Our forecast is quite close to that of the staff’s in the Greenbook, and the basic story is similar. Our differences are the same as they have been for some time—we have slightly more growth and slightly lower inflation. That reflects things we talked about before, different views about information dynamics and about potential growth. Our view of the output gap and its evolution, however, is similar. I have just a few points on some issues. On the growth front, the recent numbers suggest both a deeper adjustment in housing and a broader weakness in the economy than we anticipated, notably in capital goods orders. The effect of these developments on our forecast is not that large, however. Their significance is more in the risk to the outlook and the uncertainty, the puzzle that the investment weakness presents for the medium term. On housing and consumption, the probability of the dark scenario is still small, but it is higher than it has been and deserves some attention. The dark scenario is the risk that the reduction in credit to the household sector amplifies the decline in housing demand, which leads to a greater adjustment in prices, with a risk of a more- pronounced, prolonged decline in growth and spending. Monetary policy should not be directed at trying to put a floor on housing demand or on prices, only at limiting the risk that the weakness accumulates substantially or spreads to overall demand. Regarding capital spending, we just don’t have a good explanation for why—with margins that are still pretty good, reasonable earnings growth, solid growth in aggregate demand here and globally, relatively low interest rates, and reasonable levels of business confidence—spending has continued to come in well below our expectations. This series of disappointments, of course, has been going on for some time; it’s not just about the latest numbers for durable goods orders. Perhaps this situation will prove transitory, but it justifies a bit more caution to the outlook. Of these two risks—in housing and in investment—I’d say the latter matters more and is potentially more consequential. But both of these effects are offset, in our basic view, by the expected strength in personal income growth going forward, by what are still fairly favorable overall financial conditions, and by fairly robust external demand. Regarding productivity, productivity growth per quarter at an annualized rate has, over the past ten quarters, come in significantly below 2 percent, kind of close to the estimates of the trend rate for the period between ’73 and ’95. Some of the analysts who spend a lot of time thinking about this are starting to lose conviction that trend growth is still in the neighborhood of 2½ percent for the nonfarm business sector. We’re still viewing the recent weakness as transitory or cyclical, but the risk that trend growth is below our estimate is, I think, increasing. On inflation, despite the higher recent numbers, not much has really changed in our view. We still expect core PCE to move to below 2 percent over the forecast period, and we still see the risk as not getting quite that moderation. The sources of the recent negative surprises in the core data, which seem concentrated in medical services, probably don’t say much about monetary policy or broader inflation dynamics, and inflation expectations remain stable at reasonable levels. So our view of the growth outlook has changed a bit, but our view of the inflation outlook hasn’t changed much based on these numbers. On the markets, as many people have said and as Bill discussed at the beginning, I don’t see much that’s been troubling thus far. Although correlations across asset markets have risen, overall liquidity seems fine. There’s been very limited contagion from mortgages into other credit markets. Debt issuance seems to be continuing. People are able to raise money to finance corporate restructuring investment. There is very little concern, I think, about substantial losses, on the basis of what’s happened to date, in the core of the financial system and very limited evidence of stress among the various funds. But it’s still early in some ways, and the fundamental outlook for growth is a bit weaker and more uncertain. Risk premiums, credit spreads, and volatility still look potentially vulnerable to a more substantial reversal. The weakness in the subprime market will take some time to work through the full range of securities issued against pools of collateral that include mortgages. The complexity in valuing structured mortgage products, the difficulty in designing hedges that actually work against exposure to that risk, and uncertainty about the shape of the adverse tail and that part of the credit spectrum are all conditions that apply to a range of other structured credit markets and credit products. In the debate about the implications of this prolonged yield-curve inversion, we have tended to side with those who have found comfort in the contrary signal you see in lower levels of risk premiums and credit spreads. Yet it’s possible that the forces that may have been holding down forward rates are also holding down credit spreads and holding up the value of other assets and, therefore, may be masking weakness in the economy rather than masking strength. On balance, although the outlook still looks fundamentally positive, we see a more complicated and less benign set of risks to the outlook, more downside risks to growth, and some continued concern that we won’t get enough moderation in inflation. To us, this outlook justifies a stance of policy with a path for the fed funds rate somewhat above what is now priced into the markets. This doesn’t mean, in our view, that we need to signal that nominal rates going forward are more likely to rise than to fall from current levels; it means only that we should convey the sense that our view of the most likely evolution of policy still implies a higher path than is now priced into the markets. We can afford to be patient before adjusting policy, as Sandy said, but we need to have as much flexibility as possible going forward. This suggests that we acknowledge that the overall balance of risks has shifted a bit toward neutral, toward a flat stance of policy, but not all the way there. A delicate task for us is to do this without inducing a reaction in the market that pulls forward significantly more easing than has already occurred." fcic_final_report_full--50 Then, beginning in , the Federal Reserve accommodated a series of requests from the banks to undertake activities forbidden under Glass-Steagall and its modifi- cations. The new rules permitted nonbank subsidiaries of bank holding companies to engage in “bank-ineligible” activities, including selling or holding certain kinds of se- curities that were not permissible for national banks to invest in or underwrite. At first, the Fed strictly limited these bank-ineligible securities activities to no more than  of the assets or revenue of any subsidiary. Over time, however, the Fed re- laxed these restrictions. By , bank-ineligible securities could represent up to  of assets or revenues of a securities subsidiary, and the Fed also weakened or elimi- nated other firewalls between traditional banking subsidiaries and the new securities subsidiaries of bank holding companies.  Meanwhile, the OCC, the regulator of banks with national charters, was expand- ing the permissible activities of national banks to include those that were “function- ally equivalent to, or a logical outgrowth of, a recognized bank power.”  Among these new activities were underwriting as well as trading bets and hedges, known as derivatives, on the prices of certain assets. Between  and , the OCC broad- ened the derivatives in which banks might deal to include those related to debt secu- rities (), interest and currency exchange rates (), stock indices (), precious metals such as gold and silver (), and equity stocks (). Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this shift toward deregulated financial markets. They argued that fi- nancial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management. Likewise, finan- cial markets would exert strong and effective discipline through analysts, credit rat- ing agencies, and investors. Greenspan argued that the urgent question about government regulation was whether it strengthened or weakened private regulation. Testifying before Congress in , he framed the issue this way: financial “modern- ization” was needed to “remove outdated restrictions that serve no useful purpose, that decrease economic efficiency, and that . . . limit choices and options for the con- sumer of financial services.” Removing the barriers “would permit banking organiza- tions to compete more effectively in their natural markets. The result would be a more efficient financial system providing better services to the public.”  During the s and early s, banks and thrifts expanded into higher-risk loans with higher interest payments. They made loans to oil and gas producers, fi- nanced leveraged buyouts of corporations, and funded developers of residential and commercial real estate. The largest commercial banks advanced money to companies and governments in “emerging markets,” such as countries in Asia and Latin Amer- ica. Those markets offered potentially higher profits, but were much riskier than the banks’ traditional lending. The consequences appeared almost immediately—espe- cially in the real estate markets, with a bubble and massive overbuilding in residential and commercial sectors in certain regions. For example, house prices rose  per year in Texas from  to .  In California, prices rose  annually from  to .  The bubble burst first in Texas in  and , but the trouble rapidly spread across the Southeast to the mid-Atlantic states and New England, then swept back across the country to California and Arizona. Before the crisis ended, house prices had declined nationally by . from July  to February   —the first such fall since the Depression—driven by steep drops in regional markets.  In the s, with the mortgages in their portfolios paying considerably less than current interest rates, spiraling defaults on the thrifts’ residential and commercial real estate loans, and losses on energy-related, leveraged-buyout, and overseas loans, the indus- try was shattered.  FOMC20071211meeting--104 102,MR. HOENIG.," Thank you, Mr. Chairman. I’ll start on the local level. Overall our District economy continues to perform generally well, with ongoing weakness in the housing sector being offset by strength in agriculture, energy, and manufacturing. We have seen some slowing in employment growth over the past few months, but this appears in part to be a supply consideration. Our directors and business contacts continue to report that the labor markets are, in fact, tight across much of the District with shortages of both skilled and unskilled labor and rising wage pressures. There is some reduction in employment, obviously in the housing sector, but that is being offset by these other considerations. I would also note that manufacturing activity remains basically solid, with manufacturers reporting strong export orders. The District’s manufacturing index moved upward in November and still points to moderate growth. In addition, District manufacturers’ capital spending plans actually rose but remained below most of last year’s readings on balance. Turning to spending, general retailers reported a rebound in sales in the latter part of October and early November. Automobile dealers, on the other hand, did report weaker sales and have also become more pessimistic on future sales. Travel and tourism continues to expand in our region, with District airline traffic figures solid, particularly in the Denver area. Likewise, hotel occupancy figures have continued to increase from already strong levels in the region. As has been true for some time, housing activity, as I said, remains soft. For example, the value of residential contracts dropped again in October, and the rate of decline in residential permits steepened again in the past few months in our region. Offsetting this weakness in housing, though, is considerable strength in agriculture and energy. District energy producers continue to expand their capital investments as they are relatively confident that oil and gas prices will remain firm over the longer term. In fact, their capital expenditures have been slowed by a continuing shortage of labor and access to some equipment. Our larger regional banks are still reporting fairly good conditions. The deal flows seem to be coming through, although they are looking at those carefully, just given the environment that they find themselves in on a national level. Finally, price pressures remain mixed. Most businesses report rising input costs, both labor and materials, but differ in their ability to pass those costs on at this point. In transportation, input costs are passed through one for one through customer surcharges. Other businesses continue to find it a little more difficult to pass through the higher costs, but they are beginning to push harder on that as we talk to them. Let me turn to the national outlook. Weakness in incoming data and continuing stress in financial markets obviously are noteworthy, and others have noted that here today. Compared with the Greenbook, however, I see stronger growth in both the short run and the longer run. I expect fourth-quarter growth to be closer to 1 percent, not the zero percent in the Greenbook, and the economy to strengthen slowly through a good part of 2008, starting out slowly obviously and then picking up as we go through the year. Comparing my views with those in Greenbook, the basic difference appears to be largely in some of the judgmental adjustments in the Greenbook concerning spillovers from the housing and financial stress to consumer spending. The current Greenbook forecast, as others have noted, is similar to the Blue Chip Bottom Ten forecast, which suggests to me that it might be better seen as the downside risk outlook not necessarily the most likely outlook at this point. The first half of 2008, as I said, is likely to be somewhat slower than I previously projected because of the high energy prices and continued drag from housing. However, I expect that growth will gradually strengthen as we move toward the end of 2008 and then remain there through the rest of the forecast period. Having said this, I realize that the downside risk to economic activity does remain elevated. The housing slowdown could be deeper and last longer, and continuing financial turmoil could further affect consumer and business spending. However, while financial factors remain a risk to the outlook, in my view the economy, though it will grow below its potential, can weather these forces and is being supported by the policy actions that we have taken in the past two meetings. Against this outlook for economic growth, let me turn now to the inflation outlook. Year- over-year overall and core inflation rates have risen. In addition, Greenbook’s 2008 forecast for overall and core PCE inflation has increased since our last meeting. While below-trend growth in the near term may exert some downward pressure on inflation, the combination of higher prices for oil, commodities, and some services and dollar depreciation should place upward pressure on both overall and core inflation going forward. Over the past several years, the pass-through of dollar depreciation and higher oil prices to inflation has been limited in part because of longer-term inflation expectations remaining, as we said, anchored. My concern is that, if we continue to lower the fed funds rate into a rising inflation environment and the dollar continues to depreciate, these expectations may become unhinged perhaps more quickly than we would like to think. In this environment, I think we should not lose sight of not just the downside risk to the real economy but also some very serious upside risk to inflation. Thank you." FOMC20070321meeting--105 103,MR. LOCKHART.," Thank you, Mr. Chairman. Thank you for the earlier welcome. Over the intermeeting period, aggregate economic activity in the Sixth District showed signs of slowing. Manufacturing activity appeared to soften, with the majority of reports suggesting declining orders. Retail reports pointed to a slowing pace of sales. The BLS employment data revisions for 2006 supported the view that Florida’s economy has decelerated considerably in the wake of the housing downturn. Sales tax data suggest that retail spending in Florida actually declined in late 2006. Recovery on the Gulf Coast of Mississippi and Louisiana continues to proceed more slowly than hoped. The immediate post-hurricane boost to spending has waned, and the problems of housing and insurance availability remain largely unresolved. The biggest concern for the Sixth District continues to be in real estate markets. As stated at the last meeting, it appears to be too early to suggest that the region’s housing situation has stabilized or that the housing sector’s drag on the District has ended. Reports indicate that many areas in Florida are experiencing dramatic declines in sales of single-family homes and condos, even while new product continues to come onto the market. As a result of this oversupply, construction plans have been cut back. In January, permit issuance for single-family homes in Florida was 57 percent lower than a year earlier. For the rest of the United States the decline was 25 percent. Permits for multifamily development declined 40 percent versus a 7 percent decline nationally. This situation is most extreme in Florida. Interestingly, we do hear anecdotal reports of improved potential buyer traffic in Florida, but that improvement is not translating into sales. Buyers appear to be expecting lower prices. In the other states in the District, single-family permits were down 19 percent in January, less than the decline nationally. Regarding the region’s exposure to nonprime and subprime mortgages, the concern is again mostly in Florida. According to the Mortgage Bankers Association, over 9 percent of mortgages serviced in Florida in the fourth quarter of 2006 were subprime ARM loans; this exposure was second only to Nevada, which was at 13 percent, and compares with 6½ percent nationally. In contrast, the exposures of the other states in the District were all at or below the national level. Reports from banking contacts suggest that delinquency rates on nonprime ARM loans in Florida will continue to trend higher this year. Reduced access to credit for nonprime borrowers will slow the absorption of the current oversupply of housing product and will put downward pressure on house prices. Also, the boom in condo conversions and condo construction in 2005 and 2006 drained the supply of apartments in many areas in the District, and landlords have been able to increase rental prices as a result. Turning to our perspective on the country as a whole, much of the slowdown in real activity that occurred in the second half of 2006 reflected weakness in the housing sector. If weakness remains contained within the housing sector, the outlook, although subdued, is acceptable in our view. Much of the recent moderation in real activity is consistent with what we had forecast several months ago. Realization of this moderation does not in itself imply that we should revise our outlook. Some professional forecasters continue to anticipate that real GDP growth will rebound to close to its trend rate of 3 percent for the rest of 2007, in effect discounting any drag from prolonged weakness in residential investment. The Atlanta Fed staff forecasts for real GDP growth are consistent with these optimistic commercial forecasts. The current Greenbook forecast implies a slightly weaker outlook from extended weakness in residential investment and weaker growth of consumer expenditures, perhaps incorporating some signal from the recent financial distress in subprimes. Despite slight differences in these forecasts, the outlooks do not suggest recession at this point. Measured core inflation remains in excess of 2 percent. Our staff consensus forecast sees core inflation continuing in the range of 2 to 2½ percent for all of 2007. This forecast is a bit less favorable than the Greenbook forecast, but we have no sense that the inflation outlook has deteriorated significantly. The implications of the outlook for real output and inflation are that current policy is set about where it should be. The U.S. economy has performed about as expected. Financial market turbulence and subprime mortgage distress raise potential concerns that should be monitored, but for now it seems that the outlook has not substantially changed. Thank you, Mr. Chairman." CHRG-109hhrg28024--90 Chairman Oxley," The gentleman yields back. The gentlelady from Indiana, Ms. Carson. Ms. Carson. Thank you very much, Mr. Chairman, and thank you, Mr. Chairman, for being here today. I have a quick question concerning the housing market. At one point it was just skyrocketing and booming, and now it seems to be on the decline. Could you anticipate what kind of effect, impact that's going to have on the domestic economic growth? " FOMC20060328meeting--115 113,MR. STERN.," Thank you, Mr. Chairman. I see little in the latest information on the District economy or data on the national economy that gives me undue concern about prospects for sustained economic growth. Turning first to the District—as is frequently the case, overall it is performing much like the national economy. The expansion is broadly based, employment is growing, while the usual labor market churning continues. Sectors such as manufacturing, mining, and energy are particularly strong at this point. Some job skills, particularly in health care, accounting and auditing, technology, and the energy sector, are in short supply. Consumer spending overall is well maintained, and nonresidential construction activity appears to be improving. Housing activity is a little more difficult to summarize. Construction remains strong; sales are still relatively substantial, as best I can determine; and inventories of unsold properties are rising as well. Turning to the national economy, I said earlier I wasn’t particularly concerned about the outlook, but I really should put it more positively. It seems to me that the current state of the national economy and its prospects are both quite good at this point, consistent with growth this year of 3½ percent or perhaps even more. I’m impressed by the employment gains that we’ve seen, sustained income gains, and so on, and remind myself and others that, as the 1980s and 1990s demonstrated, the economy is certainly capable of long periods of uninterrupted expansion. I thought I would comment a bit more on two issues in particular—one is housing—where I wonder if the significance of potential developments might not be being exaggerated a bit. I certainly agree that changes in housing prices, up or down, feed into household wealth and through that into consumer spending. I think that’s a perfectly acceptable story. So if housing prices go down or level off, they will have that effect on wealth and potentially on spending. But there seems to be a view that, in some sense, an exogenous pronounced decline in housing prices is possible, maybe even likely, and that this could be more devastating for the economy. It’s not that I would quibble with that story, but I would wonder about its likelihood because it seems to me more likely that housing is the tail rather than the dog in this. That is, as long as employment continues to go up, incomes continue to go up, and mortgage rates remain relatively moderate, then I would expect that we would avoid severe difficulties in housing except for a few markets that are particularly inflated at this point. Putting it the other way around, only if overall economic conditions deteriorate, with employment declining and income growth slowing or declining and so forth, would I expect there to be more broadly based and more-severe problems in housing. The second issue I’d like to spend a little time on is the inflation outlook. The question I asked myself is, How likely is an appreciable acceleration of inflation at this point, particularly in light of the steps we have taken to get the federal funds rate back to a reasonable range? First, I would argue that inflation expectations remain very well anchored at this point. I don’t hear, as I go around and talk to various groups and meet with various business people, any doubt among the participants about the Fed’s ongoing commitment to low inflation. And I think most of the available data support that. One of the things I was looking at was a chart of one-, five-, and ten- year rates of core PCE inflation. And when you look at that, you see that the ten-year rate of inflation has been declining steadily and now is a little below 2 percent. The five-year rate has basically the same pattern. It leveled off in about 2000, but it, too, is a little below 2 percent. And, of course, the one-year rate of inflation, although it bounces around a lot more, ends up at about the same place, also a little below 2 percent. And I just don’t have a sense that there has been any unhinging of inflationary expectations at this point. Another topic that I would comment on only briefly is the issue of lags in policy. That is, presumably the full effects of the actions we’ve already taken have not yet been felt. Finally, we have looked at some forecasting equations that try to incorporate the growth in the money supply in particular and to forecast core PCE inflation. I wouldn’t claim a lot for the quality of these equations. I wish I could, but I can’t. But for the most part, these various equations provide forecasts that are very close to the Greenbook forecast. Inflation might be a little lower this year or might be a little higher this year, but they show very small changes for the most part. My view is that the Greenbook inflation forecast is a pretty good one. Like President Yellen, I originally submitted a number of 1.8 percent for inflation this year, and I don’t see any reason to change it at this point. Thank you." FOMC20070321meeting--59 57,MR. STOCKTON.," That’s possible. We have not taken that view. Overall housing construction had some unexplained strength over the past year, not from a bottom-up demographic addition but just in terms of what we would have expected given the growth in employment, income, and wealth. Admittedly, the evidence is still very tentative, but we think we see some signs of demand stabilizing around current levels so that, in our starts forecast, we’ll be able to drive the months’ supply of homes back down relative to the low level that it had actually been running from the mid-1990s to the middle of the housing boom. So I don’t think we’re seeing an excess supply of homes that people just won’t want at current prices, or roughly current prices, but that is a considerable risk. Adding up household formations and demolitions—there’s a lot of uncertainty about that, and there’s a lot of cyclical sensitivity as well to the overall household formation rates. So whether the housing stock outran the long-run determinants is kind of hard to nail down. We see that as a risk, but it’s not incorporated in this forecast. If that were the case, there could be a bigger drag on housing activity than we’re anticipating." CHRG-111shrg51290--16 Chairman Dodd," Thank you very much, Ms. Seidman. Ms. McCoy?STATEMENT OF PATRICIA A. McCOY, GEORGE J. AND HELEN M. ENGLAND PROFESSOR OF LAW, UNIVERSITY OF CONNECTICUT SCHOOL OF LAW Ms. McCoy. Chairman Dodd and members of the Committee, thank you for inviting me here today to discuss restructuring financial regulation. My name is Patricia McCoy and I am a law professor at the University of Connecticut. I also had the pleasure of living in Alabama where I clerked for Judge Vance some years ago. I applaud the Committee for exploring bold new approaches to this issue. In my remarks today, I propose transferring consumer protection for consumer credit from Federal banking regulators to one agency whose sole mission is consumer protection. We need this to fix three problems. First, during the housing bubble, fragmented regulation drove lenders to shop for the easiest regulators and laws. Second, this put pressure on banking regulators, State and Federal, to relax credit standards. Finally, banking regulators often dismiss consumer protection in favor of the short-term profitability of banks. During the housing bubble, risky subprime mortgages and non-traditional mortgages crowded out safer, fixed-rate loans. Between 2003 and 2005, the market share of non-prime loans tripled, from 11 percent to 33 percent. Over half of them were interest-only loans and option payment ARMs. These loans seemed appealing to many borrowers because their initial monthly payments were often lower than fixed-rate loans, but they had many hidden risks that many borrowers did not suspect. So borrowers flocked to the loans with the lower monthly payments, causing dangerous loans to crowd out the safer loans. Conventional lenders then decided, well, if we can't beat them, let us join them, and they expanded into dangerous loans, as well. Meanwhile, lenders were able to shop for the easiest laws and regulators. There was one set of laws that applied to federally chartered depository institutions and their subsidiaries. There is a wholly different set of laws that applied to independent non-bank lenders and mortgage brokers. At the Federal level, of course, we all know that we have four banking regulators plus the Federal Trade Commission. The States add another 50 jurisdictions on top. Because lenders could threaten to change charters, they were able to play off regulators against one another. This put pressure on regulators to relax their standards in enforcement. For example, in 2007, Countrywide turned in its charters in order to drop the Federal Reserve and the OCC as its regulators and to switch to OTS. The result was a regulatory race to the bottom. We can see evidence of regulatory failure by the Federal Reserve, the OTS, and OCC. As the Committee knows, the Federal Reserve refused to exercise its authority under HOEPA to regulate unfair and deceptive mortgages under Chairman Greenspan. The Fed did not change its mind until last summer under the leadership of Chairman Ben Bernanke. Meanwhile, OTS allowed thrifts to expand aggressively into option payment ARMs and other risky loans. In 2007 and 2008, five of the seven largest depository failures were regulated by OTS, including IndyMac and WaMu. In addition, Wachovia Mortgage FSB and Countrywide Bank FSB were forced into shotgun marriages to avoid receivership. By the way, none of this happened on my colleague Ellen Seidman's watch. She was a leader in fighting mortgage abuses when she was Director of OTS. Finally, how about the OCC? During the housing boom, the OCC allowed all five of the largest banks--Bank of America, JPMorgan Chase, CitiBank, Wachovia, and Wells Fargo--to expand aggressively into low-doc and no-doc loans. The results were predictable. Today, as a result, the country is struggling with how to handle banks that are too big to fail as a result. Bottom line, when you look at all types of depository charters, State banks and thrifts had the best default rates. Federal thrifts had the worst, and national banks had the second worst. Placing consumer protection with bank regulators turned out to be no guarantee of safety and soundness. Having it in a separate agency would counteract the over-optimism of Federal banking regulators at the top of the credit cycle. To fix these problems, we need three reforms. First, Congress should adopt uniform minimum safety standards for all providers of consumer credit, regardless of the type of entity or charter. This should be a floor, not a ceiling. First of all, that is necessary to make sure that the entity, the regulator, does not have too weak of a standard. And second, we have seen that States are closer to people at home and more responsive to their problems. Second, the authority for administering these standards should be housed in one Federal agency whose sole mission is consumer protection. This agency could either be a new agency or the Federal Trade Commission. All responsibility for oversight of consumer credit should be transferred from Federal banking regulators to this agency. And then finally, to avoid the risk of agency inaction, Congress should give parallel enforcement authority to the States and allow consumers to bring private causes of action to recover for injuries they sustain. I would be glad to take any questions. Thank you. " FOMC20080430meeting--99 97,MR. BULLARD.," Thank you, Mr. Chairman. The economy of the Eighth District continues to show signs of weakness. The services sector has continued to soften, and sales of both general and big box retailers are down from the same period last year. The residential real estate sector has continued to decline throughout the District. Across major metro areas, sales were about 15 percent below the level from last year, and single-family permits were down about 30 percent. Employment growth has slowed and is estimated to have turned negative in March for many areas. Typically, however, employment growth in the District has been stronger than that for the United States as a whole. Manufacturing has remained roughly flat, despite temporary shutdowns that have affected domestic automobile production. Also, commercial real estate construction remains strong, and vacancy rates are low; however, there are increases in the number of delayed projects. Banks in the District are still in good shape, generally speaking. There have been modest increases in total loans in all categories, including real estate. Contacts in the shipping and trucking industries reported a mixed bag. In some instances, business seems to be holding up, whereas in others it is down substantially. These businesses are being critically affected by increases in energy prices. Similarly, a contact in the fast food industry painted a picture of a business struggling with substantial increases in commodity prices. On the other hand, a contact in a large technology firm indicated that business is holding up quite well, in part because a large fraction of this firm's business is overseas. Contacts in the energy sector reported robust business prospects, as expected. A contact at a large financial firm suggested that the discovery process concerning asset-backed securities, which has been ongoing for many months, has effectively come to a close. The idea that the discovery process--and the considerable macroeconomic uncertainty that attended that process--is over is an important consideration at this juncture. My sense is that expectations of future economic performance are changing rapidly. The probability that the U.S. economy will enter into a debilitating depression-like state has fallen dramatically. In the meantime, other risks have increased markedly--in particular, that the FOMC will lose credibility with respect to its inflation goals. The U.S. economy has certainly encountered a large shock. Monetary policy can mitigate the effects of a large shock but cannot be expected to completely offset exceptional disturbances. Attempts to do too much may create more and moredangerous problems in the future. Best-practice monetary policy would do well, it seems to me, to avoid setting the stage for future problems. The problems with the rate structure, which is too low, are threefold. First, there is the risk of setting up a new bubble. The exceptionally low rates of a few years ago are sometimes cited as providing fuel for today's problems. Some have argued that today's commodity price increases are exactly that new bubble. Second, continued unabated reductions in interest rates will bring the zero bound issue into play with unknown consequences. Third, still lower rates will push the envelope further on inflationary expectations. Those expectations may appear to be reasonably well anchored today, but that is because the private sector expects us to take actions to keep inflation low and stable. Should those expectations become unmoored, it will be too late, and an era of higher and more volatile inflation would be very costly for American households. Much has been done already. A low rate environment has been created and has been in place only for a short time. Marginal moves at this juncture are minor compared with the general thrust of policy over the last nine months. The Committee would do much better at this meeting by taking steps to address eroding credibility. Thank you. " FOMC20071031meeting--75 73,VICE CHAIRMAN GEITHNER.," As the Chairman said at the Economic Club of New York, it is likely to emerge stronger. I think the outlook looks about the way it did in September. Just a few quick points. Financial market conditions are substantially better than during the peak of the panic in mid-August; but the improvement, as many of you said, is still quite limited and uneven. Sentiment is still quite fragile, and I think we still seem likely to face a protracted period of adjustment ahead as the markets work through the substantial array of challenges remaining. Growth in the United States and in the world economy in my view seems likely to slow— more here, of course, than elsewhere. Here, even though the nonhousing, non-auto parts of the U.S. economy don’t yet show significant evidence of a considerable slowdown of actual or expected demand, I think that still seems likely. In our central scenario, though, housing construction weakens further. Housing demand slows further because of the tightening of credit conditions. Prices fall further. Consumer spending slows a bit, and businesses react by scaling back growth in hiring and investment, and this produces several quarters of growth modestly below trend. I think that growth outside the United States is likely to slow a bit. It will slow toward potential, if not all the way to potential, in those economies that have been growing above potential. Although the world is larger in relative terms and somewhat less vulnerable to a U.S. slowdown than it once was, it seems to me very unlikely that domestic demand in the rest of the world will accelerate as domestic demand slows in the United States. So the risks to this outlook for U.S. growth still seem to lie to the downside. The magnitude of the downside risks may be slightly less than in September, but they remain substantial. I think the main source of this downside risk to growth is the interaction between expectations of recession probability and the credit market dynamics. Each feeds the other. As the outlook for housing deteriorates and the recession probability stays elevated, financial institutions and investors stay cautious. That caution, in turn, slows the pace of recovery in markets—in asset-backed, securitization, and structured-credit markets—and in credit growth more broadly. As expectations adjust to anticipate a longer, more-substantial period of impairment in markets, then recession probability at least potentially increases. I think that the underlying inflation numbers and the measures we use to capture underlying inflation do not suggest any meaningful acceleration in underlying inflation, and we still expect the core PCE to run at a rate below 2 percent over the forecast period. In some ways, though, the inflation outlook now feels a bit worse. It feels worse because of the modest rise in breakevens that we saw following our last meeting and because of sentiment in markets around gold, commodity and energy prices, and the dollar. The fact that breakevens at long horizons have risen or failed to fall as monetary policy expectations have shifted down is not the most comforting pattern out there. So I think we need to be very careful not to encourage any sense in markets that we’re indifferent to those potential risks. Having said that, I think the risks to that inflation forecast are roughly balanced. The range of tools we have for measuring equilibrium combined with what you see in financial market expectations suggests that monetary policy, to assess the real short-term interest rate, is at or above most estimates of neutral and, therefore, is still exerting some modest restraint on growth. The expectations now built into markets imply too much easing over the next eighteen months, more than I think we’re likely to have to do. But I think the appropriate path of monetary policy lies under the Greenbook’s assumption. Thank you." CHRG-109hhrg31539--2 The Chairman," The committee will come to order. Chairman Bernanke, good morning. In February, this committee was proud to be the venue for your first appearance before Congress on the conduct of monetary policy. Today marks your second appearance, with many more yet to come. In 2001, shortly after I assumed the chairmanship of this committee, the very first hearing I chaired was to receive the testimony of former Chairman Greenspan. We didn't know it at the time, but we had a very rough patch of economic road ahead with the bursting of the tech bubble; and 9/11 and the resulting insurance crisis and the corporate bankruptcies. Back then, we had a weak economy that everyone said was strong. Now we have a strong economy that some are trying to convince us is weak. Some of the credit for the current robust economy goes to the Federal Reserve, of course, where you and Chairman Greenspan have held inflation to lower levels and lower volatility than we have seen in all but 20 years of the life of the Federal Reserve. I would like to enter a chart showing that into the record. The lion's share of the credit goes to President Bush, who had the steadiness to guide us through recession and the courage to do the right thing in seeking tax cuts to spur growth. Now we see that the biggest spurt in tax revenue growth in 40 years has trimmed our expected 2006 deficit by a third in just 6 months, and is on track to drop the deficit as a percentage of GDP to less than half of the similar share in most European economies. Some of the credit goes to Congress, which made the tax cut stick, although we still have some work to do on making tax cuts permanent, and on spending discipline. But the largest credit of all goes to the American people, who with determination, character, and heart, showed what a great country this really is. America suffered a recession, a massive terror attack, scandals of corporate governance, and a destructive hurricane season. Through all of that, we have added 5.4 million jobs in the last 3 years; we have had 34 uninterrupted quarters of growth; we have an unemployed rate lower than that of most of the last 40 years; and we also have growth at or above the average rate for all 6 postwar decades. In June alone, the U.S. economy created 121,000 new jobs, and maintained a low 4.6 unemployment rate. I would be remiss if I did not point out that the unemployment rate is lower than the 6 percent floor that the economists used to call full employment. GDP growth for the first quarter was 5.6 percent, stronger than expected, and the fastest growth in two-and-a-half years. That, Mr. Chairman, is something we can all be proud of. This is a remarkable country and a remarkable economy that constantly renews and reinvents itself--the flexibility that Chairman Greenspan talks so much about. The Federal Reserve has led monetary policy extremely well, and I am certain that will continue to be the case during your tenure. Mr. Chairman, America is doing well, and will continue to do well. Of course, we will continue to have to work and think and innovate, because other countries have smart people and good economies as well. However, since the recession and the terror attacks, this country's economy has grown a great deal. In real terms, U.S. growth alone is half as big as the total economy of China. So with that, Mr. Chairman, I thank you and all of the many people at the Federal Reserve, most of whom we have never met, for their insight and experience and dedication. And we look forward to your testimony, Chairman Bernanke. And with that, I yield back the balance of my time and now recognize the ranking member, the gentleman from Massachusetts. " CHRG-111hhrg53244--102 Mr. Castle," Thank you, Mr. Chairman. Chairman Bernanke, let me just say in praise of you, because my questions may imply some negatives, I think you are doing a good job on monetary policy. And I think that meets one of the goals of the Humphrey-Hawkins Act. Just looking at that Act, it outlines four goals for a strong economy: full employment; growth in production; price stability; and balance of trade and budget, of which I think price stability is the one that sort of stands out now. And I think that has a lot to do with what you do. And maybe this is Government 101, but I am not 100 percent sure what your role is with the Administration. We are watching a circumstance in which we have deficits creating greatly. Debt will go up over $10 trillion, according to the budget, in the next 10 years or so. Appropriations are up dramatically, for this year at least and the ones we have passed in the House so far. The health care legislation that is being considered in the House and the Senate doesn't seem to have any real cost controls in it, some maybe passing wave at that, but that is about the extent of it, and are probably in trouble because of that. My question to you is, does the Executive Branch of government, the White House, consult with you about any of these broader economic issues? I mean, part of your responsibility under Humphrey-Hawkins is to try to make progress towards these goals. And it seems to me just setting monetary policy won't necessarily solve the problems of the full employment, the growth of production, and the balance of trade and budget. And I didn't know if that is just off-bounds for you and for them or if there is any consultation going on. And, obviously, if you have any comments about your point of view on some of these expenditures which are going on, I would be interested in hearing them, as well. " FOMC20060920meeting--59 57,MR. STOCKTON.," Thank you, Mr. Chairman. I cannot recall the precise baseball analogy employed by David Wilcox at the last FOMC meeting, but I have a vague recollection he speculated that I was either due for a forecasting hit or due to be hit by the forecast. [Laughter] In any event, since the Greenbook was completed last Wednesday, we have made several trips to the plate with consequential economic statistics on the mound. And how is the team doing? I guess I=d say, better than the Washington Nationals, not as well as the New York Mets. Last Thursday, we received retail sales figures for August. As you know, we focus on the retail control component of spending, which strips out sales at auto dealers and building material and supply stores. The August increase in this category was 0.2 percent, a bit stronger than we had expected. But both June and July were revised down, and on net these data were a touch weaker than those incorporated in the September Greenbook. Retail inventories for July also were a bit below our expectation. Housing starts for August were released yesterday. In line with our forecast, single-family starts dropped nearly 6 percent, to 1.36 million units, and the permits data point to some further declines in the months ahead. But multifamily starts declined somewhat more that we had expected. If we had to redo the forecast today, we would probably lower the increase in real GDP in the second half of this year to 1½ percent at an annual rate. Last Friday=s report that both headline and core consumer prices increased 0.2 percent in August was right in line with our forecast. The major components of yesterday=s PPI actually came in below our expectations, most especially the core finished goods index, which declined 0.4 percent in August. The only sour note was an increase in the PPI for medical services. The PPI for medical services is used by the BEA in constructing the core PCE price index, and it caused our estimate of core PCE prices for August to revise up from a high 0.2 percent to a low 0.3 percent. All in all, however, the incoming data over the past week left our forecast pretty much unscathed. I am relieved about that, because, if I do say so myself, it=s a beautifully constructed forecast. [Laughter] After all, with no further tightening of monetary policy, the economy eases into an extended period of slightly below-trend growth led by a retrenchment in the housing sector. That slower growth of activity opens a small output gap by the middle of next year but does not trigger a more precipitous cyclical contraction. Then, as the downturn in housing wanes and the associated multiplier and accelerator effects largely play out, the growth of real GDP picks back up toward potential in 2008. Meanwhile, the output gap that develops over the next year or so, in combination with inflation expectations that remain well anchored and a near flattening out of oil and other commodity prices, is projected to impart a mild tilt down in core inflation—to 2¼ percent in 2007 and 2 percent in 2008. So, what should you make of this forecast? Is it a construction as elegant and durable as say the Eiffel Tower in Paris, or is it more like the Eiffel Tower in Las Vegas—it looks pretty good a few blocks away but isn=t that impressive upon closer inspection? [Laughter] In that regard, you could not be faulted for wondering whether this forecast represents our averaging of two possibly more plausible outcomes that we simply didn=t have the courage to choose between. One view could be that this forecast is far too pessimistic. After all, our projection for growth in the second half of this year and in 2007 is now well below the consensus. Most of the available measures of aggregate activity remain solid. Real GDP is estimated to have increased 3½ percent over the year ending in the second quarter, about in line with its pace over the past several years. More recently, despite some notable month-to-month swings, manufacturing industrial production is up at a 5 percent annual rate over the three months ending in August. An even more timely economic indicator, the level of initial claims for unemployment insurance, has moved sideways through the middle of this month and does not yet suggest any inflection point in activity. Moreover, oil prices are down, the stock market is up, and financial conditions in the corporate sector remain favorable. These developments could cast doubt on our projected slowdown in real GDP. The other view might be that our forecast is too optimistic. Cyclical contractions are often precipitated by large imbalances in the economy that cause a great deal of pain and extensive damage when they get rectified. Certainly, housing is looking increasingly like a sector that could play that role. Starts and sales have dropped sharply in recent months, inventories of unsold homes are still soaring despite cutbacks in production, and prices are rapidly decelerating. This jolt is occurring while households are still dealing with the substantial hit to their purchasing power from the higher energy prices that they have encountered over the past several years. Yet all of this results, in our forecast, in only a very modest and gradual rise in the unemployment rate over the forecast period. I must admit that there were times over the past several weeks when I felt as though I=d seen this forecast before—specifically, in the summer of 1990 and in the autumn of 2000. At those times, the staff saw that forces of restraint were in place, and we projected a noticeable shortfall of growth from potential. But we failed to anticipate much in advance the impending cyclical downturn in the economy—and I doubt that we will when such an event occurs again in the future. I can assure you that we spent a great deal of time examining both of these possible critiques of our forecast, but in the end, we still view something like our projection as more likely than either of these two alternatives. So let me lay out the logic of the forecast and along the way address some of these concerns. As I noted earlier, we are now projecting the growth of real output in the second half of the year to be around 1½ percent at an annual rate, about ½ percentage point less than in the August Greenbook. The lower scheduled vehicle assemblies announced by the automakers were part of the downward adjustment. But the major source of the projected weakness in aggregate demand lies in residential construction, which is now expected to lop off nearly 1½ percentage points of growth in real GDP in the second half. If it doesn=t really feel to you like an economy that is growing as slowly as 1½ percent, there may be a good reason. Our assessment is that, except for the housing sector, the economy is growing at a pace of roughly 3 percent. So far the collateral damage from the downturn in housing has been limited, and for the most part, we expect it to remain that way, at least for a time. A pickup in nonresidential construction activity has offset some of the weakness in residential construction. Moreover, the recent declines in energy prices seem likely to cushion some of the near-term effects of the housing contraction by restoring some lost purchasing power to households and by helping to support consumer spending. With overall business sales holding up reasonably well so far, the cost of capital still low by historical standards, and financial conditions solid, outlays for equipment should move forward at a fairly rapid clip for the remainder of the year. But it seems implausible to us that the downturn in housing will not have multiplier-accelerator consequences that hold down growth going forward. Along those lines, we expect employment growth to slow more noticeably by the end of the year. Slower job gains and a further deceleration in housing wealth should damp consumer spending as we move into next year. The result is a steady, though gradual, rise in the personal saving rate over the next two years of about 2 percentage points. With the usual lags, slower growth of sales and output cause a mild deceleration in equipment spending. At the same time, fiscal policy is becoming progressively less stimulative over the forecast period. These forces are attenuated, but not offset, by the boost to spending generated by a higher estimated level of labor income and by a lower trajectory of consumer energy prices in this forecast. All told, we see these influences as likely to hold the growth of real GDP below potential over the next two years. Still, we are not anticipating the weakening in activity to cumulate into outright recession. In our forecast, the fact that the implications of the housing downturn for the broader economy are relatively limited rests importantly on two suppositions, both of which are open to question. The first is that the slump in housing produces a sharp slowdown in house prices but not a large nationwide decline in those prices. In the past, housing prices have been relatively sticky on the downside, with homeowners resisting price cuts and keeping their homes on the market longer. Our forecast envisions something similar occurring in this episode. The second assumption is that housing wealth affects consumer spending like other forms of wealth and that there are no other channels of influence of house prices and housing finance on consumption. For example, we have not incorporated any significant negative effects on consumer sentiment that might accompany a rapid deceleration of house prices. We have also made no special allowance for the decline in mortgage equity withdrawal to restrain consumption because we find the empirical evidence of such a connection to be fragile. Previous Greenbook simulations have demonstrated that turning on any of these channels would amplify the effects of a weak housing market on the aggregate economy. Their absence in our baseline forecast is one of the reasons that the economy bends but doesn=t break in response to our projected housing slump. As you know from reading the Greenbook, not all of the action was on the demand side of our forecast. In fact, we revised down aggregate supply by virtually the same amount that we revised down aggregate demand, leaving the output gap nearly unchanged from the August Greenbook. I would not be surprised if some of you were suffering a little reverse “sticker shock” from the low rates of GDP growth that we are now projecting, much of which can be traced to the downward adjustments that we made to potential output in each of the last two projections. The growth of potential is estimated to be about 2¾ percent this year and next and 2½ percent in 2008. Although we still could be characterized as productivity “optimists” with our projection of gains in structural productivity of 2¾ percent per year—a figure that is above many of the outside forecasts that we monitor—we are increasingly looking like potential output “pessimists” because of our expectation of only meager gains in available labor input. As you know, we are projecting a steepening downtrend in labor force participation and a slowing in the working-age population as the front edge of baby-boom retirements arrives late in the projection period. Our views are significantly below the consensus here. However, as we have noted in the past, if potential GDP ultimately proves stronger than we are forecasting, actual GDP will likely be stronger as well. So to a first approximation, the GDP gap and the assumed accompanying path of the funds rate would be largely unaffected by errors in our forecast of potential labor input. Much like the real side of the projection, our inflation forecast had some large moving pieces that, on net, left us pretty much in the same place as our August projection. On the favorable side of the ledger, oil prices are projected to average around $10 per barrel below our previous forecast. Taken in isolation, this development would have led us to revise down our projection of core PCE prices about 0.1 percentage point next year. But there was news on the unfavorable side of the ledger as well. On the basis of unemployment insurance tax records, the BEA revised up the growth in hourly labor compensation to an annual rate of 13¾ percent in the first quarter of the year. Once again, we are confronted with a huge difference between the signal provided by nonfarm business compensation and the employment cost index (ECI) measure of compensation, which increased at a rate of just 2½ percent in that quarter. Such wild discrepancies have led some inflation forecasters to employ reduced-form price equations that circumvent measures of labor compensation altogether. We are sympathetic to that approach, and those types of models are in our stable of forecasting equations. But we think it unwise to ignore entirely the issue of labor costs, given that they constitute two-thirds of business costs. So what do we make of this first-quarter jump in hourly labor compensation? As you know, one of the principal differences between the two major measures is that stock option exercises are included in the nonfarm business measure of hourly compensation but not in the ECI. Our colleagues at the New York Fed have been monitoring data on option exercises by company insiders, and those data suggest that an outsized jump in exercises in the first quarter probably helps to explain an appreciable fraction of the jump in hourly compensation. But that doesn=t seem to be the full story, as wages and salaries were revised up in categories, such as construction, where options probably do not figure prominently in employee compensation. In our forecast, we have assumed that stock option exercises and other nonrecurring nonwage payments provided a temporary boost to the level of income in the first quarter, about half of which will be reversed by the third quarter. What about the consequences of these higher measured labor costs for prices? Models that take the data simply at face value want to revise up the forecast of core consumer price inflation forecast between ¼ and ½ percentage point in 2007. However, these data should not be taken entirely at face value, at least as a measure of incremental business costs. As we have argued in the past, option exercises are not likely to represent a marginal cost of production and, at the very least, are probably misleading with regard to the timing of any such cost increase. Thus we have discounted the price implications of the first-quarter surge in compensation per hour, adding just a tenth to our inflation forecast for this factor. This exactly offsets the negative effects of the lower energy prices and leaves our projection of core PCE inflation unchanged at 2¼ percent in 2007. After that, a further waning of energy and other commodity cost pressures, the emergence of a small output gap, and the assumption that long-term inflation expectations continue to be reasonably well behaved cause inflation to drop to 2 percent in 2008. In that regard, the better core inflation figures of the past two months, the fall in oil prices, and the drop in various readings on inflation expectations over the intermeeting period provide us with some encouragement that inflation pressures will gradually fade over the projection period. But we would hasten to note that none of these developments cinch the case that we have turned the corner on inflation. Karen will continue our presentation." FOMC20081029meeting--232 230,MR. STERN.," Thank you, Mr. Chairman. I'll start with a few comments about the District economy, which will sound pretty familiar by now. The preponderance of the anecdotes from business contacts that I've talked with since our last meeting have been distinctly negative. It's not just a slowing of activity or some deterioration but a sharp contraction in activity, particularly with regard to discretionary spending or discretionary projects, beginning in the middle of September. The one exception to that is commercial construction, where there are enough things under way that business remains pretty good. But the backlogs are dropping, and so weakness certainly is anticipated next year. I thought another possible exception to the negative tone was the housing market in the Twin Cities--not that the housing market in the Twin Cities is in and of itself so important but that it might be representative of some middle-of-the-road markets across the country. Clearly, it's not indicative of what's going on in Florida, California, or places like those because sales volumes in the Twin Cities had been up distinctly. Some of that is no doubt due to short sales and foreclosures; nevertheless, there were some other signs that were favorable. The affordability index has really improved a lot. It is back to levels of 2002-03, which Realtors call very comfortable. The ratio of housing prices to rent has moved back to the levels of 2002-03, and that's also encouraging. I already mentioned the higher sales volumes. Unfortunately, when you get beyond those statistics and look at other things, it's too early to declare stability in the housing market or anything resembling underlying improvement. Part of the problem is something that we've talked about before. The inventory of unsold, unoccupied properties remains very substantial--by historical experience way above anything resembling normal. Second, even though the price-to-rent ratio has come down, it's still elevated relative to the longer-term historical experience. So it looks to me as though, even in that market, there are some further price declines to come and it's going to take some more time to get through all of this-- probably well into next year. As far as the national economy is concerned, I, too, have marked down my outlook for real growth for the balance of this year, for all of next year, and into early 2010 as well. This reflects to some extent the nature of the incoming data but also the intensification of the financial problems and associated headwinds, the impact of the negative wealth effect, and so on. When I looked at my June forecast, back then the forecast obviously looked better, although there were a number of what I called ""identifiable negatives."" They have proven, for worse rather than for better, to be relevant. I already talked about some of them. In addition, we still have the problem in housing with excess inventories. We have steady declines in employment, which obviously have negative implications for consumer spending, and the credit headwinds as well. So now I have the economy contracting through the middle of next year, modest growth resuming thereafter, and robust growth beginning with the second quarter of 2010--quite some distance off. On the inflation outlook, I have for some time been thinking that inflation would begin to slow this quarter. With the decline in commodity prices, the evolution of the economic outlook, and so forth, my confidence in that forecast has increased, and I do expect inflation to diminish over the forecast period. So I think I'll conclude with that. " CHRG-110hhrg44901--25 Mr. Bernanke," Congressman, I couldn't agree with you more that inflation is a tax and that inflation is currently too high, and it is a top priority of the Federal Reserve to run a policy that is going to bring inflation to an acceptable level consistent with price stability as we go forward. I would make one distinction, which is that what the Federal Reserve can control is the increase in prices on the average, over the overall basket of consumer goods and services. The enormous jumps in oil prices and other commodity prices are to some extent at least due to real factors out of the control of the Federal Reserve. The Federal Reserve cannot create another barrel of oil. It is the global supply and demand conditions which are affecting those particulars things to the most significant extent, but to the extent that the Fed does have influence on the overall inflation rate, you are absolutely right that it is very important to maintain price stability, and I take that very seriously. Dr. Paul. But if the oil prices were going up for another reason other than monetary reasons, other prices would have to come down because there would be a limit in the money supply. I think--and the prices are going up today, like I indicated in my opening statement, not necessarily because of the monetary policy of the last year but maybe for the last 15 or 20 years and the fact that we were able to export, so to speak, our inflation. Now it is coming home. Those people who have been holding these dollars are not wanting to buy them as readily. Fortunately, foreign central banks are still not dumping them but even the other central banks might not be as cooperative. So I still see tremendous pressure. I don't see any signs that you are able to do very much because all we hear about is more inflation. You know, it is not so much that they are too big to fail. It just means that everybody needs to be propped up. Congress participates in it. And all the pressure is put on the dollar. It is a dollar bubble. And I think what we are seeing is the unraveling of a dollar bubble that had been building for more than 35 years. " FOMC20070321meeting--83 81,MR. LACKER.," Thank you, Mr. Chairman. Overall, economic activity in the Fifth District expanded modestly in recent weeks, though performance across sectors remains uneven. Growth is centered in the services sector, where moderately positive readings continue. Real activity has recovered somewhat in recent weeks, and big-ticket sales have posted modest gains after two months of quite weak readings. In manufacturing, our survey respondents continue to report a downward drift in activity. They remain optimistic about their future prospects, however, though many comment on generally weak current demand. Labor markets remain tight in most jurisdictions, with the standard reports of spot shortages of skilled workers, but wage pressures are reported to be moderate. We continue to hear of some reasonably firm housing activity in a number of District localities. Home prices remain generally flat, though builders are offering more incentives to buyers. Inflation pressures appear to have moderated in March according to our latest survey, but manufacturers and service providers expect price pressures to increase modestly over the next six months. On the national level, risks seem to have risen lately, but my sense is that prospects are still reasonably sound. Subprime mortgages, obviously, have dominated the financial news in recent weeks. Concerns about the welfare of families suffering foreclosure are quite natural, and anecdotes about outright fraud suggest some criminality. But my overall sense of what’s going on is that an industry of originators and investors simply misjudged subprime mortgage default frequencies. Realization of that risk seems to be playing out in a fairly orderly way so far. Mortgage-backed securities have lost value as risk spreads have widened, and there have been insolvencies among firms that specialized in this sector. The updating of risk estimates in light of recent experience will lead to higher borrowing costs in the affected market segments, and at the margin this increase could shift some households from homeownership to renting. But in my judgment, that isn’t likely to affect the net demand for housing units. Notably, we have not seen broader risks to credit availability in other markets or to the financial safety net. Perhaps the greatest economic risk posed by recent subprime developments is legislation that impedes the availability of credit or that provides financial support ex-post that was unanticipated ex-ante but affects private decisionmaking henceforth, somewhat like ad hoc disaster relief. Housing construction continues to contract, of course, and inventories remain elevated. The choppy winter data make it hard to gauge the descent, but overall home sales seem to be holding steady, and we haven’t heard anything locally that suggests a renewed contraction in demand. So the housing outlook hasn’t changed much for me. However, the recent weakness in business investment has been disappointing. One would expect soft patches related to housing, autos, and the new truck regulations, but the broader sluggishness is a bit at odds with the generally favorable fundamentals. I still expect this investment to pick up ultimately, although I have to admit that the recent data have left me a bit less certain, especially about when. The outlook for consumer spending remains fairly healthy, though. Real disposable income growth has been powered by continuing gains in employment and firmer wage growth. So all in all, I still think the current episode of below-trend growth is fundamentally a transitory phenomenon that will most likely be behind us by the end of the year, although the recent weakness in business investment suggests more downside risk than before. Core inflation continues to firm, and it now seems clear that the fourth quarter’s energy- induced lull is over. We have yet to see much sign of the long-awaited easing in resource utilization. It’s not obvious that we will be getting any help from labor costs any time soon, and inflation expectations remain centered at or above 2 percent. So to me, the prospects for moderation in inflation remain tenuous. I continue to believe that, by summer, growth concerns are likely to be behind us, and we will want to act to reduce inflation, which we recognize is higher than we want. Thank you." FOMC20080625meeting--30 28,MR. SLIFMAN.," Last week, the Washington Post ran a front page story with the headline, ""Why We're Gloomier than the Economy."" Like the author of the Post article, we too have noticed the difference between what people are saying about the economy in surveys and what they apparently are producing and spending. Starting first with the survey indicators, the top left panel of exhibit 6 plots the plunge in the Michigan index of consumer sentiment, which is far deeper than can be explained by its usual predictors such as labor market conditions, inflation, and the stock market. The panel to the right plots two of the most timely surveys of business attitudes, which continue to suggest that the respondents are pessimistic about overall business conditions. Meanwhile, as shown in the middle left panel, although private payrolls continue to shrink, the declines have been much smaller than we were expecting and, as you can see from the shaded area (if you look very closely), [laughter] much smaller than the ones that occurred during the last recession. In terms of spending data, the most striking piece of news was the upward revision to earlier retail sales figures. At the time of the April Greenbook, real outlays for consumer goods other than motor vehicles appeared to be moving sideways (the red line in the middle right panel). However, the black line shows that according to the latest estimates--which, of course, are still subject to additional revisions--spending rose rapidly in March and April and climbed further in May. With these numbers, we revised up appreciably our near-term estimates of the growth rate of real PCE goods other than motor vehicles (the inset box). On the business side, the bottom left table, shipments of nondefense capital goods, excluding transportation, rose further in April, and new orders jumped. In addition, outlays for construction of nonresidential buildings, the bottom line of the table, continued to climb in April. All told, these indicators suggest stronger business spending than we had anticipated in our April forecast. A potentially important downside development may be emerging in the motor vehicles sector--the bottom right panel--where, according to our industry contacts, sales of light vehicles appear to be plummeting in June. Whether this is just a reaction to the surge in oil prices that will be contained within the auto sector or whether it's a canary in the coal mine pointing to something far more serious for the entire economy remains to be seen. But it certainly has grabbed our attention and highlights a downside risk to our projection. Exhibit 7 focuses on the overall GDP forecast through 2009 and some of the key factors that informed our thinking about the outlook. We had a lot of moving parts to deal with this round, and the upper panel summarizes how we put them together. First, in light of the incoming information, we revised up our forecast for the first two quarters of this year, especially the second quarter. We now think that real GDP growth came in at an annual rate of 1.1 percent in the first quarter and picked up to a 1.7 percent pace in the second quarter. As you know, earlier this year we put in some judgmental adjustments to the forecast, which reflected a combination of the tendency for negative model residuals to be correlated during cyclical downturns as well as the macro effects of financial turmoil and uncertainty that are not well captured by our models. We have interpreted some of the recent spending surprise as suggesting that we went too heavy on such effects in the April Greenbook, and so we have tempered them in this projection. That said, we still anticipate that some of these influences will show through to spending, especially in the household sector, and we expect the economy to be on a very subdued growth path for the next few quarters. As I will discuss shortly, residential investment is still projected to be a drag on economic growth well into next year. Moreover, with house prices expected to fall through the end of next year, the ratio of household net worth to income remains on a downward trajectory, reducing some of the wherewithal for consumer spending. Household purchasing power also is being held down by the surge in oil prices that Nathan discussed (the middle left panel). As shown in the inset box, by our reckoning the increases in the spot and futures prices of WTI since the April Greenbook subtract about � percentage point from real GDP growth in both 2008 and 2009, with much of the effect working through PCE. Despite these negative influences, if the story ended here, the economy still would be operating with a somewhat higher utilization rate--that is, a smaller GDP gap--than in the April Greenbook. In light of this consideration, as well as the less favorable outlook for inflation that Bill will discuss, we have conditioned this forecast on a tighter path for monetary policy than the one in the previous Greenbook. As you can see in the middle right panel, by the end of next year the federal funds rate is 100 basis points higher than in the April Greenbook. I should note here that we also have raised our estimate of the growth rate of potential GDP, which Bill will discuss shortly. Because we view our revised estimate of potential as merely the staff's catching up with what individuals and firms were already expecting, these revisions result in corresponding adjustments to the growth rate of real GDP going forward. All told, as illustrated in the bottom left panel, after increasing substantially faster in the first half of the year, real GDP is now projected to grow at an annual rate of � percent in the second half of 2008, a bit less than in our previous projection. In 2009, real GDP is expected to increase 2.4 percent, about � percentage point less than in the April Greenbook. The bottom line of the forecast is perhaps most easily seen by the path of the GDP gap. As shown in the bottom right panel, the gap starts out the projection period being much narrower than in the April forecast. By the fourth quarter of 2009, however, the gap is essentially the same as in the April Greenbook. After that high-altitude flyover of the projection, the next two exhibits swoop down for a closer look at some of the details. Exhibit 8 focuses on the housing sector. With demand weak, the overhang of unsold new and existing single-family homes-- the vacancy rate--has soared, putting downward pressure on prices. As shown to the right, the OFHEO purchase-only index of house prices fell at an annual of 6.7 percent in the first quarter of 2008, and we expect home prices to continue declining around this pace into next year. Anecdotes and common sense suggest that many prospective homebuyers, leery of purchasing an asset whose value is falling, are waiting for house prices to bottom out before entering the market. This behavior further saps already sagging housing demand. We don't have direct survey evidence for this supposition; however, the middle panels present some suggestive numbers taken from the Michigan survey. First, as shown by the black line in the panel to the left, the share of current homeowners who think the price of their home fell over the past 12 months jumped dramatically through early this year and remains elevated. In addition, the share that thinks the price will fall over the next 12 months also has drifted up. The panel on the right, which is based on work by my colleague Claudia Sahm, looks at the views of renters. Here the blue bars show the percentage of renters in the Michigan survey who say that now is a bad time to buy a house. The red line plots an estimate of house price overvaluation derived from a price�rent model that we follow. As you can see, as houses became increasingly overvalued, more and more renters became pessimistic about homebuying--apparently for affordability reasons. Of course, relative prices are not the only influence on affordability. General macroeconomic and credit market conditions also are important. Thus, even though the extent of overvaluation has diminished so far this year, renters, at least thus far, remain quite pessimistic about homebuying conditions. So what brings us out of this seeming death spiral? If house prices follow the expected trajectory, we estimate that they will move into rough alignment with their long-run relationship with rents early next year and then, as typically happens, overshoot somewhat. As the market returns to something closer to equilibrium, prospective homebuyers who had been waiting out the price bubble in rental quarters should begin to see housing as more affordable and be more willing to buy into owner-occupied housing. As that happens, the rate of decline in house prices should slow, and sales of single-family homes (the bottom left panel) should start to improve. With demand improving and the inventory overhang being worked off, we expect housing starts to level out and then begin to gain altitude slowly in 2009. Exhibit 9 presents the medium-term outlook for consumer spending and business investment. Starting with PCE, real spending is projected to fall, on balance, in the second half of this year. Tax rebates push up the third quarter and create a pothole in the fourth quarter as rebate-related spending drops off. More fundamentally, spending is held back by the effects of higher oil prices on household purchasing power, the ongoing hit to household wealth from falling home prices and earlier declines in equity prices, and the restraining effects of financial turmoil and unusually pessimistic consumer sentiment. In 2009, spending picks up as many of these factors begin to improve; but at 1� percent, the increase is still rather tepid. The middle panels focus on business outlays for equipment and software. Real spending on the high-tech component (the green bars) has slowed sharply this year and is expected to remain relatively soft throughout the projection period. The major U.S. computer manufacturers--such as HP, Dell, and Sun--have expressed caution about the outlook for sales. Meanwhile, capital spending guidance from telecommunications service providers points to a slowing in their outlays for communications equipment. As shown by the blue bars, investment outside the hightech segment has been declining at a modest pace since late last year, and we expect it to contract further over the next year and a half. Spending is held back by normal accelerator effects, tight lending standards, and gloomy business sentiment. For nonresidential structures, the lower panels, the BEA reported that outlays in the drilling and mining component (the green bars) dipped in the first quarter. Anecdotal reports suggest that this may have reflected bottlenecks stemming from shortages of skilled labor and supplies. However, recent data on footage drilled and the number of drilling rigs in operation have picked up, signaling a near-term rise in spending. Looking forward, escalating energy prices are likely to spur continued increases in investment. In contrast, as shown by the blue bars, real construction spending for buildings is projected to be very weak following sizable increases in 2006 and 2007. The evolving supply-and-demand factors for this sector are almost uniformly downbeat: Vacancy rates are moving up; sales and prices of existing properties are sagging; and financing conditions are tight for new projects. Because of these developments, we expect outlays in this category to fall throughout the projection period. Bill will now continue our presentation. " FOMC20080805meeting--130 128,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Like the Greenbook, our modal forecast shows weaker real activity and slightly higher core inflation over the forecast period. Downside risks to growth remain substantial, in my view, and have probably increased relative to what we thought in June. Risks on the inflation front remain weighted to the upside, perhaps somewhat less than in June, but this is hard to know with confidence. The adverse growth risks are worse for several reasons. The labor market and labor income are weakening more quickly than expected. Although there were some tentative signs of stabilization of housing demand in the spring, demand seems to have fallen further since. Credit conditions are tighter and are expected to be tighter longer, and this seems likely to produce a further deterioration in overall demand--note, of course, the reduction in credit for autos, the rise in mortgage rates, and the more conservative lending standards for consumer and corporate credit. Growth outside the United States seems likely to slow further. Of course, fundamental to this dynamic, as has been true for 12 months, each shift in perceptions that the bottom in overall economic growth is further away produces additional stress for financial institutions and markets, adding to the intensity of prospective financial headwinds and to concerns about downside risks to growth. Now, the adverse tail on the inflation front remains significant. Many measures of underlying inflation suggest a broad-based, if limited to date, acceleration in the rate of underlying inflation. Market- and survey-based measures of long-term expectations are high. Surveys suggest that firms are able to pass on some part of the acceleration in energy and materials costs. On the more positive side, energy, commodity, and materials prices have declined significantly, principally it seems because of expectations of slower growth in global demand. Growth is moderating significantly around the world, and it's going to have to moderate further in the most populous parts of the world as central banks there get monetary policy tighter. The growth of unit labor costs has been and is expected to be very moderate here. Profit margins still show plenty of room to absorb cost increases, and as David reminded us, you can have a relatively benign outlook for the path of core inflation without margins narrowing very dramatically. Inflation expectations have not deteriorated meaningfully here, even with the flatter expected path of monetary policy in the United States. Of course, it's very important that inflation expectations and pricing power moderate from current levels. If some of the downside risks to growth materialize, this will happen, and inflation risks will moderate. If, however, the economy continues to prove to be resilient to these downside risks, then we will face higher inflation. On balance, the rate of growth in underlying inflation suggests that growth in demand in the United States will have to be below potential for a longer period of time if inflation expectations are to come down sufficiently. This means that we will have to tighten monetary policy relatively soon compared with our previous behavior in recoveries--perhaps before we see the actual bottom in house prices and the actual peak in unemployment. However, at this point, the risks to real growth remain critical. In my view, we need to have more confidence that we have substantially reduced the risks of a much sharper, more protracted decline in growth before we begin to tighten. I think it is unlikely that we will be able or will need to move before early next year. Short-term market expectations for monetary policy in the United States seem about right at present. I don't see a strong case for trying to alter those expectations in either direction at this point. To try to pull forward the expected tightening would risk adding to the downside risk to growth and magnifying the risk of a much more severe financial crisis. On the other hand, if we avoid some of these downside risks to growth, then policy will need to tighten more quickly, perhaps, than the expected path now priced in the markets. The evolution of monetary policy expectations and of inflation expectations since May illustrates how uncertain the markets are about what path of policy will be appropriate. But the pattern of changes in both of these measures of expectations suggests that the markets believe we will get this balance right--that we will do enough soon enough to keep underlying inflation expectations from eroding materially. Thank you. " FOMC20050630meeting--372 370,MR. LACKER.," Thank you, Mr. Chairman. Economic activity in the Fifth District advanced moderately in May and June. The survey results we released earlier this week showed that manufacturing shipments edged higher and that revenues of service firms grew somewhat more quickly this month. New orders in manufacturing seemed to slip this month, however. Growth in retail sales moderated in June, as our big ticket sales index contracted slightly after having moved sharply higher in May. District housing markets remained fairly hot—maybe not as hot as Miami, but fairly hot. Home sales continued at high levels. Bids above asking prices were common in popular locations. Markets for beach properties and for condos in downtown areas are especially June 29-30, 2005 136 of 234 growth to pick up over the next six months. Our contacts also expect an upturn in capital spending growth over that period, and price pressures in the District remain contained. Indications are that the national economy continues to perform well, although concerns about the housing market and energy prices are causing jitters in some quarters about the sustainability of the expansion. Average net job growth for the three months ending in May exceeded 150,000 per month—a rate sufficient to keep up the steady improvement in labor markets we’ve seen since last year. And the Greenbook expects real GDP to average above 3½ percent through the end of 2006, slightly faster than potential. To me, the most striking revision in the June Greenbook was the 0.2 increase in the projected path for core PCE inflation through 2006. Expected inflation is now 2.1 percent for ’05 and 1.9 percent for ’06. I found this revision striking, because 2 percent is the upper limit of my own comfort zone for core PCE inflation. Moreover, market participants are aware that the core PCE index is the Fed’s preferred inflation measure. And if we allow it to drift much above 2 percent, we run the risk of unhinging longer-run inflation expectations, especially if energy prices spike up further as well. Having said that, I take heart from the fact that inflation expectations have fallen somewhat in the past couple of months. TIPS inflation compensation, both near-term and longer-run, has continued to decline even in the face of climbing oil prices. Of course, inflation expectations build in beliefs about our future behavior. I read declining inflation compensation, along with the apparent fall in inflation uncertainty for which Vincent’s staff apparently finds evidence, as implying that markets expect us to do whatever is necessary to hold the line on inflation. I see three main risks to the outlook. First, with oil markets as tight as they are, the world June 29-30, 2005 137 of 234 Second, we’ve been anticipating a handoff from housing investment to business investment over the course of this recovery. While business investment has continued to pick up, the demand for new capital appears to be limited now by the rate at which firms expect their output to grow. So the potential problem is that businesses may be reluctant to pick up more slack before they see that housing is headed for a soft landing. Yet that reluctance would interfere with or impede a smooth handoff, making it more difficult to achieve. Third, I find myself worrying about the possibility of an inflation scare in the bond market, despite the recent decline in TIPS spreads. It’s not clear how likely this is, but if it happened, it would be very costly. A spike in long-term yields could be particularly harmful today for elevated housing prices. It would raise long-term mortgage rates directly, obviously. Moreover, it would force us to raise short-term real rates. And in such circumstances I think it would be even harder for us to facilitate this handoff of investment from the housing sector to the business sector without an intervening recession. Thank you." CHRG-110shrg50369--31 Mr. Bernanke," I do not anticipate stagflation. I do not think we are anywhere near the situation that prevailed in the 1970's. I do expect inflation to come down. If it does not, we will have to react to it, but I do expect that inflation will come down and that we will have both return to growth and price stability as we move forward. Senator Shelby. Do you still believe that the fundamentals of our economy is still robust, is strong, other than the housing market and some of the financial challenges that we have coming out of that? " FOMC20061025meeting--49 47,MS. MINEHAN.," Thank you, Mr. Chairman. The New England District economy continues to grow at a moderate pace, pretty much as it was growing the last time we met, with job counts slowly increasing and business and consumer confidence relatively good about both current and future conditions. As I’ve noted before, income growth has been robust in the District, with regional income growing better than 7 percent from second quarter ’05 to second quarter ’06. Indeed, incomes in Massachusetts and Connecticut both rose about 9 percent. Reflecting this rise, the fiscal condition of the states in the region, while varied, remains positive. Regional corporate health is solid, and readings of regional stock indexes follow the positive pace of the nation’s financial markets. Contacts from a wide range of manufacturing industries reported positive trends; fewer cost pressures from commodity, energy, and interest rates; and a continuation of competitive pressures to restrain costs and keep prices stable. We regard this pressure as a return to business as usual. On the negative side, the slowdown in the housing sector becomes more apparent with each passing month. According to the overall OFHEO house-price indexes, year-over-year appreciation in the second quarter of ’06 for New England was about half of that for the nation. The change from the first to the second quarter in ’06 was virtually zero. The region now has the lowest rate of annual housing appreciation of any area of the country except the Midwest. This situation is not entirely unwelcome, as housing price levels in the region remain quite high relative to the nation, and there has been much hand-wringing locally about the effect high housing costs have on attracting skilled labor to the region. Of course, the cyclical effect of a sharp residential investment slowdown is of concern. Existing home sales volumes are down 12 percent from their 2005 peaks. New home construction is weakening significantly, and construction employment has declined in both Connecticut and Massachusetts since year-end 2005. Indeed, negative commentary from area business contacts revolved mostly around markets for products aimed at the residential housing industry. While there may be some light at the end of this tunnel, with recent lower mortgage interest rates and some sense of bottoming out, the usual seasonal slowdown in the real estate industry as winter approaches may make this improvement difficult to appreciate for some time. The effect of slowing residential investment remains one of the key uncertainties on the national scene as well. Combined with the negative effect of trade, housing trends have caused us to mark down our estimate of third-quarter GDP growth to about the level of the Greenbook. However, positive incoming data on employment, consumer spending, and corporate profits, spurred as they have been by favorable trends in energy prices, financial markets, and worldwide growth, support a modest rebound in overall activity in the fourth quarter and a forecast for 2007 and 2008 of just slightly less than potential. Indeed, I was pleased to see the upward revision to the Greenbook forecast for the fourth quarter of this year, as I had worried whether the earlier trajectory had increased the risk of a spiral downward into a recession. I don’t think that’s likely, and I realize that overall the second-half GDP projection remains about the same. But the upward revision to the fourth quarter in the Greenbook, which brings it closer to our Boston forecast, makes me somewhat more comfortable about the underlying trajectory of economic activity. We, like the Greenbook authors, have revised down slightly our estimate of potential, so our sense of any gap in resource usage remains about the same as it was at the last meeting. Thus, unemployment rises very slowly, to just about 5 percent in 2008, and inflation falls slowly as well, along the lines of the forecast at the last meeting. All in all, that is not a lot of change. I must admit, however, to some small amount of hope that we may be seeing the bottoming out of the housing market decline because of the mixture of the data that Dave referred to earlier. Moreover, other aspects of the current situation seem quite positive as well—in particular, the very accommodative nature of financial markets and the continuing profitability of the nation’s corporations. Thus, the risks to what continues to be in many ways a rather benign forecast seem to me to be a bit less on the downside than they seemed at our last meeting. Energy-driven inflation may be lower as well, but I remain concerned about the underlying pressures on resource utilization if the economy does not slow as much as we now expect. Corporate-driven productivity growth, though we haven’t seen it escalate recently, could come to the rescue here, but I think it’s hard to bet on that. Thus, I do see some continuing uncertainty as to whether inflation will be as well behaved as in either the Boston or the Greenbook forecast." FOMC20061212meeting--94 92,MR. KOHN.," Thank you, Mr. Chairman. As many of you have remarked, the incoming data on spending at least have been consistent with our basic outlook for economic activity. Weakness in housing and autos will hold activity to below the growth rate of potential for a few quarters but with limited spillover to other forms of household spending. As inventory overhangs in these two sectors are dealt with, growth will return to something like the growth rate of potential. From some perspectives, the recent data have actually suggested diminished downside risk to the story. Stabilizing house sales, recovering mortgage applications, and improving consumer attitudes toward home purchases may be the signs of a housing market beginning to find a bottom. The expected downward path of prices in the Case-Shiller index futures market has actually been revised higher over the intermeeting period; it is still sloping down but not as much. Auto producers have held production steady in the fourth quarter and announced a small increase in production for the first quarter. Moreover, consumption outside autos has remained on a healthy track. Now, the downside risks in these areas may be smaller, but they certainly haven’t been eliminated. The Greenbook projection has starts stabilizing at the current level, but we have yet to see hard evidence of that stability. The last data point was a substantial decline that was larger than we expected. Inventory overhangs in the housing sector are large and will be worked down fairly slowly in the staff forecast. Heads of households may be just coming to the realization that their kids’ tuition and their retirement will not be taken care of by further outsized increases in the value of their homes. A bit more troubling than the housing and consumption data—and perhaps indicative of other sources of downside risk—have been the rise in inventories and the softness in manufacturing production outside the auto and construction-related sectors. Much of the downward revision to private final demand from the last Greenbook to this one, taking into account both the third and the fourth quarters, was in business fixed investment, and it occurred when profits remained robust and sales—excluding autos and residential housing—strong. Evidence of broader weakness in the manufacturing sector seemed to account for at least a portion of the reaction of the financial markets over the intermeeting period. There are a number of reasons to think that this weakness is limited. The underlying economy remains in good shape. Commodity prices have continued to climb, probably partly reflecting the weaker dollar but also indicative of underlying strength in global demand. Firms are adding to payrolls in a way they wouldn’t if they were sensing the possibility of softness spreading outside manufacturing. Equity prices and risk spreads suggest expectations of continued good growth, even if in the eyes of investors it might take some easing of policy to produce that outcome. As President Stern noted, anecdotes—as reflected in the Beige Book and what we’ve heard from visitors, including the Reserve Bank chairs and vice chairs who were here very recently—suggest that businesses are experiencing and expect continued good business conditions. These anecdotes very markedly contrast to the fall of 2000, when by November the tone of the feedback from businesses had turned decidedly gloomier. The Committee has been focused on housing and consumption, but the recent data and the financial market’s response may suggest the possibility that something else could be going on. Perhaps the removal of policy accommodation has affected other forms of spending more than we had anticipated. I think that the basic story of growth strengthening to potential over the next year remains valid and that it will be strong enough to withstand a rise in longer-term interest rates that would accompany a flat fed funds rate as in the Greenbook. Moreover, the overall downside risks to that forecast probably haven’t increased very much, but they may have changed source or character. We will need to be alert to possible sources of weakness that we hadn’t anticipated. With regard to the inflation outlook, I, like the staff, have characterized the incoming data as leaving expectations for a very gradual decline in inflation intact, if the economy follows something like the Greenbook path. To be sure, core PCE inflation did not ease back, but the CPI did quite a bit. Labor cost pressures appear to be less than we had previously estimated, and various measures of long-term inflation expectations remain within their ranges of the past several years. My presumption, like that of the staff, is that at some point lagging spending growth will be reflected in labor markets and will help to remove inflation pressures. But for now, the risks around the expected downward trend in inflation remain skewed to the upside. Unit labor costs are still accelerating, although not as much as we thought they were, and businesses won’t readily absorb higher costs and reduced profit margins. The unemployment rate remains low. The index of capacity utilization in manufacturing continues to be above its long-term average, suggesting continued pressures in resource markets and, by extension, in markets for goods and services, which will contribute both to higher costs and to the ability of businesses to pass them on. The forecast path to inflation is sufficiently gradual that upward deviations from it could entail outsized costs in terms of embedding another notch up in underlying inflation and inflation expectations. Thank you, Mr. Chairman." FinancialCrisisInquiry--152 And so there should be some separation, and I am shocked and amazed because banks are still allowed to do all the activities they were doing before the crisis. But I’m not sure it has to go that far where you automatically separate everything off. There’s other risk factors to think about, such as management continuity, consistency of strategy, success over the last, you know, decade or two. There’s other factors than just the one factor of what the activity is. GEORGIOU: Thank you. CHAIRMAN ANGELIDES: Thank you very much. Thank you, Mr. Georgiou. Mr. Thompson? THOMPSON: Thank you, Mr. Chairman. Gentlemen, no calamity of this size could ever occur with it emanating signals of its building well ahead of it being visible the public at large. And so, I noticed in your testimony, both Mr. Bass and Mr. Mayo, that you indicated that, gee, I saw this coming. So what I’d like to know is how early did you see it? Not 2006 or 2007, but how much earlier than that? And what signals did you see that others should have seen as well and taken action? Mr. Bass? BASS: When you look back—Mr. Mayo talked about loan growth doubling that of GDP growth. When you look back at the housing market—and you can go back through OFHEO’s raw data, all the way back to about I think it’s 1971, you look, you can go back and plot the housing price appreciation x inflation and chart that against median income. FOMC20070131meeting--126 124,MS. MINEHAN.," Thank you very much, Mr. Chairman. The New England regional economy continues to grow at a moderate pace with relatively slow job growth, low unemployment, and moderating measured price trends. Consumer and business confidence is solid, and while retail contacts reported an uneven holiday season, manufacturers were generally upbeat about business prospects. Skilled labor continues to be in short supply and expensive. In every one of the New England states, there is concern over the long-run prospects for labor force growth, given their mutual low rates of natural increase, out-migration of 25 to 34 year olds, and dependence on immigration for labor force growth. New England is an expensive place in which to live, and concerns abound about how to attract and retain the highly skilled workers that are needed for its high preponderance of high value added industries. Obviously, there’s nothing new or particularly cyclical about the foregoing comments. But I’ve been to quite a few beginning of the year “let’s take stock of things” conferences in all the states recently, so perhaps I’ve become more impressed than usual by the medium-term to long-term challenges facing the region. In the short run, however, the positive overall trend of the regional economy does seem to be a powerful offset to the continuing decline in real estate markets. At our last meeting it seemed as though New England’s real estate problem was more significant than that in the rest of the country. But now it appears that both are similarly affected whether one looks at prices, sale volumes, inventory growth, or declining construction. As with the nation as a whole, there are signs of stabilization; but at least in New England, making any judgment about the imminent revival of real estate markets in midwinter is foolhardy at best. On the national scene, the data have been more upbeat since our last meeting. Apparently the holiday season was a bright one, with consumption likely growing at a pace of more than 4 percent in the last quarter. That’s remarkably strong given the continuing decline in residential real estate and proof—to reiterate what President Stern said—that the U.S. economy continues to be unusually resilient. Supporting consumption are tight labor markets, lower energy prices, tighter though still reasonably accommodative financial conditions, strong corporate profits and some signs of revival in business spending after declines related to housing and motor vehicle expenditures, and continuing strong foreign growth. Even inflation has moderated a bit, with three-month core price increases in both the PCE and the CPI trending down. Our forecast in Boston and that of the Greenbook are virtually indistinguishable. The last quarter of ’06 was stronger than expected. The first quarter of this year will be slightly better as well, but after that, the trajectory remains the same as it has been for the past two or three meetings. An increasing pace of growth in ’07 and ’08 as the housing and motor vehicle situations unwind, a slight rise in unemployment, and a fall in core PCE inflation to nearly 2 percent by the end of the forecast period. In many ways, this is the definition of perfection, a forecast that is seemingly getting better each time we make it, with growth a bit higher, unemployment a bit lower, and inflation ebbing slightly more. The underlying mechanics that produce this outcome are relatively straightforward, but I wonder whether we should have a heightened sense of skepticism about such a halcyon outlook. Let me focus on two reasons for such skepticism. First, all other things being equal, inflation could be less than well behaved. One reason that inflation ebbed in earlier forecasts was that slower growth brought about a small output gap and rising unemployment. Now, the output gap is virtually eliminated, and unemployment remains below 5 percent. Ebbing inflation is solely the product of recent favorable inflation readings, which are assumed to persist: lower energy prices, declining import prices, and falling shelter prices. It’s hard to tell at this point whether the recent readings on core inflation are the result of fundamentally lower inflation pressures or just luck or maybe a combination of the two. I think a similar range of uncertainty applies to oil prices and the strength of the dollar. With virtually no output gap, it seems to me that, while the baseline best guess might be lower inflation, for all of the reasons discussed in the Greenbook one should approach that analysis with some caution. Second, demand could well be stronger. The baseline forecast assumes that consumers somehow get the message some of us have been trying to deliver about the need for an increase in private saving. The saving rate moves from a negative 1 percent to a positive 1 percent, the highest saving rate in several years. As I noted before, I have to ask myself why this is likely to happen over the next coming months when it hasn’t in the wake of the housing situation in 2006. Clearly, the downturn in residential real estate, an important political issue in all our Districts and certainly devastating for subprime borrowers in particular, hasn’t affected consumer spending in general. In fact, household net worth as a share of disposable income remains quite high, buoyed in part by a likely overestimate of real housing values but also by rising equity markets. The timing of the needed increase in the personal saving rate could well be further out in the future, creating some version of the buoyant consumer alternative scenario instead of the baseline. Again, with no output gap, the potential for increased inflationary pressure is obvious. In sum, the Greenbook forecast remains in my view the most likely baseline. There are downside risks, as I mentioned before, for the seven alternative scenarios do anticipate some downside risks; but if the housing situation is beginning to stabilize, I find it hard to believe that broader anxiety about it will affect business spending or the consumer as some of these scenarios contemplate. The bigger risk may well be that business spending picks up in light of consumer strength, unemployment stays low, growth exceeds our current projections, and resource pressures become more intense. I am concerned that risks to inflation have grown somewhat since our last meeting. I think I’m still in a “wait and see” mode, as I do believe there are downside risks to the evolution of housing markets. But if the Greenbook growth forecast is right, the best risk management on our part may have to be to seek tighter policy sooner rather than later." FOMC20051213meeting--84 82,VICE CHAIRMAN GEITHNER.," Our forecast for the national outlook has not changed substantially since the last meeting, and relative to the discussions so far, I guess we’re slightly at the stronger end. The recent data have been encouraging both here and internationally. The underlying pace of demand growth seems pretty good to us—good enough to raise the probability of the expansion continuing at a pace at or slightly above trend. The inflation news has also been reassuring, though December 13, 2005 51 of 100 We believe these conditions justify some further tightening of monetary policy, perhaps another 50 to 75 basis points. We are, therefore, comfortable with the expectations now built into the market. And with that monetary policy assumption, we think the risks to the forecast and to our objectives are roughly balanced. So, relative to September and October, we see somewhat less downside risk to growth, perhaps even some upside risk, and somewhat less upside risk to inflation. As this implies, our view is very close to the Greenbook. Let me mention a few other points. The apparent strength in productivity should make us more comfortable about the sustainability of the expansion and a bit less concerned about the near- term inflation risks because, of course, if the productivity growth stays stronger longer, we can be more confident that consumer spending will stay reasonably strong even if a more substantial slowdown in housing materializes. Scenarios in which more-moderate house price appreciation or some decline in housing prices leads to a sizable increase in the personal saving rate are probably less plausible or less troubling in an environment where consumers are more confident in the outlook for the economy or more confident in their future income growth. The productivity news, combined with continued moderation in the core inflation numbers and the moderation in measures of inflation expectations, make the inflation outlook somewhat more favorable. But against these factors there are others that justify some continued attention. Of course, overall inflation is still high, even though we expect it to moderate. Various measures of underlying inflation are still above what we would be comfortable with over time. There probably is still some energy cost pressure in the pipeline. And the TIPS-derived measures of inflation expectations over the medium term, if you adjust for the carry effect, have not really moved down that much. With compensation growth accelerating, we would expect eventually to see some upward pressure on labor December 13, 2005 52 of 100 surveys and anecdotal reports of pricing behavior, as we read them, suggest that businesses are able to pass on some share of their increased costs. So for these reasons, even with the additional tightening priced into the markets, we probably face some modest upside risk to our inflation forecast and to our objective, and we should continue to lean against this risk in what we do and what we say. We don’t see evidence yet to support a concern that the path of the nominal fed funds rate now priced into the markets risks going too far. Housing may be slowing a bit, but not really much. Other spending indicators look strong—probably stronger than we thought—and the strength is broader than it has been across the components of GDP. Expected real rates don’t suggest a high degree of concern, in our view. It’s just some concern, but not acute concern about the downside risk to future growth. If you try to take out expected inflation from forward rates, it looks as if real rates move up over the 2- to 5-year horizon. Equity prices, credit spreads, and the implied volatility of most asset prices don’t seem to suggest a lot of concern about significant deterioration ahead in the pace of the expansion. Although we don’t think the narrowing of the term spread itself or the low overall level of the yield curve offers clear guidance about monetary policy—clear guidance in terms of arguing for a softer or firmer stance than the other fundamentals might suggest—we’re somewhat more inclined to take the view that this change in the structure of term premia suggests we will have to do more than otherwise would have been the case. So all of this suggests to us that we should continue to tighten further and signal that we think we have still more to do." FOMC20070509meeting--65 63,MR. PLOSSER.," Thank you, Mr. Chairman. The near-term outlook for the Third District is moderate growth going forward. The major source of the strength in the District continues to be employment growth, and nonresidential construction is fairly stable and modestly healthy. However, manufacturing continues to be sluggish and residential construction weak. Job growth has picked up considerably in our District, having grown at 0.9 percent at an annual rate in the past few months. Unemployment rates have fallen in the region, and the labor market in Pennsylvania in particular has been especially strong. To get a better handle on labor market conditions, in our last business outlook survey we asked a panel of firms whether they had experienced problems filling jobs in the past three months because applicants didn’t have sufficient qualifications. Remarkably, more than two-thirds of our firms said that they had trouble with this and that the percentage has been growing since we first started asking the question three years ago. The strength in the regional labor markets is reflected in the rebound in our staff’s indexes of leading indicators of economic activity in the three states in our District, especially in Pennsylvania, where the index is predicting stronger growth over the remaining three quarters of the year. An area of stability in our region’s economy has been the ongoing modest strength in nonresidential construction. The growth in this sector has recently been largely in noncommercial construction—hospitals, education buildings, and so forth. However, general commercial vacancy rates in Philadelphia have been falling steadily, and the absorption rate in Center City is nearly at a record high. With regard to manufacturing, growth is stalled. According to our April manufacturing survey, our general activity index is close to zero, or just mildly positive, as it has been since late last year. Both new orders and shipments are close to zero, as they were. Further, in April the index of future capital expenditures was down somewhat and below the averages that we have been seeing in most expansions. The only bright spot was the significant bump-up in our future activity index, which signaled that more-robust activity is anticipated by our survey participants. It also comes as no surprise that residential construction remains weak in the District, and housing permits have continued to decline as the value of residential construction contracts has as well. Also, there seems to be little or no appreciation in house prices. On the inflation front in the District, prices paid and prices received by manufacturers have moderated a bit. Further, retailers are reporting very little change in prices over the past few months. In summary, the Third District is growing slowly, and our staff projection is for modest growth going forward. Labor market fundamentals appear strong, but we have yet to see any sign of the pickup in manufacturing that some of the national numbers indicate. On the national level, since the last meeting I have actually become a bit more comfortable with the economic situation. While I say that I am more comfortable, that’s a relative not an absolute statement. The most recent month’s readings on core inflation were welcome, but I think that caution and vigilance are still the order of the day. Indeed, the Greenbook authors, as we’ve noted, seem to have been revising their forecast of core inflation upward slightly over the past several months rather than downward, and that to me is a bit disturbing, even if the numbers don’t change a whole lot. News that has made me more comfortable with the projection of a somewhat quicker return to something closer to trend growth in the second half of the year is the recent strength in durable goods orders and the ISM numbers, which are indicating that manufacturing has picked up. Further, recent strength in manufacturing was broadly based, and the output of business equipment was strong. Along this dimension, I am in agreement with the latest forecast of the Board staff. However, these reports represent only one month of data, as people have said, and although they are consistent with a modest bounceback in the second quarter, there is still substantial uncertainty. I hope that, in the coming months, those data will be reinforced as new data come in; but, again, at this point that is only wishful thinking. I would add, though, that my business contacts, particularly in the financial sector, continue to report to me that business loans are strong, C&I loans are strong, demand is strong for loans, and balance sheets and firms still look good. So they see things as looking good from their perspective, but that positive news is not really showing up in some of these other numbers, at least as yet. So I’m a bit puzzled by that. Furthermore, job growth and personal income growth appear to be on solid footing, and I find myself increasingly puzzled by the weakness in the labor market as portrayed by the Greenbook forecast. The strength in personal income, along with a rebound in asset markets, leads me to view consumption as somewhat healthier going forward than the Greenbook sees it. Those circumstances, coupled with the more positive news on investment to which I just alluded, lead me to view closer-to-trend growth as the best forecast and, therefore, to have a little more optimism in my outlook for the second half of the year and into ’08. That is reflected in the forecast that I submitted. That said, I realize there are significant risks to this return to trend growth. The biggest risk remains housing. The extreme fluctuations in weather over the past four to five months have made discerning trends a lot more difficult, and I’m not sure exactly how much seasonal adjustment factors are bouncing the numbers around and making it harder to disentangle effects. Inventories of housing, as we have talked about, remain extremely high, and there is very little signal of a pickup in demand, at least as yet. However, I’m a little skeptical that this sector will continue to subtract a full percentage point of real growth from the forecast, as the Greenbook suggests. I’m a little more optimistic than that. I remain optimistic in part because I think real mortgage rates remain relatively low. I see strong income growth continuing, and I am increasingly less concerned, actually, about the spillover from subprime markets. So I can envision housing demand strengthening a bit more than is implied in the Greenbook, and that leads to less of a subtraction going forward. On the inflation front, I’m a bit less worried than last time but far from sanguine. The last core PCE inflation number was obviously very encouraging at something close to zero, but, again, we have to be very careful in extrapolating out one month’s data. As I said before, the Greenbook authors seem to be inching up their forecast of core inflation or at least pushing the decline out further into the future, and that concerns me a bit. I believe inflation is still too high. Inflation expectations are stable, but they are too high as well, and we need to bring that rate down. Thus, we need to be vigilant here and continue with a somewhat restrictive policy. In regard to my forecast, I’m not going to say much. I just assure you that, without collusion, President Lacker’s view of the forecast and how it evolves is very similar to mine. So rather than repeat what he said, I will just let his comments largely speak for mine. I have a slightly faster return to trend growth, partly because my productivity estimates are somewhat higher. I thought Janet Yellen’s comments about her productivity analysis were quite thoughtful, and I appreciate them. The optimal monetary policy, or at least my preferred path for monetary policy, might include some tightening if trend growth returns more quickly than we had indicated. But, indeed, my forecast for core PCE was actually down to 1.7 percent by 2009. I’ll stop there. Thank you." FOMC20070807meeting--98 96,MR. KOHN.," Thank you, Mr. Chairman. Building on what the Vice Chairman just said, I have been listening in on that Morning Call. I’ve found it very useful, and it’s certainly an opportunity to ask questions if you have them. My forecast for the most likely outcome for output over the next few years is close to that of the staff—growth a little below potential for a few quarters, held down by the housing correction, and the unemployment rate rising a little further. Although some recent data for housing, consumption, and capital spending have been a bit to the soft side, we need to view those data against the background of a lower path for potential GDP and recall the tendency we’ve seen over the past several quarters for short runs of data that are a little hotter or a little cooler than we expected. I think this is sort of what it feels like when the economy is running at about 2 percent. I see a number of reasons to think that moderate growth remains the most likely outcome going forward. First, as President Stern has stressed from time to time, is the natural resilience of the economy, its tendency to grow near potential unless something is pushing it one way or another. If anything, this resilience has probably increased over the past couple of decades, reflecting more- flexible labor and product markets. Second, global growth remains strong, supporting the growth of exports. I don’t think this growth should be undermined by the fact that some unknown quantity of losses in the U.S. mortgage market is being absorbed by investors overseas, and the recent declines in the dollar will reinforce the effects of good foreign demand for U.S. goods and services. Third, the most likely factor to throw the economy off its potential is the financial markets. My most likely forecast assumed that the credit markets would begin to settle down over coming weeks with some, but limited, net tightening of conditions. I’ll return to the subject in a bit, but my outlook in this regard does rest fundamentally on the very strong financial condition of the nonfinancial business sector and commercial banks and my expectation that most households accounting for the vast bulk of consumer spending will not find credit availability newly constrained. Finally, a resumption of growth in consumption should be supported by moderate growth in jobs and household income as the rebound in productivity is limited by the slower path for trend productivity and as income shares shift a little toward labor. I also assumed that households would not face a repeat of the rise in gasoline prices that has taken something out of recent consumption demand. Then moderate growth in consumption along with good export markets should, in turn, support business investment spending. I expect this path for output to be associated with core inflation remaining in the neighborhood of 2 percent. If energy prices follow the path in futures markets, total inflation would come down to 2 percent as well. Basically I don’t see anything in my central tendency forecast for the economy that would push inflation very much one way or another. The economy produces around its long-run potential. My NAIRU was 4¾ percent. Inflation expectations as best we can judge are anchored at something like 2 percent PCE inflation. I’m encouraged that the most recent data on prices have tended to confirm that core inflation remains fairly low. Most measures of compensation also do not show a marked acceleration that might be associated with producing appreciably beyond the economy’s sustainable level of production. Risks around my inflation forecast remain to the upside, provided that output follows my most likely path. Utilization is tight. The recent run-up in energy prices could still feed through to expectations. The damped increase in productivity growth implies greater pressure on business costs and margins. Historically, nominal wages have tended to respond more sluggishly to changes in trend productivity than do prices, and this could be especially the circumstance when workers have seen real incomes held down by higher energy prices and business profit margins have been high. At the same time, like many around this table, I think that the downside risks around the forecast of moderate growth and production going forward have increased. For some time I thought that the risk of a shortfall from our central tendency outweighed the risk of an overshoot, mainly centered on housing and consumption. But the financial developments of the last intermeeting period have appreciably increased those risks. As many have remarked, and Bill said so nicely, problems have spread from the subprime sector to a good part of the mortgage market more generally, including a severe restriction on securitization of nonconforming mortgages. Some business credit has been affected. Spread are widening across a broad array of instruments and ratings. This has occurred in an atmosphere of greatly increased volatility and uncertainty, partly related to the questions about the pricing of complex structured credits that weren’t well understood and compounded by a loss of confidence in the rating agencies. The uncertainty is also a reflection of the perception that activity and prices in the housing market have not yet shown any signs of beginning to stabilize. I agree that we need to keep our focus on the effects of these developments and the financial markets on the economy, not on the distribution of wealth in the financial sector. The relationship of financial markets to real activity is multifaceted, not easily modeled with interest rates and stock prices, especially when markets are reconsidering risk. Tightening nonprice terms of lending, the reduced availability of credit, and simply the pervasive sense of uncertainty about the price of assets and cash flows can also affect spending. In such an environment, it wouldn’t be surprising if businesses and households postponed capital investments. I agree that this reassessment is a fundamentally healthy but somewhat messy correction to more-sustainable term and risk premiums. The most likely outcome is that it will be limited in duration and effect, and that’s what I assume for my forecast. Well-capitalized banks and opportunistic investors will come in and fill the gap, restoring credit flows to nonfinancial businesses and to the vast majority of households that can service their debts. In the end, credit conditions will be tighter than they were a little while ago, for the most part justifiably so, and the effect on output will probably not be very large. To be sure, the latest episode comes on top of a rise in term premiums over the May to June intermeeting period. As a consequence, financial conditions have tightened noticeably in the past few months, even abstracting from market disruptions of the last week. The federal funds rate has been as high as it has been in part to offset the accommodative effects of low volatility and tight term and credit premiums. I think that, even in the relatively benign adjustment scenario, we’ll need to look at whether that rate is still sufficiently supportive of economic activity. But in the circumstances—that is, the benign adjustment—that reassessment can await further information about aggregate demand and further assurance that inflation will remain low. I assumed an easing of policy in 2008 and 2009 in my projections to take account of this. But we can’t know how the market situation will evolve. I also believe that there’s a non-negligible chance of a prolonged and very messy adjustment period that would feed back substantially on confidence, wealth, and spending. With the rating agencies discredited and markets vulnerable to adverse news on the economy, the period of unusual uncertainty could be prolonged. The greatest risk is in the household sector, where uncertainty about valuations of mortgages could continue to feed back on credit availability, housing demand, and prices in a self-reinforcing cycle. Moreover, as lenders and borrowers revise assumptions about house prices even further, credit from home equity lines of credit and mortgage refinancings will become even less available and more expensive, putting to the test the hypothesis that I have been working under—that the feedback from housing on consumption can be approximated by a wealth effect, not something more serious working through housing equity withdrawal. As I noted, I don’t think this is the most likely outcome, but this tail of distribution is a lot fatter than it was only a month or so ago. Thank you, Mr. Chairman." FOMC20050809meeting--165 163,MS. BIES.," Thank you, Mr. Chairman. I want to focus my comments today on some macroeconomic perspectives and on what we’re learning in the supervisory reviews of mortgage products that we and other regulators are undertaking now. On the positive side, when we look at the large volume of ARMs in existence, most of them are of the traditional form. And currently those ARMs are at a point—whether they’re adjusted annually or they started out as 3-year fixed-rate loans and then move to annual adjustments—where they will be reset. For the ones that started out in 2002 with fixed rates for three years, this is the year when they will go to annual resets. We know all of them, since they’re indexed to short-term rates, are going to have a big increase whenever their anniversary August 9, 2005 70 of 110 To the extent that long mortgage rates or the reindexed rates are very close to those available to most borrowers on refinancings, it looks as if most of these ARMs can be converted into a fixed-rate product without a large amount of payment adjustment. There will be some, but it seems likely to be manageable for many of these borrowers. On the other hand, we’re seeing a lot of subprime ARMs where this may not be true. As you know, those ARM products that have been pushed into the subprime market are much more problematic. So the affordability for that group of customers is questionable. They are going to be hit not only by higher gas prices but higher monthly mortgage payments when their rates are reset. And that is going to be more of an issue as we go forward and as we continue to raise short-term interest rates. Also, I’m a bit more pessimistic about what is happening with regard to some of these option ARMs and the more esoteric ARMs that are being marketed and have been marketed particularly in the last nine months. Bankers as a whole I think clearly are doing a good job at underwriting these. We have some lenders on the edges, though, that we’re working on. But these mortgage market developments have some significant macroeconomic implications. Many of these loans started out with teaser rates that were below current market rates. So first of all, the rates have to catch up to the market level. Then also, the index to which the rate is tied will have moved up by about 250 or more basis points, say, by the end of the year. So if they are interest-only loans, the rate could go from something that maybe started out with a “1” and could get to something with a “4” in front of it. And all of a sudden the monthly payments are going to go up fourfold. Even if defaults don’t increase, it certainly is going to pull August 9, 2005 71 of 110 Another issue is that apparently many of these loans have limits on how much the payment can go up each year in order to try to make the annual adjustment easier. But that puts borrowers in a predicament because it throws them into negative amortization. During the teaser period, they’re in negative amortization; and the cap on the index used to reset the monthly payment could put them further into negative amortization. So if they do want to get out of the ARM and switch to a fixed-rate loan, they have to cover the additional negative amortization. Many of these loans have prepayment penalties, so the lenders recoup that. That may be problematic in moving more people into fixed-rate products as interest rates rise. And to the extent borrowers go to fixed-rate mortgages, they’ll go to fully amortizing loans, which could be a financial burden—even though we are beginning to see mortgages of 40 years and longer. The leverage that we see in households on their borrowing I think is another indication that if they’re stretching to be able to afford these houses, it will be more problematic for them to stay in the houses as their monthly payments go up—perhaps even double or triple. So, when we talk about the wealth effect of housing price bubbles, I’m getting concerned around the edges that we could see a major impact on cash flows of both subprime and prime borrowers because these ARMS are indexed to short rates and those rates are moving up. Since ARMs are a big chunk of the mortgage market today, we have to realize that we can’t just look at long-term mortgage rates and the affordability of housing. We need to look at the short rates, too, because they’re getting to be more and more important. As I look overall at the economy today—and I’m going to echo some of the comments I’ve heard around the table—I’m very comfortable that we have gotten past the soft spot of the spring. I also am a little pessimistic regarding how this recent bounce will be sustained. But I August 9, 2005 72 of 110 And in my view, that is a good pace of growth. I also believe, to echo the comments Governor Kohn just made, that the market has reacted to the understanding that we may have to push rates up even further. There is a tremendous amount of liquidity in the market, and I think that’s what the market is seeing. When we talk about accommodation, the market is looking at the liquidity that can flow into deals for both commercial activity and for consumers. So I think we need to continue to push the funds rate upward. And personally, my number for the upper limit on the funds rate is much higher today than it was three to four months ago." FOMC20070131meeting--124 122,MR. STERN.," Thank you, Mr. Chairman. Trends evident in the District economy for some time fundamentally are continuing. Specifically, employment is increasing moderately and steadily. Most components of aggregate demand are expanding, and I would note, in particular, strength in nonresidential construction. There has been no significant acceleration of inflationary pressures or of wage pressures. The housing sector is subdued, but the District data on sales and starts suggest stabilization, as do the national data. The data on the inventory of unsold homes perhaps are contradictory to that statement because there are still a lot of unsold properties; at least those data suggest that it will be some time before there is any pickup in housing activity. In any event, as Bill Dudley mentioned, mortgage delinquencies and foreclosures are rising, albeit starting from a fairly low level, and though that probably won’t have a significant effect on economic performance, it could be a political issue in Minnesota and elsewhere in the District. As far as the national economy is concerned, it seems to me that the incoming data over the past several months underscore a couple of things. First, the data demonstrate, again, the underlying resilience of the economy. Second, they bolster the case for sustained growth over the next year or more, accompanied by steady to diminishing core inflation. Let me elaborate briefly on those observations. The economy apparently grew better than 3 percent in real terms again last year, despite the significant run-up in energy prices, the appreciable decline in housing activity, and problems in the domestic auto industry. As I think about the prospects for ’07, I see little in the broad scheme of things to suggest that overall real growth over the next year will be much different from that over the past year or, for that matter, much different from that experience from ’03 through ’05. It also seems to me that our earlier concerns about the possibility of a further acceleration of core inflation have diminished, largely on the basis of the incoming information on inflation, thereby through the process of elimination heightening the outlook for steady to declining core inflation. I actually think that case is pretty good, partly because some of the factors that boosted core inflation were transitory and partly because inflation expectations, as best I can judge, have remained well anchored. That’s the message I get, at least from financial markets, from labor markets, and from conversations with our directors, other business people, and so forth. So for me, overall the near-term to medium-term outlook both for real growth and for inflation is constructive. I’ll stop there." FOMC20060920meeting--148 146,MR. KROSZNER.," Thank you very much. Unfortunately, I think we find ourselves in an uncomfortable position like that of six weeks ago, with a continuing mix of inflationary pressures and decelerating economic growth at the same time. I think the fundamentals are in place for a continued moderation of growth but not a contraction, much as the Greenbook describes. Obviously, housing is a risk that everyone has talked about. But the key, as many people have also mentioned, is maintaining contained inflation expectations, and that comes down to thinking about whether some of the factors that we’ve been seeing have been more transitory or more persistent. Let me first talk about growth and go through the C plus I plus G plus net exports. I would agree with the staff’s characterization that world economic growth is not quite as strong as some others have put forward. I don’t think we’re going to be seeing an enormous export boom. Also, as briefly mentioned, I see very little on the government stimulus side. Tax revenues, as Governor Warsh mentioned, were very high. Spending is being kept relatively tight. On investment, we’re seeing some strength in capital spending. My concern is, if consumption goes as low as the Greenbook suggests, what the return on this capital spending will be. Is it going into the right areas? I was a little concerned when President Poole mentioned that the air freight company is expanding rapidly but the on-the-ground delivery company is not expanding at all. So are they going to have to invest in parachutes to get these in? [Laughter] But that is precisely the concern that I have—that capital spending may not conform perfectly to what consumption demand is going to be. We certainly saw this in the late 1990s and early 2000s. I’m just a bit worried about that now, especially given the potential tension between slowing consumption and robust investment growth. Now, regarding consumption—we’ve talked about the potential support from lower energy prices and some positive wealth effect from stronger equity markets, but obviously housing is one key here. It’s a key partially in overall investment but also in the uncertainty that it causes in consumers’ minds. Housing is one of the worst areas for data. It’s very difficult for us to have any concept of what prices are doing because it’s not a market like any other. We do have the Case-Schiller index, and we do have some better indexes that people are now betting on, but they’re still very poor indicators of prices relative to the indicators we have in other markets. We also know that there can be queues and that extras can be thrown in, so there’s a lot of uncertainty with respect to where prices are going. That concerns me quite a bit because I think we just don’t have a good handle on it. Permits and starts have continued to come down from where they were at our last meeting and are now at levels of the beginning of 2003 or even starting to slip into 2002. If they flatten out there, the housing sector is still historically reasonably good. But there’s no indication that we’re necessarily at a turning point and that things are going to flatten out. There is the wealth effect, the direct effect on people’s consumption behavior of lower wealth going forward, and also the confidence effect. We don’t have a perfect analogy with the previous times in which we’ve seen these housing downturns— we have a different context in that the economy is broadly more robust—and so I think it’s less likely that we’re going to see a major housing problem. But I think it is a real risk, and we have to be sensitive to it. On the inflation outlook, we have to come back to transit