…I tend to agree, and have talked about it, more than once, on this blog. Billionaire speculator George Soros (a possible short seller), in his book on the crisis, lays out an economic/market theory he calls “Reflexivity.” The theory roughly says that “man, through active trading/investment, can significantly influence the outcome of financial events.” That sounds a lot like market manipulation, doesn’t it? Yet the S.E.C., the FED, other banking regulators, and our government have never seriously investigated short selling during the financial crisis and whether it was legal and/or appropriate. Why? I and others, who were at Ground Zero of the financial crisis and on the losing end of these speculators have a lot to share that could help our markets, financial system, and financial stability. P.S. Here are a couple of examples: Did you know that short seller Paulson paid the Center for Responsible Lending millions and they wrote negative reports about IndyMac (which I recall had false allegations/claims in it), Wells Fargo, and other banks? Also, there were lot’s of misleadingly derogatory names assigned to mortgage assets by the press (I believe some of these names were given to them by short sellers.): ”toxic”, “liar”, “garbage”, “worthless”, but think about it, backing all of these loans was an American home. So they were not close to being “worthless” and that’s why they recovered so much of their value post-crisis.”, Mike Perry, former Chairman and CEO, IndyMac Bank

Excerpt from Howard Marks Memo to Oaktree Clients: “What Does the Market Know?”, January 19, 2016:

“It seems clear to me: the market does not have above average insight, but it often is above average in emotionality. Thus we shouldn’t follow its dictates. In fact, contrarianism is built on the premise that we generally should do the opposite of what the crowd is doing, especially at the extremes, and I prefer it.

A Case in Point –The Crash of 2008

This year 2008 culminated in the greatest panic I’ve ever seen. The events that built up to it included:

• Massive subprime mortgage defaults and the failure of mortgage backed vehicles,
• Meltdowns at funds that had invested in those vehicles, notably two Bear Stearns funds,
• Rescues of Merrill Lynch by Bank of America; Wachovia by Wells Fargo; and Washington Mutual by JPMorgan (after it was first seized by the Office of Thrift Supervision),
• Decisions on the part of BofA and Barclays not to acquire Lehman Brothers, and on the part of the U.S. Treasury not to bail it out, leading to Lehman’s bankruptcy filing,
• The appearance that Morgan Stanley would be next if it couldn’t secure additional capital, and
• Widespread speculation regarding other firms that might follow.

A massive downward spiral ensued. Among the contributing factors were:

• Precipitous declines in the prices of bank stocks,
• Large-scale short selling of the stocks (the “uptick rule” previously mandated that a stock could only be sold short at a price above the last trade, meaning short selling couldn’t force the price down. But the rule was repealed in 2007, so there ceased to be limits on when stocks could be shorted. Thus short sellers could force stock prices down….whether intentionally, in what in the 1920s were called “bear raids,” or just because they thought the stocks were right to sell),
• Dramatic increases in the cost to insure the debt of banks through credit default swaps.

In the environment described above, the downward spiral in bank stocks was intensified by the follow factors (where they were intentionally manipulated, I can’t say for sure):

• It was easy to bet against the banks by buying credit default swaps (CDS) on their debt.
• It was easy to depress bank stocks by selling them short.
• The declining stock prices were taken as a sign the banks were weakening, causing the cost of buying CDS protection to rise.
• The rising cost of CDS protection was taken as a negative sign, causing the stocks to fall further.

I can tell you, it had the feel of an unstoppable vicious circle. Some compared it to the “China Syndrome”: a 1979 movie with Jane Fonda and Michael Douglas in which an out-of-control nuclear reaction threatens to propel reactor components through the earth’s core, from the U.S. to China. Thus the stock of panic-ridden Morgan Stanley (for example) fell 82%, to less than $10.

But it’s important to note that the negative feedback loop described above was able to continue without reference to….and not necessarily in reasonable relationship to….actual developments at the banks or changes in their intrinsic value. Eventually, however, the Treasury restricted short selling in the stocks of 19 financial institutions deemed “systemically important.” Morgan Stanley secured a $9 billion injection of convertible equity from Mitsubishi UJF Financial Group. The panic subsided. The economy and capital markets recovered. And Morgan Stanley’s stock traded at $33 a year later.

Do you wish you had taken the market’s instruction in 2008 and sold bank stocks? Or do you wish you had rejected its advice and bought instead? In short, did the market know anything?

There are three possible answers:

• The market was flat wrong in 2008 when it took Morgan Stanley’s stock so low.
• The market was right; it properly reflected the possibility of a meltdown that could have happened but didn’t.
• The market was wrong in the case of Morgan Stanley in 2008, but most of the time it isn’t.

I like the first, and the second is appealing as well. But while a meltdown certainly was possible, the below-$10 price probably assigned too high a likelihood. And, of course, I’m not persuaded by the third.”

What Does the Market Know

…Between late April and early October, the Fed kept the interest rate over which it has most direct control, the federal funds rate, at 2 percent. But when the economy weakens, the “natural” interest rate — the rate that keeps the economy on an even keel — falls. By staying in place, the Fed’s target interest rate was rising relative to that natural rate. The gap between expected interest rates and the natural rate was rising even more. Fed officials spent the late spring and summer of 2008 warning that rates would have to rise to combat inflation. Futures markets showed a sharp increase in expected interest rates…. . In mid-September, shortly after the collapse of Lehman Brothers, the Fed refused to cut interest rates further, citing the risk of inflation. (To his credit, Chairman Ben Bernanke subsequently admitted that not cutting rates then was a mistake.) It did not cut rates until weeks after the crisis had become undeniable. It was against this backdrop of tighter money that the financial stress of 2007 turned into something far worse in 2008…..We could have had a decline in housing without a Great Recession. That’s what we went through for two years. What we could not have had without a Great Recession was a decline in nominal spending. If it had cut rates faster, or merely refrained from talking up future rate increases, the Fed might have kept that decline from happening or at least moderated it. Australia had a housing boom and debt bubble, too, but kept a steadier monetary policy. The consequence was a mild correction, but nothing like our Great Recession. It took decades for the Fed’s responsibility for the Great Depression to be widely accepted and it may take that long for most people to see its responsibility this time around. The Fed of 2008 feared inflation too much and recession too little. It placed too little weight on market expectations about future conditions and on how its behavior affected those expectations. If these mistakes go unrecognized, they could well be repeated.”, David Beckworth and Ramesh Ponnuru, “The Subprime Reasoning on Housing”, The New York Times, January 27, 2016

“Here’s another article showing that, with the benefit of hindsight, the “experts” at The Fed really don’t know what they are doing and often cause financial instability and economic crises. It’s way past time for Congress “to audit the Fed’s monetary policies” and probably time to require the Fed to get control of the supply of money and grow it slower and more prudently (as Nobel Laureate and monetary expert Milton Friedman long ago advised) and then let the free markets set the natural rates of interest. P.S. This article is focused on the  post-crisis Fed decisions. I am one of many, including Nobel economists, who believe that the Fed’s loose monetary policies (artificially managed rates well below the natural rate of interest) pre-crisis were the major fuel for unsustainable asset bubbles, like housing, real estate, stocks, etc. Read Mr. Friedman’s famous paper on monetary policy which I have posted on this blog. Greenspan/Bernanke/Yellen’s Fed ignores his advice and warnings.”, Mike Perry, former Chairman and CEO, IndyMac Bank

The Opinion Pages

Subprime Reasoning on Housing

By DAVID BECKWORTH and RAMESH PONNURU

Credit Eiko Ojala

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IT has become part of the accepted history of our time: The bursting of the housing bubble was the primary cause of a financial crisis, a sharp recession and prolonged slow growth. The story makes intuitive sense, since the economic crisis included a collapse in the prices of housing and related securities. The movie “The Big Short,” which is based on a book by Michael Lewis, takes this cause-and-effect relationship as a given.

But there is an alternative story. In recent months, Senator Ted Cruz has become the most prominent politician to give voice to the theory that the Federal Reserve caused the crisis by tightening monetary policy in 2008. While Mr. Cruz (who is an old friend of one of the authors of this article) has been criticized for making this claim, he shouldn’t back down. He’s right, and our understanding of the great recession needs to be revised.

What the housing-centric view underemphasizes is that the housing bust started in early 2006, more than two years before the economic crisis. In 2006 and 2007, construction employment fell, but overall employment continued to grow, as did the economy generally. Money and labor merely shifted from housing to other sectors of the economy.

This housing decline caused financial stress by sowing uncertainty about the value of bonds backed by subprime mortgages. These bonds served as collateral for institutional investors who parked their money overnight with financial firms on Wall Street in the “shadow banking” system. As their concerns about the bonds grew, investors began to pull money out of this system.

In retrospect, economists have concluded that a recession began in December 2007. But this recession started very mildly. Through early 2008, even as investors kept pulling money out of the shadow banks, key economic indicators such as inflation and nominal spending — the total amount of dollars being spent throughout the economy — barely budged. It looked as if the economy would be relatively unscathed, as many forecasters were saying at the time. The problem was manageable: According to Gary Gorton, an economist at Yale, roughly 6 percent of banking assets were tied to subprime mortgages in 2007.

It took a bigger shock to the economy to bring the financial system down. That shock was tighter money. Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy. This point is easy to miss because the Fed lowered interest rates between September 2007 and April 2008. But raising rates is not the only route to tighter money.

Between late April and early October, the Fed kept the interest rate over which it has most direct control, the federal funds rate, at 2 percent. But when the economy weakens, the “natural” interest rate — the rate that keeps the economy on an even keel — falls. By staying in place, the Fed’s target interest rate was rising relative to that natural rate. The gap between expected interest rates and the natural rate was rising even more. Fed officials spent the late spring and summer of 2008 warning that rates would have to rise to combat inflation. Futures markets showed a sharp increase in expected interest rates.

Market indicators of expected inflation fell sharply that summer, a sign that the economy was getting weaker and monetary policy tighter. Nominal spending showed the change. After growing for years at a relatively steady rate, it began to drop.

In their early August meeting, some Fed policy makers nonetheless anticipated that they would raise rates soon. Inflation expectations and nominal spending kept falling. In mid-September, shortly after the collapse of Lehman Brothers, the Fed refused to cut interest rates further, citing the risk of inflation. (To his credit, Chairman Ben Bernanke subsequently admitted that not cutting rates then was a mistake.) It did not cut rates until weeks after the crisis had become undeniable.

It was against this backdrop of tighter money that the financial stress of 2007 turned into something far worse in 2008. With nominal spending falling at the fastest rate since the Depression, households, businesses and banks all had incomes lower than they had expected. That made servicing debts and paying wages harder than expected. It also lowered asset values, since those were premised on expected streams of future income.

And, of course, the crashing economy made the housing crisis worse, too. That’s why the standard account of the crisis took hold. It’s true, after all, that housing fell and then, along with the economy, plummeted. Untangling cause and effect is tricky. But the timeline is a better match for the theory that the Fed is to blame. The economy started to tank not right after housing began to fall, but right after money tightened.

We could have had a decline in housing without a Great Recession. That’s what we went through for two years. What we could not have had without a Great Recession was a decline in nominal spending. If it had cut rates faster, or merely refrained from talking up future rate increases, the Fed might have kept that decline from happening or at least moderated it. Australia had a housing boom and debt bubble, too, but kept a steadier monetary policy. The consequence was a mild correction, but nothing like our Great Recession.

It took decades for the Fed’s responsibility for the Great Depression to be widely accepted and it may take that long for most people to see its responsibility this time around. The Fed of 2008 feared inflation too much and recession too little. It placed too little weight on market expectations about future conditions and on how its behavior affected those expectations. If these mistakes go unrecognized, they could well be repeated.

David Beckworth is a former economist at the Treasury Department and a visiting scholar at the Mercatus Center; Ramesh Ponnuru is a columnist for Bloomberg View and a visiting fellow at the American Enterprise Institute.

A version of this op-ed appears in print on January 27, 2016, on page A27 of the New York edition with the headline: Subprime Reasoning on Housing

“Europe’s long experiment with ultralow interest rates is prompting unexpected shifts in Germany’s deeply entrenched culture of saving….The shift in home buying is more pronounced. The volume of residential-real-estate transactions almost quintupled to €23.5 billion ($25.4 billion) in 2015 from €4.8 billion in 2008, according to Statista, a data firm. Germans have long opted for renting over buying, supported by tenant-friendly laws and a fear of debt. In German, “debt” and “guilt” are the same word, Schuld, and many Germans equate the two. Now, however, low interest rates have made borrowing extremely affordable and sparked fears among some Germans of inflation. Home buying has become something that offers risk-averse Germans a sense of security, said Olaf Stutz, professor of asset management at the Frankfurt School of Finance & Management. Buyers are people like Holger Schmidt, an industrial engineer who never considered buying a home until a few years ago. The 43-year-old father of two bought two apartments, one to live in and one to rent.“ After the risk of inflation grew and the future of the euro became uncertain, I changed my mind,” said the resident of Aschaffenburg, in Bavaria, who took the plunge in 2012, when interest rates were already falling dramatically. Real estate’s new haven status trumps what Mr. Schmidt calls a huge fear among Germans: “What if I lose my job, how will I pay the mortgage?” Parents now chat about the rising value of their homes at their kids’ parties. “The more you hear about it, the more you want to do it on your own,” he said. “It was like becoming aware of the upside, when before you were looking only at the risk.”, Madeleine Nissen, “Germany’s Cautious Savers Find New Taste for Risk”, The Wall Street Journal, January 26, 2016

Markets

Germany’s Cautious Savers Find New Taste for Risk

Low rates cause shift from bank savings deposits to index funds and real estate; buying a home instead of renting

A pedestrian looks at residential property displayed for sale in an estate agent window in Ingolstadt, Germany, in October. Low interest rates have spurred more Germans to opt for buying homes instead of renting. PHOTO: KRISZTIAN BOCSI/BLOOMBERG NEWS

By Madeleine Nissen

FRANKFURT—Europe’s long experiment with ultralow interest rates is prompting unexpected shifts in Germany’s deeply entrenched culture of saving.

For decades, Germans have faithfully parked much of their personal wealth in old-fashioned savings institutions while shunning home buying and its associated debt. Those habits were cemented by the shock of hyperinflation in the 1930s and supported by a strong postwar economy and an inflation-averse central bank that kept returns predictable.

But since the financial crisis hit and the European Central Bank slashed interest rates for countries sharing the euro to around zero, Germany’s saving formula has collapsed—and savers are reacting by taking on more risk.

“Permanent low interest rates changed my wife and me from savers into investors,” said Thomas Krauss, a 55-year-old marketing expert from Düsseldorf who used to contribute to a retirement savings plan.

Old-style pension plans “yielded almost zero,” so during the financial crisis, Mr. Krauss opted to invest in index funds. His wife of 30 years “felt uneasy about changing from the familiar investment mix of insurance and saving deposits,” but they switched about six years ago and have since outperformed traditional savings returns, he said. The recent downturn in the stock markets doesn’t make Mr. Krauss nervous. “The shift was a strategic decision and independent of short-term developments,” he said.

Germans have among the world’s highest household rates of saving, according to the Organization for Economic Cooperation and Development. Only 14% of Germans invest in equities, compared with 56% in the U.S. and 23% in Britain, according to finance-industry association Deutsches Aktieninstitut.

The shift in home buying is more pronounced. The volume of residential-real-estate transactions almost quintupled to €23.5 billion ($25.4 billion) in 2015 from €4.8 billion in 2008, according to Statista, a data firm.

Germans have long opted for renting over buying, supported by tenant-friendly laws and a fear of debt. In German, “debt” and “guilt” are the same word, Schuld, and many Germans equate the two.

Now, however, low interest rates have made borrowing extremely affordable and sparked fears among some Germans of inflation. Home buying has become something that offers risk-averse Germans a sense of security, said Olaf Stutz, professor of asset management at the Frankfurt School of Finance & Management.

Buyers are people like Holger Schmidt, an industrial engineer who never considered buying a home until a few years ago. The 43-year-old father of two bought two apartments, one to live in and one to rent.

“After the risk of inflation grew and the future of the euro became uncertain, I changed my mind,” said the resident of Aschaffenburg, in Bavaria, who took the plunge in 2012, when interest rates were already falling dramatically.

Real estate’s new haven status trumps what Mr. Schmidt calls a huge fear among Germans: “What if I lose my job, how will I pay the mortgage?”

Parents now chat about the rising value of their homes at their kids’ parties.

“The more you hear about it, the more you want to do it on your own,” he said. “It was like becoming aware of the upside, when before you were looking only at the risk.”

The shift is being encouraged by German banks, which are hawking more aggressive investment options as low interest rates squeeze the margins on lending.

“Advisers desperately try to sell their overpriced products,” said Jürgen Becker, an office worker near Düsseldorf. He said the marketing push is so intense—despite his obvious lack of interest—that it seems driven more by sales quotas than financial acumen.

“I have lost confidence that my bank would give me proper advice,” said the frustrated saver, whose displeasure is shared by many Germans.

The Association of German Banks said its members are acting appropriately. “I do not think that banks are pushing products too much,” said spokesman Thomas Schlüter. “The prices clients pay in Germany for banking products are extremely low,” meaning banks must find other ways a way to earn money, he said.

German banks over recent years earned roughly 75% of their income from the margin between rates on savings accounts and the loans they could make, according to statistics from the Bundesbank, Germany’s central bank. Plunging rates dragged German banks’ interest revenue down to €204 billion in 2014 from €419 billion in 2007, according to the Bundesbank.

“German banks’ business models are particularly vulnerable to low interest rates because Germany is a country with very high saving deposits,” Bundesbank board member Andreas Dombret said.

January 18, 2016, Joe Light, The Wall Street Journal

Markets

Market for Private-Label Mortgage Bonds Is Recovering, but Slowly

Sales of bonds that helped spark financial crisis are selling at quickest pace in five years

By Joe Light

Sales of the bonds that helped spark the global financial crisis are selling at their quickest pace in five years. But investors and analysts say what is surprising about the market for so-called private-label mortgage-backed securities isn’t how strong it is, but how moribund.

Financial institutions issued $61.6 billion in private mortgage bonds in 2015, up from $54.1 billion in 2014 but a fraction of the $1.19 trillion issued at the peak of the housing boom in 2005, according to new data from Inside Mortgage Finance, a trade publication.

What’s more, most of 2015’s new mortgage bonds weren’t formed out of new loans but rather out of repackaged old loans, underscoring how few new mortgages are being securitized, said IMF publisher Guy Cecala. “The market’s on life support,” he said. More than seven years after the financial crisis began, bond issuers, ratings companies and the government are struggling to revive the private-mortgage-bond market.

Private mortgage bonds helped drive the growth of risky mortgages in the run-up to the financial crisis and often carried high ratings even though the underlying loans were to borrowers with shaky credit, unverified incomes and tiny down payments.

Few in the mortgage industry want to see the riskiest loans return, but they do want to see private investors take on a greater role. Right now, the vast majority of mortgage bonds are guaranteed by the government through mortgage-finance companies Fannie Mae, Freddie Mac or agencies.

Many of the new securities are merely repackaged. For example, in November, Fitch Ratings issued ratings on four bonds packaged by Nomura that were made up of mortgage securities originally issued by now-defunct bankWashington Mutual.

During the crisis, some investors felt burned by bonds that weren’t as safe as believed and by mortgage servicers they felt didn’t always have their best interests at heart.

To help reconstruct the market, officials from the U.S. Treasury Department over the past year and a half have brought together lenders, investors, ratings firms and other stakeholders to devise new deal terms that the parties are comfortable with.

But some analysts say that the private mortgage bond market’s biggest hurdle right now is that lenders think they can make more money by hanging onto loans themselves rather than by securitizing them and selling to investors.

Apart from the repackaged bonds, most postcrisis private-label securities have been filled with so-called jumbo mortgages loans to high-quality borrowers. Large banks such as Wells Fargo & Co. and J.P. Morgan Chase & Co. lately have been happy keeping such loans on their balance sheets, restricting the supply available for securitization, said Andrew Davidson of mortgage-analytics company Andrew Davidson & Co.

On the opposite end of the credit spectrum, lenders have had trouble finding a sweet spot of borrowers who don’t fit the requirements of government-backed mortgage programs and yet still are low-risk enough to be attractive to investors and meet new federal mortgage rules.

Angel Oak Mortgage Solutions in December issued $135 million in subprime-mortgage-backed securities in which borrowers paid an average rate of 7.5% but had an average credit score of 683 and down payment of 28%.

In comparison, the Federal Housing Administration backs loans to borrowers with credit scores as low as 580 and down payments of 3.5%.

“I don’t know if we will ever go to the limits of when the music stopped” during the boom, said Angel Oak head of capital markets John Hsu. “Clearly that was not a place where the industry should have gone.”

Some private investors say they want to take on more mortgage-credit risk, but are having trouble finding ways to do it. Some investors as a result have turned to new securities issued by Fannie Mae and Freddie Mac that in effect sell some of the government’s mortgage-credit risk.

Money management firm AllianceBernstein L.P. invests in the Fannie and Freddie securities, but because of the lack of a private-label market has also turned to buying whole mortgage loans directly from lenders, a relatively cumbersome process that requires the firm to take on some of the responsibilities of managing the loans, said head of securitized assets Michael Canter.

“We want to have more mortgage credit risk in our portfolios,” Mr. Canter said. “It’s only because of [the PLS] breakdown that we had to venture into the whole loan space.”

On the Couch, Howard Marks, Oaktree Capital Management, L.P.

January 15, 2016, Neil Irwin, The New York Times

Economy

Federal Reserve Started 2010 With Hope, Then Fear and Fitful Activism

By NEIL IRWIN

WASHINGTON — When 2010 began, the United States economy seemed to be on the mend and leaders of the Federal Reserve discussed how they would unwind their extraordinary rescue efforts from the crisis that erupted in 2008. The term “exit strategy” was mentioned 37 times in their first two policy meetings of the year.

By the time the year ended, the Fed was pumping a further $75 billion a month into the financial system by buying bonds, aiming to keep the young expansion from falling apart. And though they did not know it at the time, Fed officials were on the path toward another half-decade of zero interest rates and creating trillions of dollars from thin air.

Transcripts of the Fed’s 2010 policy meetings, released Friday after the customary five-year lag, show how it got from Point A to Point B. The central bank’s officials forged a halting, unsure path toward greater activism as they realized that the global financial crisis, which had seemed over when the year started, had really just entered a new stage — a sovereign debt crisis in Europe and the threat of economic stagnation in the United States.

During the eight meetings of the Federal Open Market Committee that year, plus two unscheduled emergency conference calls, Chairman Ben S. Bernanke and his colleagues concluded that the economy was in greater peril than it had seemed at the start of the year. They agreed upon fresh actions intended to guard against a new recession or falling into a deflationary trap.

Janet L. Yellen, the current chairwoman who served in two senior roles in 2010, emerged as a major ally of Mr. Bernanke and an early voice in favor of more activism.

“Given the tenuous state of business and consumer confidence, I consider it critical at this juncture that this committee not be perceived as falling behind the curve, being unwilling to act, or being out of touch with the mounting concerns we see in the markets and on Main Street,” Ms. Yellen, then the president of the San Francisco Fed, said at the Aug. 10 policy meeting. “The data show a considerable slowing of the economy during the summer, and the near-term outlook has been marked down appreciably.”

At that meeting, she also urged her Fed colleagues to consider options to ease monetary policy further, even though “our quiver has fewer arrows than I’d like.” It would take three more months before the committee as a whole agreed with her and undertook a $600 billion effort at “quantitative easing,” or bond buying, frequently referred to as “QE2” because it was the second such move by the Fed.

The start of QE2 — Mr. Bernanke hated that term, he made clear in one meeting, as he unsuccessfully urged his colleagues to refer to the program by what as he viewed as the more technically precise “large-scale asset purchases” — was a controversial move inside and outside the Fed.

After the decision, which coincided with an election that swept a Republican Congress skeptical of government intervention into power, the Fed faced sharp criticism from conservative lawmakers and from Germany and Brazil, among other countries. Objections included the ways bond buying could distort financial markets and foreign exchange prices, and the burden the Fed was taking on itself to right an economy with problems that went deeper than insufficiently easy monetary policy.

What was less well understood at the time, but is made plain by the new transcripts, is how the internal debate at the Fed resembled the external one, with many of the objections outsiders raised to the Fed’s monetary activism also articulated behind closed doors at the central bank’s Washington headquarters.

“My views are increasingly out of step with the views of most people around this table,” Kevin M. Warsh, a Fed governor who was a close adviser to Mr. Bernanke on financial market matters, told his fellow policy makers at the November meeting.

“The path that you’re leading us to, Mr. Chairman, is not my preferred path forward,” he continued. “I think we are removing much of the burden from those that could actually help reach these objectives, particular the growth and employment objectives, and we are putting that onus strangely on ourselves rather than letting it rest where it should lie.”

He added: “The benefits strike me as small and fleeting. The risks strike me as unknown, uncertain, and potentially large.”

Mr. Warsh ultimately voted for the action, saying he would dissent if not for personal loyalty to Mr. Bernanke and because “I wouldn’t want to undermine at this important moment the chance that this program could be successful.”

The transcripts also show how Fed officials grappled with the crisis in the eurozone, especially Greece, that nearly spiraled out of control in the spring and in the fall. But the signature action of the Fed in 2010 was the decision in November to start its second round of quantitative easing.

Several other supporters of the action were also uneasy. “This is a difficult decision for me, and I think it was a difficult decision for most of you,” said Daniel K. Tarullo, another Fed governor. “The only people I worry about are the people who think that the decision was easy, whether to do nothing or to do precisely this, because I do think that, as many people have pointed out, there are nontrivial costs and nontrivial benefits.”

At the same time, the transcripts contain a couple of prescient references to the action setting the stage for “QE3,” as a round of bond buying that would commence in September 2012 was frequently called.

“Quantitative easing is like kudzu for market operators,” said Richard W. Fisher, then president of the Dallas Fed. “You’re familiar with this analogy because you’re a Southerner, Mr. Chairman. It grows, and it grows and it may be impossible to trim off once it takes root in the minds of market operators.”

After all the officials had spoken, Mr. Bernanke, who often displayed a collaborative style that aimed to unite officials, set up the final vote with this reminder: Nonaction is a type of action, too.

“Any action we take or don’t take is going to expose us to the judgment of history if we make the wrong decision,” he said. “Not taking action is a risky step, just as taking action is a risky step.”

A version of this article appears in print on January 16, 2016, on page B1 of the New York edition with the headline: Fed Started 2010 With Hope, Then Fear and Fitful Activism

…The strategy worked well. Share prices jumped 30% in 2013 alone and house prices rose 13% in that year. The resulting rise in wealth increased consumer spending, leading to higher GDP and lower unemployment. But excessively low interest rates have caused investors and lenders, in their reach for yield, to accept excessive risks in equities and fixed-income securities, in commercial real estate, and in the overall quality of loans. There is no doubt that many assets are overpriced, and as the Fed normalizes interest rates these prices will fall. It is difficult to know if this will cause widespread financial and economic declines like those seen in 2008. But the persistence of very low interest rates contributes to that systemic risk and to the possibility of economic instability…..Unfortunately, the recently released minutes of December’s Federal Open Market Committee meeting made no mention of financial-industry risks caused by persistent low interest rates for years to come. There was also no suggestion that the Fed might raise interest rates more rapidly to put a damper on the reach for yield that has led to mispriced assets……Fed officials say that macroprudential policies should be used to prevent financial instability. But there are few such policies in the U.S. beyond the increased capital requirements for the commercial banks. Nothing has been done to limit the loan-to-value ratios of residential mortgages or the leverage in commercial real-estate investments. Moreover, the commercial banks supervised by the Fed represent only about one third of the total capital market. The Fed has no ability, for example, to reduce risks in the shadow banking or insurance industries.”, Martin Feldstein, “A Federal; Reserve Oblivious to Its Effect on Financial Markets”, The Wall Street Journal, January 14, 2016

Opinion

A Federal Reserve Oblivious to Its Effect on Financial Markets

The Federal Open Market Committee last month didn’t even mention risk from persistent low rates.

By Martin Feldstein

The sharp fall in share prices last week was a reminder of the vulnerabilities created by years of unconventional monetary policy. While chaos in the Chinese stock market may have been the triggering event, it was inevitable that the artificially high prices of U.S. stocks would eventually decline. Even after last week’s market fall, the S&P 500 stock index remains 30% above its historical average. There is no reason to think the correction is finished.

The overpriced share values are a direct result of the Federal Reserve’s quantitative easing (QE) policy. Beginning in November 2008 and running through October 2014, the Fed combined massive bond purchases with a commitment to keep short-term interest rates low as a way to hold down long-term interest rates. Chairman Ben Bernanke explained on several occasions that the Fed’s actions were intended to drive up asset prices, thereby increasing household wealth and consumer spending.

PHOTO: GETTY IMAGES/OJO IMAGES RF

The strategy worked well. Share prices jumped 30% in 2013 alone and house prices rose 13% in that year. The resulting rise in wealth increased consumer spending, leading to higher GDP and lower unemployment.

But excessively low interest rates have caused investors and lenders, in their reach for yield, to accept excessive risks in equities and fixed-income securities, in commercial real estate, and in the overall quality of loans. There is no doubt that many assets are overpriced, and as the Fed normalizes interest rates these prices will fall. It is difficult to know if this will cause widespread financial and economic declines like those seen in 2008. But the persistence of very low interest rates contributes to that systemic risk and to the possibility of economic instability.

Unfortunately, the recently released minutes of December’s Federal Open Market Committee meeting made no mention of financial-industry risks caused by persistent low interest rates for years to come. There was also no suggestion that the Fed might raise interest rates more rapidly to put a damper on the reach for yield that has led to mispriced assets. Instead the FOMC stressed that the federal-funds rate will creep up very slowly and remain below its equilibrium value even after the economy has achieved full employment and the Fed’s target rate of inflation.

Fed officials say that macroprudential policies should be used to prevent financial instability. But there are few such policies in the U.S. beyond the increased capital requirements for the commercial banks. Nothing has been done to limit the loan-to-value ratios of residential mortgages or the leverage in commercial real-estate investments. Moreover, the commercial banks supervised by the Fed represent only about one third of the total capital market. The Fed has no ability, for example, to reduce risks in the shadow banking or insurance industries.

The Dodd-Frank law imposed restrictions on bank portfolios and increased banks’ capital requirements, which have created new problems by reducing liquidity in financial markets. When bond investors and bond mutual funds look to sell, there may be no ready buyers to prevent sharp falls in bond prices. The resulting rise in long-term interest rates could then reduce equity prices as well.

Moreover, the Fed is planning a path for short-term interest rates that is likely to raise the rate of inflation too rapidly in the next two years. The December FOMC minutes show that members expect to have a negative real federal-funds interest rate until sometime in 2017, much too low for an economy already at full employment. The danger is that very low interest rates in this environment would lead to a higher rate of inflation and higher long-term rates. The Fed could prevent that faster rise in inflation by increasing the federal-funds rate more rapidly this year and next.

Fed officials also make the case that stimulating the economy by continued monetary ease is desirable as protection against a possible negative shock—such as a sharp fall in exports or in construction—that could push the economy into a new recession. That strategy involves unnecessary risks of financial instability. There are alternative tax and spending policies that could provide a safer way to maintain aggregate demand if there is a negative shock.

The Fed needs to recognize that its employment goals have essentially been reached and that the inflation rate will reach its target of 2% in the foreseeable future. The economy would be better served by a more rapid normalization of short-term interest rates.

Mr. Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of the Journal’s board of contributors.

…From 2003 to 2006, the period in which the housing bubble inflated most dramatically, the share of loans backed by Fannie and Freddie fell from more than half to around a third, according to Inside Mortgage Finance, an industry newsletter. Crisis-era loans packaged into securities by Fannie and Freddie have experienced realized loss rates of around 3%, compared with 23% for those packaged into securities by Wall Street, according to Mark Zandi, chief economist atMoody’s Analytics.”, Nick Timiraos, “The Financial Crisis Still Divides GOP, Democrats”, The Wall Street Journal, January 12, 2016

“This is a false comparison by Moody’s Analytics. (Mark Zandi is a well-known advisor to and supporter of liberal politicians.) With the benefit of years of hindsight, it’s clear that Fannie and Freddie (as government sponsored enterprises) had the best rates/prices, so they cherry-picked all the lowest-risk non-conforming Alt-a and subprime mortgage loans from mortgage originators, for their own portfolios. Leaving the riskier mortgages to be securitized by Wall Street in private MBS. In addition, the government created mortgage programs for Fannie, Freddie, FHA, and VA mortgages that allowed these borrowers to modify and/or refinance their loans and dramatically lower their mortgage rates and payments (and even reduce principal balances), even if they were underwater (their mortgage exceeded their home’s value) or could not document their income. Underwater and/or Alt-A borrowers in Wall Street’s private MBS could not even refinance their mortgages to take advantage of lower mortgage rates. As a result, private MBS borrowers defaulted early on and the loans were sold on either a distressed basis or the homes were sold into a housing bust, before the Fed’s monetary policies (QE)…historically low mortgage rates…..caused nominal housing prices to once again rise significantly from the bottom. I am happy to go on and on, but this is just not a fair or relevant comparison. P.S. By the way, Fannie and Freddie bought hundreds of billions of AAA Alt-a and subprime private MBS from Wall Street, driving this marketplace.”, Mike Perry, former Chairman and CEO, IndyMac Bank

…In televised debates, GOP candidates have blamed the crisis partly on the Federal Reserve, which they say maintained low interest rates for too long, and on Fannie Mae and Freddie Mac, the government-backed mortgage-finance firms that effectively set lending standards for much of the housing market. They also say the crisis response did too little to address the power of large banks and instead saddled small banks that didn’t play major roles in the crisis with a punitive compliance burden. In a November debate, businesswoman Carly Fiorinasaid the law provided a “great example of how socialism starts,” because the government, having created a problem by overpromoting homeownership, then stepped in to solve it. She cited the Consumer Financial Protection Bureau as an example of such overreach.”, Nick Timiraos, “The Financial Crisis Still Divides GOP, Democrats”, The Wall Street Journal, January 12, 2016

“The Republicans are right and liberals are wrong. I will publicly debate any politician, economist, or journalist, anytime, anywhere on this important issue. Why is it important? Because if you don’t understand what really happened, how can you decide policy/what to do?”, Mike Perry, former Chairman and CEO, IndyMac Bank

Politics

Financial Crisis Still Divides GOP, Democrats

Parties’ different interpretations on what caused bust shape their proposals for regulating Wall Street

The George Washington statue in front of Federal Hall and the New York Stock Exchange in Manhattan. PHOTO: RICHARD B. LEVINE/NEWSCOM/ZUMA PRESS

By Nick Timiraos

The 2016 presidential campaign is offering ample evidence for why Washington, eight years after the financial crisis, remains so divided on how to regulate Wall Street: Republicans and Democrats still have wildly different interpretations about what caused the bust.

GOP candidates fault government policies and low interest rates for fueling the housing bubble that preceded the crisis. They strongly support easing financial regulations passed in the aftermath, singling out the 2010 Dodd-Frank rules signed into law by President Barack Obamaas too onerous.

Democrats say the crisis was fueled by private-sector and regulatory failures, not government policy. But they are divided over the need to break up big banks and the role of a 1999 law signed by President Bill Clinton that repealed parts of the Glass-Steagall Act, a New Deal-era statute that separated commercial and investment banking. The fight has put front-runner Hillary Clinton on the defensive by highlighting broader concerns over her willingness to stand up to the financial lobby.

Anger at Wall Street among primary voters in both parties illustrates how “extreme antibusiness populism on the left is intersecting with extreme antigovernment populism on the right,” said Will Marshall, president of the Progressive Policy Institute, a centrist Democratic think tank.

Economists say many of the proposals floated by candidates fall short, to the degree that they turn on oversimplifications of what drove the bust.

“In this kind of environment, you want a short, punchy message to be effective,” said Douglas Holtz-Eakin, who is president of a conservative think tank and advised Sen. John McCain on economic policy during his GOP presidential run in 2008. Such catchphrases, he said, don’t always translate into good policy.

In televised debates, GOP candidates have blamed the crisis partly on the Federal Reserve, which they say maintained low interest rates for too long, and on Fannie Mae and Freddie Mac, the government-backed mortgage-finance firms that effectively set lending standards for much of the housing market.

They also say the crisis response did too little to address the power of large banks and instead saddled small banks that didn’t play major roles in the crisis with a punitive compliance burden.

In a November debate, businesswoman Carly Fiorina said the law provided a “great example of how socialism starts,” because the government, having created a problem by overpromoting homeownership, then stepped in to solve it. She cited the Consumer Financial Protection Bureau as an example of such overreach.

Former Florida Gov. Jeb Bush has said capital requirements for the nation’s biggest banks are too low, even though they are much higher now than before the crisis.

Critics of Dodd-Frank say a bigger problem is that the law doesn’t do enough to solve the problem of firms being too complex. They are also wary because the law assumes a lack of regulation—rather than the unwillingness to use regulatory powers that existed at the time—is what drove the crisis.

“Republicans have legitimate criticisms, but you have to propose some sensible alternatives” to Dodd-Frank, such as improving the mechanism for how failing banks are liquidated, said Mr. Holtz-Eakin, whom GOP lawmakers appointed to a congressional panel investigating the crisis. “I don’t see how you can say, ‘We’ll just get rid of Dodd-Frank.’ ” An additional hurdle, he said, is that Democrats have reflexively resisted even technical changes to the bill “regardless of the merit.”

Several GOP candidates have pinned blame for the crisis on Fannie and Freddie. The firms successfully used their lobbying clout to resist tougher capital standards before the boom, but the loans they backed still performed better than mortgages that were packaged into securities by the Wall Street firms, which steadily eroded Fannie and Freddie’s market share.

From 2003 to 2006, the period in which the housing bubble inflated most dramatically, the share of loans backed by Fannie and Freddie fell from more than half to around a third, according to Inside Mortgage Finance, an industry newsletter. Crisis-era loans packaged into securities by Fannie and Freddie have experienced realized loss rates of around 3%, compared with 23% for those packaged into securities by Wall Street, according to Mark Zandi, chief economist at Moody’s Analytics.

While Republicans want to undo postcrisis rules, Democrats are divided over whether Washington should go further to break up big banks by restoring the Glass-Steagall Act.

For Mrs. Clinton, restoring Glass-Steagall wouldn’t do enough to oversee large nonbank financial institutions like insurers and hedge funds. “I just don’t think it would get the job done,” she said at a Democratic debate in November.

Critics of Wall Street deregulation say her answer undersold the role global banks had in extending credit to lightly regulated nonbank firms that fueled the housing bubble. “I knew when you merge large insurance companies and investment banks and commercial banks, it was not going to be good,” said White House hopeful and Vermont Sen. Bernie Sanders, who as a House member voted against the 1999 Glass-Steagall repeal.

Mrs. Clinton’s challengers have cast resistance to reinstating the law as a reflection of the unhealthy influence of Wall Street donations to candidates of both parties.

“I would agree that Glass-Steagall is not the most important thing, but it does draw clear lines” around broader attitudes toward challenging the power of Wall Street, said Dean Baker, co-founder of the left-leaning Center for Economic and Policy Research.

In that sense, the position on the 1999 law has become a proxy for Democrats over whether a candidate would appoint regulators to aggressively enforce existing regulators and prosecutors that would bring more criminal cases against financial misconduct. “There’s a lot of pressure to side with the industry in those areas,” said Mr. Baker.

“The money illusion (created by our central bankers at The Federal Reserve) also helps to reduce debt burdens. Sensible lenders would index contracts to inflation. Humans, focused on nominal value, generally do not, and so lenders suffer as inflation erodes promised receipts. Say a person makes $50,000 a year and takes a $300,000 mortgage loan. The payments would take 34 percent of pre-tax income. Now let’s say inflation boosts wages 2 percent a year. After a decade, the same monthly payment would take just 28 percent of that person’s monthly income. Inflation can similarly ease the burden of national debts. And, during good times, the money illusion helps to fuel what John Maynard Keynes memorably called the “animal spirits.” By inflating economic measures, it creates the appearance of greater prosperity, encouraging people to borrow more, spend more, risk more. It sends a clear message: Join the party, you must…..In a 1997 study, two-thirds of respondents judged that a worker who got a 5 percent raise during a period of 4 percent inflation would be happier than a worker who got a 2 percent raise during a period of zero inflation. And the illusion is more than a feeling. The same study asked respondents to imagine that their income and prices had both increased by 25 percent over the previous six months. Some 38 percent of respondents said they would be less likely to buy a leather armchair that now cost $500 rather than $400, while 43 percent said they would be more likely to sell a desk that was now worth $500 rather than $400. Inflation did not change the real value of the armchair and desk, but it did change people’s decisions. (Some economists refuse to believe that people are tricked by inflation, or at least that they err on a scale sufficient to affect economic patterns. These economists prefer to believe that people behave rationally, a belief that, in a wonderful instance of irony, happens itself to be irrational.)…..In part, the Fed wants a little inflation simply to avoid deflation. Economists generally agree that a general decline in prices, or deflation, is more disruptive than a general increase, or inflation. Consumers delay purchases, awaiting better deals. Growth stalls, prices fall further, and it can be very hard to break the resulting cycle. Japan has been trying for two decades.”,Binyamin Appelbaum, “’Star Wars,’ and How a Force Helps the Federal Reserve”, The New York Times, January 12, 2016

‘Star Wars,’ and How a Force Helps the Federal Reserve

Binyamin Appelbaum

This is a story about “Star Wars: The Force Awakens”… and the Federal Reserve. Wait! Keep reading. Some cheap tricks are entertaining.

The movie, as of Sunday, had collected more money from American audiences than any other film in American history. In less than a month, its domestic box office receipts have totaled $812 million.

This is a record. It is also a great example of “money illusion,” the human tendency to take nominal prices more seriously than actual value.

The new “Star Wars” is not the most successful movie in American history. Adjusting for inflation, it has earned about half as much as the original “Star Wars” in 1977, according to Box Office Mojo. It lags even further behind the inflation-adjusted $1.74 billion haul of the real champion, “Gone With the Wind.” (Put differently, the money earned by “Gone With the Wind” in 1939 bought almost twice as much stuff as the new movie’s receipts.)

Yet the nominal record strikes people as more interesting and important than the inflation-adjusted rankings. When I tweeted about the real rankings earlier this week, several people responded that I was a party-pooping pedant. Disney, which released the movie, is celebrating; the media is trumpeting the news; and the hullabaloo is likely to draw even more people to see “Star Wars” because, after all, everyone loves a winner.

A Star Wars fan in Los Angeles last month. The movie has set box-office records, if you don’t take inflation into account. Credit Robyn Beck/Agence France-Presse — Getty Images

The emphasis on nominal box-office records makes it possible for Hollywood to portray the movie business as a growth industry. Every blockbuster is bigger than the last, every summer a record-setter. The reality is that the movie industry sold about 80 million tickets during an average week in 1930, or 65 tickets for every 100 Americans. In 2015, theaters sold about 23 million tickets a week, or 7 per 100 Americans.

This emphasis on nominal records is successful because people prefer to pretend the value of money is constant. Research suggests we don’t even realize that we’re doing it.

In a 1997 study, two-thirds of respondents judged that a worker who got a 5 percent raise during a period of 4 percent inflation would be happier than a worker who got a 2 percent raise during a period of zero inflation.

And the illusion is more than a feeling. The same study asked respondents to imagine that their income and prices had both increased by 25 percent over the previous six months. Some 38 percent of respondents said they would be less likely to buy a leather armchair that now cost $500 rather than $400, while 43 percent said they would be more likely to sell a desk that was now worth $500 rather than $400. Inflation did not change the real value of the armchair and desk, but it did change people’s decisions.

(Some economists refuse to believe that people are tricked by inflation, or at least that they err on a scale sufficient to affect economic patterns. These economists prefer to believe that people behave rationally, a belief that, in a wonderful instance of irony, happens itself to be irrational.)

And now comes the part you’ve been waiting for: The money illusion doesn’t just help Hollywood. It also helps the Federal Reserve.

People don’t like inflation. They tend to regard it as a kind of theft. And the confusion caused by inflation looks like an additional downside.

But the Fed has concluded that a little inflation is a good thing. It aims to keep prices rising about 2 percent a year, and, at the moment, Fed officials are actually worried there isn’t enough inflation. Prices have climbed by significantly less than 2 percent in each of the last three years.

In part, the Fed wants a little inflation simply to avoid deflation. Economists generally agree that a general decline in prices, or deflation, is more disruptive than a general increase, or inflation. Consumers delay purchases, awaiting better deals. Growth stalls, prices fall further, and it can be very hard to break the resulting cycle. Japan has been trying for two decades.

Standard measures of inflation also tend to overstate it, so avoiding deflation actually requires keeping measured inflation above zero. One reason for the bias can be technological improvement. The first iPhone went on sale in 2007 for $599, and the price dropped significantly soon after. The most recent iPhone went for more, but the price increase ignores the vast quality improvement. The memory in the newest iPhone is twice as large as on the original; the camera is better; the display is sharper; it has more sensors; and there are a world of apps that make it a multiuse tool.

Inflation also increases the Fed’s ability to stimulate the economy by cutting borrowing costs. Let’s say short-term interest rates are at 5 percent and inflation is at 2 percent when the economy falls off a cliff. If the Fed cuts rates to zero, while inflation remains at 2 percent, the cost of borrowing drops to negative 2 percent, increasing the impact of the stimulus.

But on top of all of this, it turns out that the confusion caused by inflation — the money illusion — also has some important benefits. During economic downturns, businesses are often reluctant to cut wages, delaying necessary economic adjustments, because workers hate wage cuts. Inflation helps the medicine go down. Holding nominal wages steady, or raising wages more slowly than the pace of inflation, offers a more palatable route to gradually reducing the value of those wages.

The money illusion also helps to reduce debt burdens. Sensible lenders would index contracts to inflation. Humans, focused on nominal value, generally do not, and so lenders suffer as inflation erodes promised receipts. Say a person makes $50,000 a year and takes a $300,000 mortgage loan. The payments would take 34 percent of pre-tax income. Now let’s say inflation boosts wages 2 percent a year. After a decade, the same monthly payment would take just 28 percent of that person’s monthly income. Inflation can similarly ease the burden of national debts.

And, during good times, the money illusion helps to fuel what John Maynard Keynes memorably called the “animal spirits.” By inflating economic measures, it creates the appearance of greater prosperity, encouraging people to borrow more, spend more, risk more.

It sends a clear message: Join the party, you must.

A version of this article appears in print on January 12, 2016, on page A3 of the New York edition with the headline: ‘Star Wars,’ and How a Force Helps the Federal Reserve.