October 08, 2015
Ben Bernanke was on the Diane Rehm show on Tuesday (unsolicited plug: one of the most serious talk shows around). Anyhow, there was much good back and forth on the show. I will skip over most of what the former Fed chair said (here‘s my comment on saving Lehman), but I do want to address his response to the question of why the Fed didn’t see the financial crisis coming.
Here’s the sequence:
“REHM It’s remarkable that you said that the recent financial crisis was the worst in human history, even worse than the Great Depression. But that’s where I think an awful lot of people wonder, if it was so big, why didn’t you see it coming and why couldn’t you have done something to stop it before it happened?
“BERNANKE Well, again, we were aware of the fact that house prices were very high. And we thought it quite possible that they would correct at some point. By 2006, 2007, we also were aware of the problems in the subprime lending market. What we did not anticipate and no one anticipated was the vulnerability of the financial system overall to a run, a panic. You know, in the 19th century, early 20th century, we had bank runs all the time. People would run to the bank, pull their cash out and the bank would have to close. That was this, in the 1930s story. So now we have deposit insurance. We didn’t see that coming.
“BERNANKE But there’s still a lot of short-term money in banks — whether it was lent through what’s called the repo market or — in any case, money that is not insured, which ran just like the old-fashioned depositors ran. And, you know, we — there was just not enough appreciation that that was possible or that it would happen. Once it happened, it brought the whole financial system down, essentially to its knees. And then, you know, the rest is history, as they say.”
Okay, I will say that I did not know the specific path the crisis would take, but it really should not have taken huge insight to anticipate serious financial fallout from the collapse of the housing bubble. Even in normal times housing is a highly leveraged asset, with people putting down just 20 percent of the purchase price on a prime mortgage. At the peak of the bubble, a large percent of loans had zero or less down. (Many people borrowed to cover closing costs, meaning they started out underwater.)
If you recognized the bubble and anticipated a large drop in house prices, how could you not realize that a large share of these mortgages would go into default? Furthermore, when they did default, the losses would be much higher than usual since the underlying asset in many cases had lost 30–50 percent of its value. In these circumstances, how could it be a surprise that many banks, and certainly Fannie and Freddie, would go under? I continue to be surprised that Bernanke and the other folks at the Fed were surprised.
In my own writings about the housing bubble I often made reference to the problems its collapse would cause for the financial system, but I did not emphasize this aspect of the problem. There were two reasons for this.
First, I really didn’t know the specifics of how it would play out. Fannie and Freddie were easy, they are sitting on a ton of mortgages, but I really didn’t know who would be holding the bag when the music stopped. (Who knew that AIG was issuing hundreds of billions of credit default swaps against mortgage backed securities?) Warren Buffett has a great line about how when the tide goes out we find who was swimming naked. You did have to wait for the tide to go out in this story.
The other reason why I didn’t hype the financial crisis aspect of the story was that I was hoping to be taken seriously. I had plenty of economists derisively dismiss the idea of a nationwide fall in house prices. (Hey we had never seen this before, just like we had never seen a nationwide run-up in house prices.) Running around talking about financial crises was not a good way to get taken seriously.
Anyhow, if someone saw the bubble, it seems to me they should have anticipated some very serious financial fallout. I have a hard time understanding how Bernanke and the Fed could have been caught by surprise — unless they didn’t really see the bubble.