The former Federal Reserve Board chairman talks about quantitative easing, the rise of non-bank lenders and why Bear Stearns could be saved during the crisis but not Thornburg Mortgage
Mortgage Banking
December 2015
By Robert Stowe England
It has long been a point of debate. Do the times make the man? Or does the man make the times? In the case of Ben S. Bernanke and the Fed’s battle to tame financial panic during the financial crisis of 2007-2009, historians in the future may conclude it was perhaps a little of both.
The eyes of the world were on Bernanke, chairman of the Board of Governors of the Federal Reserve System, at the height of the financial crisis as he and Treasury Secretary Hank Paulson led a series of innovative initiatives to stop a financial panic and prevent solvent institutions from failing.
The first tremors struck in August 2007 and the crisis slowly burned away, consuming a string of smaller mortgage companies until it flared up in March 2008 with the rescue of Bear Stearns and its sale to JPMorgan Chase in a Fed-led bailout that Bernanke justified because Bear Stearn’s failure posed systemic risk.
The panic roared to its fiery peak in September 2008 with the conservatorship of Fannie Mae and Freddie Mac, which ultimately required $187 billion in injections from Treasury, paid for by taxpayers. It was quickly followed by the bankruptcy of Lehman Brothers and an initial $85 billion rescue of American International Group (AIG) (a bailout that would eventually require the government to advance $182 billion in loans).
A series of innovative emergency lending facilities and guarantee programs and capital injections from Troubled Asset Relief Program (TARP) funds into the largest banks finally stabilized the system in late 2008.
In spring of 2009, stress tests of the nation’s 19 largest financial institutions--an initiative led by new Treasury Secretary Timothy Geithner--showed that 10 of the institutions would need an additional $75 billion in capital to survive, should the economy deteriorate further. Markets were reassured, as the shortfall was less than expected. As a result, a degree of confidence was restored to the banking system and the atmosphere of crisis subsided.
Bernanke, who served two four-year terms as chairman from 2006 to 2014, was a player in all these events. Under his leadership, the Fed adopted an interest rate target range of zero to 0.25 percent for the short-term Federal Funds Rate. That near-zero target still remains in effect nearly two years after his departure. At Bernanke’s behest, the Fed also embraced inflation targeting, a goal he had long cherished, setting the target at 2 percent in 2012.
Beginning in 2009, the Fed under Bernanke launched the first of three rounds of quantitative easing (QE)--monthly purchases of Treasuries and mortgage-backed securities (MBS) to bring down longer-term interest rates to boost the economy and housing sector.
The third round of QE, launched in late 2012, was the largest, at $80 billion monthly in purchases or $1 trillion a year. The QE purchases increased assets on the balance sheet of the Fed from $800 billion to $4.5 trillion by the end of 2014, and assets have remained at that level since then.
The first reduction or tapering of asset purchases began in January 2014. The task of gradually reducing and ending the monthly purchases of securities fell to Bernanke’s successor, Chairman Janet Yellen, who took the reins of the Fed in February 2014.
In one of those unexpected coincidences of history, Bernanke arrived at the Fed well prepared to fight financial panic because he had devoted much of his time as an economics professor at Stanford University and then later at Princeton University to studying monetary policy in the Great Depression.
He graduated from Harvard University in 1975 and earned a doctorate at the Massachusetts Institute of Technology (MIT) in 1979. His mentor at MIT was professor Stanley Fischer, who is now vice chairman of the Fed.
Fischer encouraged a young Bernanke, who was a student in Fischer’s first-year class in macroeconomics and monetary policy, to read the 860-page tome, A Monetary History of the United States, 1867-1960, by Milton Friedman and Anna Schwartz.
Fischer told Bernanke that reading the book would either excite him or put him to sleep and, based on his reaction to the book, Bernanke would be better able to decide on the intellectual path he would pursue in his academic career. “I found the book fascinating,” Bernanke writes in his new book, The Courage to Act: A Memoir of a Crisis and Its Aftermath, published in October by W. W. Norton.
The Friedman-Schwartz book documented how three episodes of money-supply contraction by the Fed--one just before the 1929 stock market crash and two more in the early years of the Great Depression--led to many bank failures and deepened and prolonged the Great Depression.
“After reading Friedman and Schwartz, I knew what I wanted to do. Throughout my career I would focus on macroeconomic and monetary issues,” Bernanke wrote in his book.
While at Princeton, in addition to teaching classes, Bernanke became an adviser to the Fed. In 2002, President George Bush nominated him to a post as governor in the Federal Reserve System and he subsequently left academia.
Which brings us back to the question of the times versus the man. “It is kind of amazing Bernanke got the job at the time he did,” because he brought important insights from his study of the role of monetary policy in the Great Depression, says David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, Washington, D.C. One key lesson Bernanke took from his study was that the Fed’s biggest mistake was to fail to be the lender of last resort to prevent solvent institutions from failing.
As a result of the Fed’s failure to provide liquidity at a time of financial panic and duress, “The arteries of the economy were clogged with the carcasses of dead banks,” during the Depression, Wessel says.
To avoid a possible repeat of that outcome, Bernanke early in the crisis began to seek out ideas for policy prescriptions for innovative short-term lending programs within the Fed. The best of those ideas were refined and prepared the Fed for the challenge that lay ahead.
Born on Dec. 13, 1953, in Augusta, Georgia, Bernanke grew up in Dillon, South Carolina, where he worked in his father’s pharmacy. At the age of 11, he won the South Carolina state spelling bee.
Mortgage Banking caught up with Bernanke at the Brookings Institution and asked him about his tenure and his new book.
Q: You’ve written that inflation targeting was your most cherished pre-crisis priority. Why is this better than having the Fed use its discretion to respond flexibly to economic developments, as was the case under former Fed Chairmen Alan Greenspan and Paul Volcker? And how early in your term as chairman of the Fed were you able to get the Fed to take its first substantial steps toward adopting inflation targeting?
A: The value of inflation targeting is its transparency. It provides a specific target the Fed has to try to meet and define. It requires explanations of how the Fed is going to achieve that target, as well as providing public forecasts. So I was interested primarily in shifting the Fed from a less transparent institution to a more transparent institution because I thought that it would make monetary policy more effective, particularly in situations where inflation and interest rates are quite low. In such a situation, the room for moving interest rates around is limited. So that was my thinking.
Under Greenspan the transparency increased over time, starting in 1994, when it was the first time they began to announce the interest-rate changes. I pushed if further as chairman [of the Fed], and in 2012 we put out a policy statement saying that our inflation target was 2 percent and that we would take a balanced approach to meeting that target and meeting our employment goals.
Q: You write in The Courage to Act that the Federal Open Market Committee [FOMC] took an important initial step toward inflation targeting at its October 2007 meeting--well before the policy was officially adopted. Former Vice Chairman Donald Kohn led a subcommittee that looked at ways the Fed could improve monetary policy communications, including perhaps by adopting an inflation target. You write that while the subcommittee did not recommend inflation targeting to the full committee at that meeting, you proposed moving in that direction by publicly releasing numbers from each of committee members revealing what each thought was meant by price stability and the rate of inflation they expected three years out, assuming their preferred monetary policy was followed. Back in 2007, members of the Federal Open Market Committee had a median three-year inflation forecast close to 2 percent.
A: At that time I was trying to go slowly and not to go faster than the political consultation or the committee’s agreement. But by each person stating where they thought inflation would be three years out, that was saying something about where members of the committee wanted inflation to go over time. And so it was a substitute for a target until we actually had an official target.
Q: And the Federal Reserve Board for the first time officially adopted inflation targeting and announced an inflation target of 2 percent in January 2012.
A: That’s right.
Q: Critics charge the Fed should have raised the Federal Funds Rate sooner in the 2000s to contain or deflate the housing bubble. What do you say to those critics? What is the right tool for dealing with a housing bubble?
A: So I think the Fed has some responsibility for the housing bubble. But it’s not monetary policy. Monetary policy was appropriately focused on helping the economy recover from the 2001 recession and avoiding deflation risks that occurred in 2003. Beginning in June 2004, the Fed raised interest rates fairly promptly [steadily in 17 quarter-point increments, peaking at 5.25 percent in June 2006].
My view of the housing bubble is that, to the extent government policy was a factor, it was primarily failures of regulation rather than monetary policy. The Fed, along with other bank regulators, didn’t do enough to prevent bad mortgage lending.
There were other factors that led to the housing bubble. For example, [Yale University economics professor and Nobel laureate] Robert Shiller emphasized the role of psychological factors and noted that house prices began to accelerate in 1998, well ahead of the Fed’s 2001 rate cuts. So I don’t think the evidence supports the idea that monetary policy was a cause of the housing bubble. I think a better approach to defusing it would have been through regulation rather than through monetary policy.
Q: In August 2007, as the subprime crisis began to take its toll, you laid out the case for the Fed to be prepared to do more in an email to Vice Chairman Kohn, New York Fed President Timothy Geithner and board member Kevin Warsh. You made your case for what you called a blue-sky list of options, some of which were later implemented in some form or another. What was the process that led to the blue-sky list?
A: It began as part of my management approach to convene groups of senior staff and policymakers to discuss broadly the possible approaches to the problem. That was called blue-sky thinking. We came up with lots of different ideas, many of which went into the garbage can. However, some of them provided the basis for some of the responses we ultimately undertook during the crisis. This was an ongoing process in which we held regular discussions. They were like a doctor’s diagnostic discussion, where you throw out ideas and then try to think about what could go wrong, and then discuss the advantages and disadvantages of each approach.
These ideas were then circulated and discussed broadly with the Federal Open Market Committee when it was necessary and appropriate. In some cases they led to actual policy responses. I felt that doing that would both allow for more creativity and more good ideas, and would also get those individuals who give those involved in the blue-sky discussions a stake in what was going on.
Q: I noticed at the end of your book you refer back to the blue-sky approach, and wrote as well about the benefits of a collegial approach to solving problems. You indicated there was a lack of that in Washington. It sounds great. How do you inspire the political system to move in that direction?
A: Well, that is obviously not going to be an easy proposition. However, I would suggest that voters ought to take into account the willingness of the people they are electing to solve problems and work with other legislators. It’s not just a matter of being able to state principles. You also have to get things done.
Q: You have said that the Fed’s role in the rescue of Bear Stearns by JPMorgan Chase in March 2008 should not be seen as creating moral hazard. What is the case for that view?
A: I discuss that in my book. The middle of a financial panic is not the time to be focusing on moral hazard, but a time you should be trying to put out the fire first and deal with revisions to the fire code later. But in the case of Bear Stearns, the shareholders were almost wiped out. I don’t think the conditions of the sale were such that any other firm would say, “That looks like an attractive proposition to me.” So, I think that the moral hazard was minimized by keeping the share price relatively low. They got $10 a share in the end, but that was much less than the price two weeks earlier, which was over $60 a share. And the company disappeared--it was absorbed by JPMorgan.
Q: And many people lost their jobs.
A: Many people lost their jobs, too. That’s right.
Q: You state that after Bear Stearns, you were facing two challenges. The first would be to do the right thing. The second would be to explain to the public and politicians why what you were doing was the right thing. Why was it so difficult to make the case to the public?
A: Well, from the public’s perspective, all they saw was that the Fed was bailing out Wall Street--and that made them angry and they said, “Why aren’t we getting bailed out?” That’s how it looked. But what was actually happening is that we were trying to protect the financial system from collapse because we knew--and the facts would bear us out eventually--that if the financial system implodes, the economy would not be far behind.
So, the right explanation was that we were doing what we were doing because we wanted to protect the American economy and the livelihoods of ordinary people. But from the point of view of people on Main Street who do not understand the connection between finance and the broader economy--to them, this was just helping Wall Street without helping them. Nevertheless, I think it was the right thing to do.
Q: Paul Volcker said the Fed’s efforts in rescuing Bear Stearns extended to the very edge of its lawful and implied powers under section 13(3) of the Federal Reserve Act, which gives the Fed broad power to lend to an individual or corporation, and not just depository institutions, in “unusual and exigent circumstances. You had put action under that provision in what you called the “Hail Mary” section of your blue-sky options list. So why was it possible to invoke section 13(3) in the case of Bear Stearns but not invoke it a few weeks earlier in the case of Thornburg Mortgage, a real estate investment trust [REIT} based in Santa Fe, New Mexico? Ultimately the Fed invoked the section 13(3) clause to bail out AIG. What was the guidance that ultimately drove your decision to bail out Bear and AIG but not Thornburg?
A: It was not our intention to protect every firm that failed, because there were thousands of firms that failed. It just illustrates the point that we were not using that authority because of concern about the firm per se--the shareholders, the creditors and the management. Rather, we used that authority to take action as needed to protect the broad financial system. Unfortunately, I guess, Bear Stearns posed a systemic risk, in the sense that we felt its uncontrolled collapse would be very damaging to the broad system and the economy, while Thornburg was a smaller, less complex firm.
At that point we had not used section 13(3). It was our feeling that this was an extraordinary power. It hadn’t been used since the Depression. We thought it would be more appropriate to use it only in the broad public interest--which means not to protect an individual firm, no matter how deserving, but rather intervene when necessary to protect the overall system and economy. Bear Stearns’ failure was a threat to the economy and Thornburg’s failure was not.
Q: In your book, you report that in May 2008 the Fed conducted stress tests on the four remaining major investment banks--Goldman Sachs, Merrill Lynch, Lehman Brothers and Morgan Stanley. There were two scenarios. One was facing the conditions that brought down Bear Stearns--the so-called Bear 1 scenario. And then there was a lighter version of that crisis, Bear 2. None of the banks could pass the Bear 1 stress test. What was that telling you about the challenge you were facing?
A: Well, it showed that it was not just an issue of capital but also liquidity. Investment banks in particular are vulnerable to liquidity runs because they finance themselves very extensively using uninsured wholesale funding, particularly short-term funding. The withdrawal of that funding could put pressure on those firms even if they were solvent. That was actually the first step toward reforms that now require banks and other financial institutions to hold adequate liquidity as well as have enough capital.
Q: In your book, you write that you agree with the view expressed by Gary Gorton, Yale University professor of management and finance, at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming, in August 2008. At that conference, he gave a presentation in which he said the United States was experiencing a financial panic like the old-fashioned ones, where there were runs on the bank. This time, however, the runs did not consist of people lining up to take deposits out of banks, but the runs were instead occurring out of sight. Why does this view of the crisis affect the policies you would employ to contain and end the crisis?
A: Because in a financial panic the entire financial system is at risk. Following the collapse of Lehman Brothers [in September 2008], the financial panic accelerated. We saw credit freeze up. We saw asset prices drop sharply. We saw confidence drain away. And the effects in the economy were very sharp and immediate. So financial panic took a bad situation and made it much worse.
Q: But the fact that it was occurring out of view of the public and the political class made it more a challenge for the Fed to explain its extraordinary actions to provide short-term liquidity.
A: There weren’t people lining up in the streets to take out their deposits, because deposit insurance protected ordinary depositors. But there was a run on so-called wholesale funding, such as repurchase agreements [repos] and commercial paper. The run was less obvious, at least from a television perspective, because it was happening electronically. But as that situation began to worsen, we responded as central banks have always responded--by serving as the lender of last resort and making sure that financial institutions had access to short-term cash to meet their funding needs.
Q: In your book, you cite Walter Bagehot, the editor of Britain’s magazine The Economist, who in the 19th century advised that during a financial panic, central banks should provide essentially unlimited short-term credit to fundamentally solvent financial institutions and markets.
A: I did cite him, yes.
Q: Over Lehman weekend in September 2008, Barclays was considering buying the so-called good bank part of Lehman Brothers. However, the U.K. regulator would not allow Barclays to guarantee the assets during the period before the board voted on the deal. What do you think would have happened if the Fed had lent money to Lehman to keep it afloat until the board at Barclays could have its vote?
A: So you have to get the facts straight first. Barclays ultimately bought the broker dealer business at Lehman, a small part of the overall firm. They did not make an offer on the overall firm, because their regulator told them they couldn’t.
Q: In the book, you addressed a hypothetical case in which Barclays could have bought Lehman, but in which case it would require a loan from the Fed to make sure Lehman had sufficient cash to survive from the time a deal was accepted until weeks later, when the Barclays board would vote on the deal.
A: In the hypothetical case, if Barclays did make an offer, they would still have the same problem in that under British law, they couldn’t guarantee the liabilities until shareholders approved--which would be some weeks further away. And we didn’t think Lehman could survive that long.
Q: You also expressed doubt that a consortium of banks could pool resources to rescue Lehman Brothers. Why did you think this could not work? How might it have played out?
A: I was not personally at the meeting in New York where this was discussed. I was back in Washington. But, as reported to me, the Wall Street CEOs at the New York meeting that weekend might have considered helping another firm buy Lehman, but they were not interested in some kind of consortium or bailing out Lehman themselves. This was the case, in part, because they were afraid for their own stability. They thought that even if they bailed out Lehman, there would be potentially other firms that would come close to failure. So there was not a lot of enthusiasm among the Wall Street CEOs to save Lehman in the absence of a buyer.
Q: In the end, you came to the conclusion after the $85 billion initial bailout of American International Group that the federal government would need to inject capital into the financial institutions to bring a halt to the accelerating financial crisis. That was the case, in part, because it appeared that more of them were soon likely to fail, too, in a series of runs on short-term funding.
A: That’s right. The Fed was at the end of its power at that point. The Fed didn’t have any more capacity to keep saving firms.
Q: The Fed has ended its quantitative easing monthly purchases. Yet it still has $4.5 trillion in accumulated assets from the three rounds of QE. How do you think the presence of those assets will affect the future conduct of monetary policy or the ability of the Fed to deal with future crises?
A: To the question about assets on the Fed’s balance sheet, those assets are entirely Treasury securities and government-guaranteed Fannie Mae and Freddie Mac securities, and are not a particular problem for monetary policy. Monetary policy is going to be conducted in the near term by raising the short-term interest rate, the Federal Funds Rate.
The Federal Open Market Committee has told us that at some point they will stop reinvesting the proceeds of maturing securities and that after that point, the balance sheet will start to run down naturally in a perfectly predictable way. At some point over a period of years, the balance sheet should return to something near its pre-crisis size.
Q: In the mortgage market, higher costs for servicing from regulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and higher capital requirements under Basel III have shifted much of the mortgage originations market away from regulated depository institutions to less regulated non-bank mortgage companies with less capital and liquidity. Isn’t this outcome the opposite of what was needed for the system? What should be done about it?
A: Well, first it was very important for the banking system to have adequate capital and strong oversight to avoid another crisis in the future. But I agree that to the extent credit extension is moving outside the banking system and into the shadow banking system, regulators need to pay close attention to that. And the Dodd-Frank reforms and other reforms have given regulators the authority they need to do that. And, in fact, they are doing that.
Q: You stated in your book you were pleased with Dodd-Frank and Basel III provisions that require banks to hold more capital and have more liquidity.
A: Right.
Q: The Department of Justice has pursued mostly corporations for fraud and other wrongdoing tied to the financial crisis rather than individuals. What do you think of its strategy and how could more individuals have been held to account?
A: Yes, I’m a bit puzzled by the strategy of penalizing large institutions for misbehavior, which effectively is punishing the shareholders where presumably there was something inappropriate that was done by some individual or group of individuals. I think in many cases it would have better if the Department of Justice had pursued individual cases and looked for individual mistakes or individual malfeasance. That would have been more beneficial because it would have given us greater clarity on what actually happened.
Q: And perhaps it could have served as a deterrent, although you cannot know for sure.
A: Yes, that’s right. MB
Robert Stowe England is a freelance writer based in Milton, Delaware, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon.com. He can be reached at
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