The Republican Party Today
Department of "Huh?"

Greg Ip on Ben Bernanke

Greg Ip writes:

Bernanke, in First Crisis, Rewrites Fed Playbook: WASHINGTON -- On the afternoon of Thursday, Aug. 9, with a panic driving up short-term interest rates in Europe and the U.S., Federal Reserve Chairman Ben Bernanke's office became a war room. His closest advisers took seats in the burgundy leather chairs around a coffee table or telephoned in from their now-aborted vacations.

Mr. Bernanke, a former academic vaulted 18 months earlier to the world's most powerful economic job, was seeking counsel from colleagues of all stripes, from a thirtysomething former investment banker to a Federal Reserve veteran of nearly four decades who had participated in almost every important Fed decision of the past 20 years. He pushed them to spit out as much information as possible about the day's events. What, he asked, do we know? What must we learn? And what are our options?

The roots of the crisis had been apparent for months. In rising numbers, homeowners with subprime mortgages -- those made to the least credit-worthy home buyers -- were delinquent on payments. Hedge funds and other institutions had bought opaque securities backed by these mortgages, but they were difficult to value and potentially hard to trade. That morning it became clear that European banks had more exposure than previously thought, sparking a scramble for cash by some banks and a reluctance to lend that instantly jumped the Atlantic.

The Aug. 9 meeting in Mr. Bernanke's office kicked off weeks of brainstorming over ways to restore calm to credit markets. The wide-ranging tone of the subsequent discussions was encapsulated in subject lines of some emails Mr. Bernanke and his aides exchanged: "blue sky." One Fed governor spent hours on the phone grilling contacts on Wall Street. Another official helped broker a deal to help mortgage lender Countrywide Financial Corp. through a financing squeeze, aiming to avert a disruptive unwinding of complex loan agreements....

Whether Mr. Bernanke made the right calls in the most severe shock to U.S. financial markets since Sept. 11, 2001, will be clear only in hindsight. Critics charge that he and his colleagues, prior to August, underestimated the housing bust's magnitude and its potential spillover to markets. They say the Fed team should have shifted its focus from inflation to the slowing economy far sooner. Its efforts to restore order through the Fed's little-used discount window have shown limited results.... Nonetheless, he has dispelled some doubts about the ability of a former academic to run the world's most powerful central bank in time of crisis. Should that hold, this could have a calming effect on markets that could work to his advantage during future turmoil. "I was concerned that his academic strength did not give him the market savvy he needed," says Stephen Roach, Asia chairman of Morgan Stanley. "His performance has allayed my concerns."...

Fed officials made a troubling discovery: They had assumed banks, financially healthier than they were 15 years ago, would be a pillar of stability. But banks were increasingly reluctant to lend to each other and increasingly unable to borrow for more than a few days. Their "knees were knocking," Mr. Warsh reported to his colleagues. Opportunistic buyers -- the investors who buy when everyone else is selling -- didn't want short-term IOUs known as asset-backed commercial paper at "any price," Mr. Warsh told them. Six days after the crisis began, on Wednesday, Aug. 15, a new threat emerged, from Countrywide Financial Corp., the country's largest mortgage lender. For years, Countrywide had relied largely on short-term borrowings to write mortgages, before selling the loans to investors, usually in the form of mortgage-backed securities. Now Countrywide was finding it increasingly difficult to sell its mortgages or raise funds. It notified bankers that it planned to draw down an $11.5 billion credit line it had arranged for such a contingency....

As Mr. Bernanke's precrisis planning had indicated, the so-called discount window would play an important part in the response. The window was the Fed's central tool at the time of its creation in 1913. A bank facing a loss of deposits could borrow from the window, putting up collateral such as commercial loans, discounted from their face value. The window had fallen into disuse over the years and borrowing from it now carried a stigma -- it was seen as a sign of desperation for banks unable to borrow elsewhere. The discount rate usually sits a full percentage point above the federal-funds rate, so most banks can find cheaper funds elsewhere.

In the end, Mr. Bernanke and his group agreed that day the Fed should lower its discount rate by half a percentage point and extend the term of such loans to 30 days from one...

Comments