David R. Henderson  

George Selgin on Bernanke's Spinning

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Moreover, thanks to Bloomberg's having forced the Fed to disclose the contents of all three Maiden Lane portfolios, we now know that, by April 3, 2008, when Bernanke made the same "investment grade" claim in testifying before the Senate Banking Committee, some Maiden Lane securities had already been downgraded to below investment grade. Furthermore we know that Maiden Lane I's portfolio was chock-full of toxic securities. Reacting to these disclosures, Ohio Senator Sherrod Brown, a member of the Senate Banking Committee, opined that "Either the Fed did not understand the distressed state of some of the assets that it was purchasing from banks and is only now discovering their true value, or it understood that it was buying weak assets and attempted to obscure that fact."

That Bernanke should repeat the "investment grade" claim in his book, after the true nature of the Fed's purchases has been disclosed, seems pretty surprising. So, for that matter, does his admission -- offered in defense of the Fed's subsequent decision to let Lehman go under -- that the Fed "had no legal authority to overpay for bad assets." If the Fed really lacked such authority, then its purchase of Bear's assets wasn't legal. If it did have permission to overpay, then the reason Bernanke gives for the Fed's having let Lehman Brothers fail -- a reason he only started referring to when questioned by the Financial Crisis Inquiry Commission (FCIC), almost two years after the rescue -- is phony.

This is from George Selgin, "The Courage to Refuse," October 31, 2015.

On the Fed's speculation:

Although the Fed's defenders, Bernanke among them, are quick to note that all three Maiden Lane portfolios eventually recovered, so that the Fed (or rather taxpayers) bore no losses, the fact that they did doesn't at all suffice to square the rescues in question with Bagehot's well-considered advice. That advice simply doesn't allow central banks to place risky bets on troubled firms. Bagehot never says that it's OK for a central bank to set his advice aside provided that its gambles end up paying off.* The Fed's apologists also fail to consider that, while the Fed itself may have come out of the deals it made smelling like roses, the same cannot be said for several of the private firms that took part in them.

The conclusion:
The plain truth is that, despite his professed devotion to Bagehot, Ben Bernanke was never able to heed the principles laid down by that great authority on last-resort lending.** Nor is it hard to see why. When confronted by a failing SIFI, it generally takes more courage for a central banker to refuse aid than to grant it. After all, if the SIFI survives, the central banker can claim credit, whereas if it doesn't he can at least claim to have "acted." On the other hand, if the SIFI is left to fail, the costs are obvious and immediate, whereas the benefits are largely invisible and remote. Bad as it was, the drubbing Bernanke took for bailing out Bear and AIG was nothing compared to the horsewhipping he received, even from some people whose opinions he had reason to care about, after he let Lehman fold. The usual public choice logic applies. In any event, no one knows how to calculate the net present value of present and future financial losses. And who, in the midst of a crisis, would pay attention if someone managed to do it?

And that is why it makes little sense, after all, to blame Ben Bernanke for the Fed's irresponsible bailouts. Apart from allowing Lehman Brothers to fail, he only did what just about any central banker would have done under the same circumstances. For among that tribe, the courage to act is one thing; the courage to refuse to rescue large, potentially insolvent firms is quite another. And that is why we need laws that make such rescues impossible.

The whole thing, which is long, is worth reading.

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COMMENTS (19 to date)
Kevin Erdmann writes:

But the securities were only toxic because of Fed policy.

baconbacon writes:
But the securities were only toxic because of Fed policy.

This doesn't fit. AIG's counter parties were demanding AIG raise more capital for months while 10 year tips spreads were above 2%. TIPS spreads collapsed basically as AIG announced that it was going bankrupt. Tons of securities dropped from investment grade as a direct result of AIG's bankruptcy, not future inflation expectations.

Khodge writes:

@kevin erdmann
I would be more inclined to blame fiscal (legislative) policy and then make it the legislature's responsibility to fix. We have a Fed policy that is covering up congress' policies. The question becomes the jurisdiction (or lack thereof) of the Fed.

Kevin Erdmann writes:

Investors were demanding capital because the collateral behind those securities lost 25% of its value because the Fed decided, with the publics consent, that that was acceptable.

Then after that, in September 2008 in quick succession, tips spreads collapsed, then Lehman failed, then the Fed made a policy decision even more hawkish than what they had been following before Lehman failed, and AIG finally toppled the day after.

George Selgin writes:

Mr. Erdmann's suggestion that the Fed was responsible for the decline in value of AIG's collateral is absurd to the point of being brazen, as are his suggestions concerning the timing of the decline. An accurate timeline for the events in question is here.

Kevin Erdmann writes:

George, let me start out by saying I have a tremendous amount of respect for your work. Also, I should preface this by saying I have been doing a lot of work over the past year on the topic, which has led me to the conclusion that home prices in 2005 and 2006 were a reflection of supply constraints, mainly in NYC and California, and in fact standard DCF models of home values suggest that demand-side excess could not have had much to do with the price level at the top. If you haven't been following my work, and there is no reason you should have, that probably sounds absurd too. But that is where I am coming from. I think baconbacon has some disagreements with me, as you might see here, but I think after following my work himself, he would say that it isn't nearly as absurd as you might expect when you look at the totality of the evidence.

On this issue, though, I think your logic has a bit of a catch-22. On Sept. 14, Merrill Lynch sold to Bank of America, on Sept. 15 Lehman failed, on Sept. 16, the Fed had a meeting where their head trader said:
"the probability of easing has gone up fairly significantly. But I think it’s hard to interpret because it’s really not about 25 versus zero. It’s really about zero versus 50 or maybe even 100 as you look out longer term. Either the financial system is going to implode in a major way, which will lead to a significant further easing, or it is not."
and several committee members explained that banks in their districts were unable to lend to borrowers who had always been reasonable credit risks in the past because of liquidity issues. Then the committee voted to keep rates at 2% with an expectation of eventual hikes to stave off inflation (5 year TIPS spread was about 1% at the time).
Literally, that night, they announced the capital infusion to AIG. So, did the final collapse on Sept. 16 have nothing to do with the Fed policy position at that meeting? Do you think the Fed posture at that meeting was reasonable? If the failure of AIG was inevitable and foreseeable, why was it so absent from Fed concerns that morning?

Other than that, I don't know how your timeline undermines my comment. Starting in 2007, coincident with home prices collapsing by about 1% per month, while the Fed kept referring to the housing collapse as "ongoing" and saying that inflation is their main concern, AIG's creditors naturally kept ratcheting up their demands. I just noticed that they were still using the term "ongoing" at the September 2008 meeting. Isn't there some point where we can fault them for not supporting credit and real estate markets? Clearly at that point real estate prices were a product of crisis and disequilibrium.

Even if I am right that the Fed should have been more accommodative going back to at least 2007, it is still going to be the firms that were most leveraged and most exposed to collapsing asset values that fail. In hindsight, we can say that AIG was too cavalier about the risk of those securities, and I wouldn't necessarily disagree. But, if there is consensus in this country that homes across the board should be allowed to drop 25% - and much more than that in the most active real estate markets - and firms should have modeled their risk profiles on that possibility, then I'd rather have the devil himself managing the currency. If homes had fallen by 5% and AIG had collapsed, you'd have a point, but 25% in the course of a couple of years? If that's what creditors have to be prepared for, we might as well make people pay cash for homes. If you say that prices were only correcting, as most people do, then you're begging the question. The way a housing bubble should correct is by building houses, leading to falling rents. That is certainly not what happened. The housing bubble collapsed because the Fed pulled back on the currency too much.

George Selgin writes:

Kevin, if you mean that errors of Fed policy during 2007-8, including its having contributed to a general liquidity shortage through its policy of sterilized lending prior to September '08, played some part in declining asset prices, then I don't disagree with the claim. But there was surely more to the collapse of MBS, CDOs, and related stuff, than that. I don't believe any amount of Fed easing could have kept the relative price of such assets from declining once housing prices started to decline. I also don't think that the Fed could have kept housing prices from declining. As for timing, NGDP growth did not fall of substantially until mid-2008. By then, as the timeline I supplied shows, the problems in the subprime and subprime derivatives markets had become notorious. The firms that were calling upon AIG to ante-up long before September were responding to this reality.

Perhaps there is still more to your argument that I haven't grasped. I would be glad to peruse the whole thing if you send it my way. Lord knows,, I don't mind being proven wrong, and especially so when its a matter of having underestimated the Fed's capacity to do harm!

Kevin Erdmann writes:

Thanks for the reply, George. Unfortunately it's complicated. I'm trying to find a book deal, because it's the only way I think to contain the whole thing. I would love to hear what you think. If you're interested, the best way is probably to just click on my name and work your way backwards. I'm on part 76 right now.
Along the way, I have found most of the accepted facts about the episode to be unfounded. There was not a change in types of borrowers, basic character of mortgages,etc. I'm sure it seems hard to believe. I think if you work back a few posts, you'll get an idea of the thesis and some of the surprising empirical evidence.

Shayne Cook writes:

Mr. Selgin, Mr. Erdmann:

From Mr. Selgin's comment ...

"But there was surely more to the collapse of MBS, CDOs, and related stuff, than that."

From Mr. Erdmann's comment ...
"There was not a change in types of borrowers, basic character of mortgages,etc."

Gentlemen, (Mr. Erdmann especially), I suspect your understanding of the events and contributing factors leading to, during, and subsequent to the financial crisis might be better informed if you fully understand and apply the concept of "technical default".

The "Cliff notes" version is just this:
Any given debt instrument - and all securitizations/derivatives thereof - can and did go into "technical default" long before, and completely independently of, failure of borrowers to actually service the debt.

It was the embedded "technical default" provisions of debt instruments (and derivatives) - not actual debt service default incidence - that was the single greatest impact to debt instrument pricing at the time.

Kevin Erdmann writes:

I agree that this was an issue. Do you know of a good source of data or any information about specific securities in 2006-2007 on this issue?

Michael Byrnes writes:

George Selgin wrote:

"I don't believe any amount of Fed easing could have kept the relative price of such assets from declining once housing prices started to decline. I also don't think that the Fed could have kept housing prices from declining."

I'm probably going to butcher this, but I think that part of Kevin's argument is that home prices rose for supply/demand reasons (as opposed to overly loose monetary policy reasons), at least in high-demand areas. Compared to the number of people that would like to live in, say, San Francisco, there is relatively little housing and what is there commands a huge premium. I'm not exactly sure how Kevin widens his argument to acount for housing in lower demand areas like suburban Phoenix.

Kevin Erdmann writes:

Michael, you've basically got it. There was some price movement late in the boom, after the Fed had begun raising rates, in a couple places like Phoenix, that seems excessive. I don't know if I will have an explanation for that other than speculative fervor. But in the aggregate the amount of the boom possibly attributable to speculation is very small. Rising prices by metro area tended to correlate with rising rents. Even rent inflation in Phoenix in 2005 was rising, which is strange if there was overbuilding. Overbuilding should be associated with real rent expansion and rent deflation, but even in Phoenix we saw the opposite.

Shayne Cook writes:

Mr. Erdmann:

"I agree that this was an issue. Do you know of a good source of data or any information about specific securities in 2006-2007 on this issue?"

I presume that question was posed to me, but in any event, I'll respond...

The incidence of "technical default" wasn't just an issue during this period, it was THE issue during the period. And I'm afraid there is no single source of "good data" on this. That in fact was and is the problem. Each and every individual mortgage debt instrument is unique, specifying what is and what is not a "default event".

Every borrower knows (or should know) that failing to make their payment in full and on time triggers a "default event". We'll call that an "actual default" for purposes of illustration here.

But there are any number of other conditions that can and do arise that also trigger a "default event". And they are entirely dependent on the rest of the terms and conditions listed in each individual loan/debt instrument agreement. We'll call those "technical default" events for illustration purposes here.

Common examples of "technical default" would be if you fail to make your homeowner insurance policy payments in full and on time. A "technical default" also accrues if you, the debtor/homeowner do anything to materially degrade the market value of your home - material being defined as degrading the market value to below the mortgage principal balance due. So large and unanticipated downward fluctuations in local market value also indicate "technical default" due to the resulting change in Loan-to-Value (LTV) ratio.

In context with the events leading up to and including the financial crisis, a large, but non-deterministic number of individual mortgage loans went into "technical default" simply due to rapid and unanticipated drops in market value - the so-called "bubble bursting" and "homeowners under water" metaphors. (I really hate metaphors.)

And it DID NOT MATTER which geographical location[s] were experiencing the most or least changes in market values. Nor did it matter specifically how many geographical locations were experiencing the underlying asset (downward) re-pricings. The aggregated mortgage securitizations and all of their derivitives - Collateralized Debt Obligations (CDO), Mortgage Backed Securities (MBS), etc. - were not bundled by geographical location.

Investment banks and creditors hadn't purchased (leveraged) just "Phoenix area" MBS/CDO/etc., or "San Francisco area" MBS/CDO/etc/, or "New York area" MBS/CDO/etc. such that they could re-price the securitizations based on those home market fluctuations. They were buying (and had bought) bundled, aggregated securities, and derivatives thereof - with no means of rationally re-pricing based on individual local home markets.

So attempting to understand or explain what was going on with the financial system, based solely on what was going on in the individual Phoenix home market, or the San Francisco home market, or the New York home market is an exercise in futility - precisely the sort of futility the financial markets, Fed and Treasury were facing at the time.

Data on changes of "actual default" incidence/rates associated with the underlying loans was/is readily accessible and measurable. That real-time data on "actual default" rates by itself is then used to rationally (and un-violently) re-price the related securitizations. The financial markets already have/had in-place mechanisms in place to deal with that, and the financial markets are not fragile to even large fluctuations in "actual default" rates. That in fact is the purpose of many securitizations/derivatives - create/sell instruments that are purposely price-sensitive to "actual default" fluctuation, for risk-tolerant investors, and purposely price-insensitive to "actual default" rates for risk-averse investors.

But no one - not the financial markets, nor the Fed, nor Treasury - had any rational basis for re-pricing any of those instruments/securitizations when it became apparent that many/all contained debt instruments that were known to be in "technical default" - simply due to large-scale and widespread underlying asset (homes) market re-pricing. (The "toxic paper" metaphor.)

The financial markets are/were fragile to that scale of known unknowns. That was the financial crisis.

Kevin Erdmann writes:

Shayne, the condition you describe would actually be a very useful piece of evidence in favor of my thesis that a liquidity crisis created the bust.

I would be very appreciative if you could point me to any specific information about any securities where the market price was declining before cash flows on the underlying loans declined.

Shayne Cook writes:

Mr. Erdmann:

Perhaps I should clarify my perspective here. While I realize you are deeply invested and enchanted by your "the Fed caused it" thesis, I am not.

Much like George Selgin, I consider your statements such as those in your first comment here ("But the securities were only toxic because of Fed policy.") uninformed and ludicrous to the point of absurdity.

My purpose in offering a basic explanation of the "technical default" phenomena, and its impact on re-pricing of related financial instruments, was intended to inform your thinking on the financial crisis. It is clear to me that none of your prior work, nor your comments here, reflect any aspect of your having addressed the "technical default" issue, nor that you had even suspected it existed as an issue.

But it is quite clear to me now that I've completely failed in my attempt to inform your thinking in this matter.

Kevin Erdmann writes:

What would be useful is some data or some link to actual timelines of values, cash flows, and status of specific securities. I would love for you to inform me. I am really dying to get my hands on that sort of information, and I would greatly appreciate any help you can give me. You seem to have some knowledge of the issue. Can you help me?

Shayne Cook writes:

Mr. Erdmann:

You have to understand that the source information you seek is embedded within millions of individual private mortgage debt contracts. And in context, it is even more deeply embedded within the various securitizations/derivatives/etc., which are, in and of themselves, also separate private debt contracts.

It is, by law, NOT public information - not in raw data form, nor in Fed, Government, or even banking sector aggregated public data.

The existence of your loan, each of your loan payments, and the end of your loan (when you have paid it off) ARE, by law, reported to the Federal Reserve System and become a matter of public record - because each of those events represents a real inter-bank transfer-of-funds event affecting the entire reserve system.

Similarly, and for precisely the same reason, any and all default events (either "actual" or "technical", as I've described for illustration above) are, by law, reported to the Fed - in real time - and thereby become a matter of public record, and publicly available data.

What is not and was not detailed in this reporting, is what "triggered" the default event - was it "actual" default, or "technical" default, per my illustrative definitions?

For the Fed, and for the entire financial system, that distinction used to be completely irrelevant - a default event is a default event is a default event, ad nauseum. All default events were assumed to have identical impacts to the financial system, the reserve system, and asset pricing models. That proved to be a critically defective working assumption during the financial crisis period, as I've attempted to explain here.

A "technical default", while a legitimate default event per terms and conditions of private contract - and public by law/legally mandated reporting - DO NOT have the same effects as "actual default" on either the financial system, inter-bank transfers within the reserve system OR asset pricing models! The distinction was never thought to be important, but it in fact was and is critically important.

You say, "I am really dying to get my hands on that sort of information ...". I can well imagine you are.

You are merely echoing the exact same sentiment that dominated the entire financial sector, the Fed, the Federal Government, millions of homeowners, etc., etc. beginning in 2006. You're about 8 years late to realize that having "that sort of information" is pretty important.

Something I find intensely amusing about all this, is that the very folks you and others are blaming for the financial crisis and its corrective actions - Bernanke, Gietner, Paulson, et. al. - are the exact same people who fully understood this phenomena and its impacts AND effected correction, some 7 or 8 years before you and those others even start to ask the right questions.

You ask, "Can you help me?"

As much as I'd like to, I'm beginning to think I can't. I'll refer you to Mishkin. His work seemed to be helpful for some of may former MBA students. When and if they actually bothered to read it, of course.
(It's potential for helpfulness to you is similarly conditional.)

Shayne Cook writes:

George Selgin:

I have two questions.

Before I post those, though, I'll preface that I may be in general agreement with what seems to be the point of your critique of the Bernanke/Fed actions at that period of time - but for entirely different reasons. Certainly, had the Bernanke Fed acted differently the future would have evolved differently, perhaps even with fewer costly/detrimental unintended consequences.

My first question relates to your concluding statement...

"And that is why we need laws that make such rescues impossible."
... and is this: Is there such a thing as a law that makes the cited infraction impossible?

For example, existing laws against premeditated murder do not actually make premeditated murder impossible.

My second question relates to a, what I consider, a related/relevant, but nonetheless hypothetical case ...

Among your many impressive accomplishments listed, is that you are currently "Professor Emeritus of Economics at the University of Georgia". (NOT hypothetical).

The hypothetical case is: Suppose I were a grad student (or even and undergrad) in one of your economics courses. You gave me a course assignment (for grade) to write and submit a brief review of Ben's newly released book - as you have done here. And of course, being the conscientious, but not necessarily gifted, student that I am (NOT hypothetical), I submitted, for grade, the exact same review that you've presented here. (Ahead of yours, or course, such that plagiarism is not the issue.)

My question is this: How much of your metaphorical "red ink" would be on my paper when you handed it back to me?

(No need to answer my two questions, by the way. I'm just a student of economics, and definitely not an attorney. But I do know that a good attorney never, ever asks questions for which they don't already know the answers. I already know the answers to my two questions.)

Kevin Erdmann writes:


In research I have read on the 2006-2007 period, the 2006 and 2007 cohorts of loans that underlie those securitizations have default rates that begin to sharply rise around the beginning of 2007. Are you saying that those loans were largely not in arrears, but were just being categorized as in technical default because of issues like the declining market value of the property? Are you saying that reported defaults overstate actual defaults in 2007?

Please be patient with me. I'm slow, but I'm trying to learn.

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