In FED We Trust

A
t the beginning of October 2008, after some of the toughest weeks of the Great Panic, the lines in Ben Bernanke’s face and the circles under his eyes offered evidence of more than a year of seven-day weeks and conference calls that stretched past midnight. Sometimes all that seemed to keep Bernanke going was the constantly restocked bowl of trail mix that sat on his secretary’s desk and the cans of diet Dr Pepper from the refrigerator in his office. But the balding, bearded chairman of the Federal Reserve managed a smile as he confided that he had a title for the book he would write someday about his watch as helmsman of the world economy:
Before Asia Opens
…

The phrase was a reference to the series of precedent-shattering decisions that Bernanke and others at the Fed and Treasury had been forced to make with insufficient sleep and inadequate preparation on Sundays so they could be announced before financial markets opened Monday morning in Asia, half a day ahead of Washington and New York.

Before Asia Opens
… was not a laugh line. The subprime mortgage mess was made in America, and that meant the U.S. government was forced to lead the cleanup. Ben Bernanke had more immediate power to do that than any other individual. The president of the United States can respond instantly to a missile attack with real bullets; he cannot respond instantly to financial
panic with real money without the prior approval of Congress. But Bernanke could and did.

Yet the United States had become so dependent on the flow of money from abroad and the business of American financial institutions was so intertwined with those overseas that Bernanke didn’t have the luxury of waiting until the sun rose over Washington to make decisions and pronouncements. Hence the subject line Goldman Sachs economists put on one of their weekly e-mails: “Sunday is the new Monday.”

There was the Sunday in March 2008 when the Federal Reserve shattered seventy years of tradition and lent $30 billion to induce JPMorgan Chase to buy Bear Stearns, a flailing investment bank the Fed neither regulated nor officially protected.

And the Sunday in August 2008 when Bernanke and Treasury Secretary Henry Paulson, the nation’s self-appointed investment banker in chief, decided to seize Fannie Mae and Freddie Mac, the government-sponsored, shareholder-owned mortgage giants that had borrowed heavily from abroad.

And the Sunday in late September 2008 when Bernanke and his Wall Street field marshal, Timothy Geithner, then president of the Federal Reserve Bank of New York, pressured the Federal Deposit Insurance Corporation to invoke an emergency law to subsidize Citigroup’s attempt to strengthen itself by acquiring Wachovia.

Yet no Sunday of the Great Panic would prove as consequential and controversial as September 14, 2008, the day Bernanke, Geithner, and Paulson allowed Lehman Brothers to fail after a desperate search for someone to buy it.

The government-sanctioned bankruptcy of a Wall Street firm founded before the Civil War marked a new phase in the Great Panic, a moment when financial markets went from bad to awful. The
Wall Street Journal
dubbed it the “Weekend That Wall Street Died.” Lehman’s bankruptcy was the largest in U.S. history. The financial market reaction was ugly. At the end of trading on Monday, the Dow had plummeted over 500 points, its biggest one-day drop since September 17, 2001, when trading resumed following the 9/11 attacks. While financial giants led the way down — Goldman Sachs stock lost 19 percent, Citigroup 15 percent — every major sector on the S&P 500 index posted a loss. Other economic indicators were also negative: in anticipation
of a global slowdown, oil prices plunged, while spooked investors sent the price of supersafe Treasury bills soaring. In a sign of what was coming, dozens of traders crowded around the specialists who trade American International Group, America’s largest insurance company, on the New York Stock Exchange floor as Monday’s trading began. AIG shares, which had closed on Friday at $12.14, opened Monday at $7.12 and ended the day at $4.76.

As horrible as the first day after Lehman was, the bigger fear was that nobody knew where the collapse might end. Bernanke, Geithner, and Paulson confronted the biggest threat to American capitalism since the 1930s, and their responses were commensurately big.

Within one week, they:

married venerable brokerage house Merrill Lynch to Bank of America
all but nationalized AIG, pumping in $85 billion of Fed money to keep it alive
risked taxpayer money to halt a run on money market mutual funds no one ever considered guaranteed by the government
administered last rites for Wall Street’s investment-banking business model by converting Goldman Sachs and Morgan Stanley into Fed-protected bank-holding companies
pleaded with Congress to give the Treasury $700 billion to prevent catastrophe, a request that ultimately led to a Republican administration taking a government ownership stake in the nation’s biggest banks

The Fed was the first responder. It acted as quickly and forcefully as its leaders could manage in order to prevent the country — and the global economy — from plunging into the abyss. Bernanke bluntly said as much later: “We came very, very close to a global financial meltdown, a situation in which many of the largest institutions in the world would have failed, where the financial system would have shut down, and … in which the economy would have fallen into a much deeper and much longer and more protracted recession.”

In ways that the public and politicians had never before appreciated, that weekend, and the months that followed, would reveal that the Federal Reserve
had become a
fourth branch of government
, nearly equal in power to the executive, legislative, and judicial branches, though still subject to their constitutional authority if they chose to assert it.

Ben Bernanke and a small cadre of advisers would vow to do
whatever it takes
to avoid a possibility that, until 2008, was unthinkable: a repeat of the Great Depression.

T
HE
R
EPUBLIC OF THE
C
ENTRAL
B
ANKER

The Federal Reserve — one chairman, six other Washington-based governors, the twelve presidents of regional Fed banks that dot the map from Boston to San Francisco, 21,199 employees — is given extraordinary latitude. Few checks exist on its actions beyond the oath of the chairman and other governors to obey the Constitution and laws of the United States and the admonitions of its lawyers, a strong unwritten sense of what constitutes sound central banking, and the awareness that Congress has the power to curb the Fed’s independence if it strays too far from what the public deems acceptable. As Berkeley economic historian and prolific blogger Brad DeLong put it: “It is either our curse or our blessing that we live in the Republic of the Central Banker.”

During the reign of Alan Greenspan — which wasn’t much of a republic — the smart people of the Federal Reserve allowed the housing bubble to inflate. They stood by as banks and investors made ever bigger bets on the flawed assumption that housing prices would never fall across the country. They encouraged financial engineering that created securities so complex that neither inventor nor seller nor buyer could fully understand them, instruments that proved toxic to those who bought them and to everyone around them. They shielded financial engineers from attempts at government regulation and restraint. With huge sums at stake, they trusted investors and traders to protect themselves — and the rest of us — better than even the smartest government regulator could hope to. Ultimately, they failed to see that the big banks that the Fed was charged with supervising were gambling with the global economy. It was, among other things, a colossal failure of imagination.

When the bubble burst, Greenspan was gone. Ben Bernanke, the Prince
ton professor who had devoted an academic career to understanding the Great Depression, had taken his place. The Bernanke Fed initially misdiagnosed the condition. It underestimated the harm that the bursting housing bubble was doing to the U.S. economy and its banking system. It was surprised repeatedly and was forced to apply ever-larger tourniquets to stop the bleeding until the Fed and the Treasury finally talked Congress into a $700 billion blood transfusion — and even that was insufficient.

As the crisis accelerated, the Fed came under fire from all sides — accused of being overly generous to Wall Street by helping JPMorgan Chase buy Bear Stearns, overly punitive in its terms for lending to AIG, and overly complacent for letting Lehman die. The Fed was simultaneously charged with putting so much credit into the economy that it was creating tomorrow’s inflation and putting in so little that it was ignoring today’s risk of deflation.

Like central banks elsewhere, the Fed is traditionally the “lender of last resort,” a phrase borrowed from the French in the eighteenth century by Sir Francis Baring, who described the Bank of England as “the dernier resort.” The phrase conveys the Fed’s role as the ultimate protector of the financial system on which the entire economy relies. Until the Great Panic, “lender of last resort” usually meant lending to sturdy banks at times when frightened customers wanted to pull out their money. The point was to allow healthy banks to reimburse depositors without forcing the banks to demand early repayment of sound loans or to dump securities in overwhelmed markets — or to sell the furniture — none of which would be good for the overall economy. Banks were regarded as special: taking savings from millions and channeling them into loans for productive investments that individual savers would never have made directly. If banks stopped lending, the economy stopped. The Fed was there to look after the banks. When other companies, even other financial companies, ran into trouble, well, that was someone else’s problem — or so the Fed thought.

A
UTHORITY AND
A
BDICATION

In the Great Panic, Bernanke took the Fed beyond the traditional role of lender of last resort to the core of the banking system. When he took office
in February 2006, the Fed had $860 billion of loans and securities on its books, nearly all supersafe U.S. Treasury securities. By the end of 2008, the Fed had more than $2.2 trillion of loans and securities on its books, most of them riskier than U.S. Treasury securities. The Fed was lending not only to conventional commercial banks, but also to investment banks, to insurance companies, to auto finance outfits like GMAC, to industrial companies like General Electric, and indirectly to homeowners and consumers. As the law required, the Fed demanded collateral, a security or something else that it could sell if the borrower didn’t pay back the loan. But as the Great Panic intensified, the Fed became less picky about collateral. A widely circulated comment on one blog labeled it “the pawnbroker of last resort.”

And when it looked like even that wasn’t enough and that the political system was paralyzed, Bernanke’s Fed in March 2009 said it was prepared to put an additional $1 trillion into the economy — buying up Treasury bonds and mortgages in the markets.

The Great Panic was different from the succession of lesser panics and recessions that occurred in the late twentieth century. As frightening as some of those seemed at the time, the Fed managed them with the standard central banker tools — moving interest rates up and down, lending to healthy banks that needed quick cash, cajoling the chief executives of big banks to do what was needed to prevent crises that threatened the financial system. Jimmy Carter had recruited Paul Volcker to restore global confidence in the U.S. economy and the U.S. dollar and to end an inflationary spiral that, at the time, seemed unstoppable. In Ronald Reagan’s years, Volcker helped big American banks cope with massive losses on loans they had made to Latin American governments. His successor, Alan Greenspan, steered the economy through the storms of the 1987 market crash and then helped clean up the mess left by savings and loan associations that were pulled under by a combination of shortsighted regulation and lousy real estate loans.

But the Great Panic was much bigger — in price tag, in geographic scale, and in duration. And so was the Fed’s response. What the Bernanke Fed did was necessary. Inaction at a time of such pervasive economic peril would have been devastating. But the Great Panic challenged the ideology of capitalism: economies do best when markets, not governments, decide who gets credit
and who does not. What’s more, the Fed’s actions challenged the essence of democracy: the people’s elected representatives levy taxes and spend money.

Barney Frank, the sharp-tongued sharp mind who chaired the House Financial Services Committee, captured the issue clearly. Labeling Bernanke “the loan arranger” with his sidekick, Paulson, Frank said, “I think highly of Mr. Bernanke and Mr. Paulson. I think they are doing well, although I think it’s been inappropriate in a democracy to have them in this position where they were sort of doing this stuff unilaterally. They had no choice. And it’s not to their discredit, but … this notion that you wait until there’s a terrible situation and you just hope that the chairman of the Federal Reserve would pop up with the secretary of the Treasury and rescue you. It’s not the way in a democracy … you should be doing this. …

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