Bad Analysis Caused Fed Failure to Predict Severity of Economic Crisis

An article on Bloomberg by Scott Lanman that details some of the confusion in the Federal Reserve in the years leading up to the financial crisis.  It references a letter written by Ben Bernanke for the benefit of the Financial Crisis Inquiry Commission on December 21, 2010.  The letter can be read in its entirety on the FCIC’s website.

According to Bernanke, policy-makers at the fed failed to recognize and diagnose problems with the economy and the housing market in particular because Fed economists didn’t find major risks.  I find this to be unacceptable, in part because it is evident from Bernanke’s letter that economists and advisors at the Fed did see at least some risk, which appeared to be brushed aside by those making policy.  I also find this unacceptable because there are plenty of people who did see the crisis coming, and profited from it greatly (John Paulson, for one).  I realize hindsight is 20/20, but aren’t these people supposed to be some of our best and brightest?  Isn’t preventing financial collapse one of the main reasons the Fed even exists in the first place?

According to the latter, a 2005 Federal Open Market Committee meeting where the Fed was briefed on potential dangers posed by the mortgage system and housing market and were told that “even in the face of a large drop in housing prices, the national mortgage system might bend but would likely not break and that neither borrowers nor lenders appeared particularly shaky at that time”.  Fair enough.  The Fed felt that the market’s underlying fundamentals were still strong, and that “it was hard for many FOMC participants, in the summer of 2005, to ascribe substantial conviction to the proposition that overvaluation in the housing market posed the major systemic risks that it did.”

Now fastforward to 2006 when “FOMC  participants expressed nervousness about the growing “ingenuity” of the mortgage sector”.   Particularly the issues of negative amortization and “nontraditional lending practices” that were based upon the assumption that home values would continue to rise.  At this time Bernanke says that he felt home prices would decline, but that the decline would be a healthy correction.

In 2007 the FOMC noted that “the subprime market in particular was very unsettled and reflected deteriorating fundamentals in the housing market.”  By August 2007, “participants expressed concern that the effects of subprime developments could spread to other sectors and noted that we had been repeatedly surprised by the depth and duration of the deterioration of these markets.”

By the Fall of 2008, Lehman Brothers collapsed, and there had been considerable debate about whether the government should undertake a bailout or not.  Bernanke says he favored a solution that “would involve tools such as a robust resolution authority and a capital injection program, neither of which was authorized at that time.”

What I see here is a clear pattern of slowly increasing recognition that something might be wrong with the economy, and a failure to take steps to do anything about it before it was too late.  To me the Fed failing to see the impending economic crisis is something along the lines of the C.I.A. failing to see the coming collapse of communism: an epic failure that should really lead to an examination and overhaul of the institution itself.