How Could Ye Be So Blind About Subprime?

federalreservebuildingThere is nothing more frightening than when those in charge of the economy miss something that was as plain as the nose on your face. Such was the situation with the Federal Reserve and the subprime mortgage crisis in 2007.   The FOMC met on August 7th and claimed there was not enough evidence of a subprime problem. Three days later on August 10th, Federal Reserve Chair Ben Bernanke held a rush conference to keep a credit freeze from happening and this was the first action out of many for the oncoming financial crisis onslaught:  :

The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets. The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.

From the newly released 2007 FOMC meeting transcripts:

On August 10, 2007, the Committee reviewed developments in money and credit markets, where strains had worsened in the days since its last meeting. Participants discussed the condition of domestic and foreign financial markets, the Open Market Desk's approach to open market operations, possible adjustments to the discount rate, and the statement to be issued immediately after the conference call. On August 16, 2007, the Committee again met by conference call. With financial market conditions having deteriorated further, meeting participants discussed the potential usefulness of various policy responses. The discussion focused primarily on changes associated with the discount window that would be directed at improving the functioning of the money markets.

The Fed needed to get out more. Anyone on the street knew there was a problem with subprime mortgages. One could tell just by the glazed look on the face of young woman who thought buying a property with a 10% mortgage interest rate and balloon payments was a good investment. After all, she reasoned, one could break up rooms and then rent each for $1500 when the average rent for a one bedroom apartment in the area was $550. The rambling denials always claimed the property value would double in five years. All the FOMC has to do was talk to that family on government financial assistance who were buying a house. The mortgage lender said there was no problem they were on welfare and had a past bankruptcy two years ago. Contrast that with triple A rated mortgage backed securities bundled up in CDOs being traded like shiny gold coins on Wall Street. Buried deep in the mortgage related derivatives were these same subprime mortgages. Suddenly in 2007, peddling these derivatives became an issue as less were willing to buy them. Investors realized there was a stink bomb buried deep within. Yet the repackaging up of toxic assets doesn't get a mention by the Fed in their FOMC August 2007 meeting transcripts.

Five long years have passed since the start of the financial crisis, primed by subprime mortgages. The FOMC released their meeting transcripts. and it is astounding what the most powerful group of private citizens in America missed about subprime, contagion and the economy. On August 10th, 2007 was the subprime jig was up. Other institutions wanted to stop buying derivatives based on subprime mortgage loans due to dependencies. This started freezing up credit markets. Then FOMC Vice-Chair Tim Geithner clearly was in denial about subprime and the domino effect of mortgage backed securities. From the August 10th 2007 transcript:

Apart from those that are more narrowly in the mortgage market that can’t basically sell any non-agency products, I don’t think we’re seeing any sense of funding pressure.

Chair Ben Bernanke also had a blind eye to what was coming just a year later:

The market is not operating in a normal way. The idea of providing liquidity is essentially to give the market some ability to do the appropriate repricing it needs to do and to begin to operate more normally. So it’s a question of market functioning, not a question of bailing anybody out.

More amazing is how short the August 10th meeting actually is. A 100 foot financial tsunami was visible in the distance and not a alarm bell was sounded. Only Jeff Lacker asked a question as to why commercial paper was freezing up and the Fed asset repurchasing involved mortgage backed securities intervention. William Dudley's response on their $19 billion dollar repurchase of one derivative as an intervention gets the prize for how much in denial the FOMC were about subprime backed derivatives.

Our feeling is that the $19 billion we added today should be more than enough, and so we would expect the fed funds rate to come off.

And so began the series of mortgage backed securities repurchasing that is still going on today, five years later.

Alphaville has poured over the 2007 transcripts and pulled more quotes which will shock and annoy. Bear in mind this was five years ago when no one could imagine where we are today.

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Comments

CDOs run rampant in China

Apparently there's a growing problem in China with repackaged debt being sold through third-party brokers. It was a trend that used to be common in the US and UK too... remember the Collateralised Debt Obligation crisis?

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CDOs via SPVs

Who can forget the tranches of garbage filled up with toxic assets in such a way they were fraudulent and can never be proved?

It was global so if China has this, no surprise. They didn't do any reforms period and why Fisher's proposal to make SPVs considered an affiliated, the banks holding companies is very good. They would dump these CDOs into little SPVs then parked in the Cayman's or where-ever so no legal action, outside the law, plus tax haven status.

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