THE FEDERAL RESERVE

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THE FEDERAL RESERVE

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MARKETWATCH

"Another inflation gauge is set to enter the red zone, but no worries at the Fed. Here’s why"


By Jeffry Bartash

Published: Aug 26, 2018 8:22 a.m. ET

Federal Reserve Chairman Jerome Powell is watching inflation closely, but the former Wall Street risk manager says gradually rising inflation is not sufficient cause to raise U.S. interest rates.

Yet another key measure of U.S. inflation could soon hit the highest level in six years, but don’t expect the head honcho at the Federal Reserve to get uptight.

A barometer of inflation that strips out food and energy is likely to reach 2% for the first time since 2012.

Known as core PCE, it’s one of the two inflation gauges the Fed follows the closest and plays a big role in determining when the central bank raises the cost of borrowing.

The headline PCE number, which includes food and energy, breached 2% in the early spring and is already at the highest level in six years.

These inflation figures are included in the monthly report on consumer spending that will be issued Thursday.

Rising inflation used to make Fed bigwigs quiver in their boots and move fast to pour cold water on the economy through higher interest rates.

That’s no longer the case, though.


Starting in the early 1990s and continuing through the slow economic recovery of the past decade, the Fed has been more willing to keep interest rates low.

Automation, the Internet, cheap Chinese labor and other factors have worked to produce a remarkable era of weak inflation both in the U.S. and abroad.

Inflation in the U.S. has topped 4% only once since 1991, and just briefly, in 2008 when the economy was plunging into the worst downturn since the Great Depression three-quarters of a century earlier.

For the most part it’s hovered between 2% and 3% and as recently as three years ago inflation was effectively zero.

In a major speech last week, Powell suggested that changes in the level of inflation were no longer as useful in helping the Fed to decide when to raise interest rates.

He argued the Fed needs to adopt a more sophisticated “risk management” strategy that looks “beyond inflation for signs of excesses” in the economy.


Signs of excesses aren’t all that obvious — partly why the yield on the 10-year Treasury note is surprisingly still stuck below 3%.

Stock indexes such as the S&P 500 and Nasdaq Composite are even pushing back into record territory.

Consider the ultra-tight labor market.

The unemployment rate keeps falling and now sits at a nearly 20-year low of 3.9%, but worker pay is still rising less than 3% a year.

And while companies say they have to pay more for raw materials and transportation costs owing to tariffs and other shortages, they’ve had trouble passing on price increases to customers reluctant to pay them.

Inflation as measured by the PCE would likely have to move rapidly toward 2.5% or 3% to force the Fed to cast aside Powell’s gradualist approach to raising interest rates.

Even then, Powell insists, it would have to be clear to the Fed that shifting inflation is not merely a temporary phenomenon.

For all his avowed “caution,” though, Powell is on board for at least several more increases in the Fed’s benchmark short-term interest rate.

The central bank appears locked in on a rate hike at its next big meeting in late September.

The so-called fed funds rate is slated to rise to a range of 2% to 2.25% from its current 1.75% to 2% target.

Eventually the Fed expects to end up around 3%.

Still, the Fed is moving more at a turtle’s pace than that of a hare.

No worries there.

“The speech was largely a spirited defense of the Fed’s slow-but-oh-so-steady rate hikes,” said Doug Porter, chief economist at BMO Capital Markets.

https://www.marketwatch.com/story/anoth ... 2018-08-26
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Re: THE FEDERAL RESERVE

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MARKETWATCH

"Analyst: NY Fed president becoming a bit more dovish"


By Steve Goldstein

Published: Sept 6, 2018 12:23 p.m. ET

New York Fed President John Williams, a key Federal Reserve official, signaled in remarks made in Buffalo that he has turned a bit more dovish, according to an analyst.

Chris Low of FTN Financial said Williams highlighted "the puzzle" why wage growth hasn't grown more aggressively after previously flagging concerns about overheating.

Williams also use the word "Goldilocks" to describe the economy, as was often done in the 1990s, Low points out.

Low said Williams may have lost his appetite for tightening all the way to 3.5%.

https://www.marketwatch.com/story/analy ... ewer_click
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Re: THE FEDERAL RESERVE

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MARKETWATCH

"Fed official: The fleeting impact from Trump’s stimulus is at its height right now"


By Steve Goldstein

Published: Sept 7, 2018 12:53 p.m. ET

The president of the Dallas Federal Reserve said Friday the tax cuts and federal spending increases are having their biggest impact right now, suggesting they will not make lasting changes to the economy.

Robert Kaplan, in an interview with Fox Business Network, said the economic impact from the Tax Cuts and Jobs Act will decrease next year.

“It is our view and it’s my view at the Dallas Fed that we’re at the height of the impact of the stimulus right now, the fiscal stimulus."

"That will fade somewhat in ’19 and will fade further in ’20 and you still got some headwinds, sluggish labor force growth because the demographics [of] aging and sluggish productivity, those will start to kick in more as the fiscal stimulus fades,” he said.

Kaplan said trade disputes are having the impact of limiting capital expenditure growth.

“The tax legislation and tax reform cause companies to accelerate capex that they might have done a year or two from now to do it today because of the tax incentives,” Kaplan said.

“I also think you’re seeing additional capex in the energy business because of the production growth, high prices but I do think companies are telling me that they, yes, they are taking a wait-and-see approach because of the uncertainty around trade."

"So, it’s having a little bit of a chilling effect and so that’s something to just be aware of and take note of.”

As for the jobs report, Kaplan said it didn’t change his view of the U.S. economy.

He also said he’s been expecting wage growth to accelerate, as it did in August.

“I’ve been expecting for several months now that you’d see the wage number firming."

"And it’s consistent with a tight labor market, I still believe that a lot of the big structural drivers in the world, automation, globalization will mute overall inflation pressures."

"But I actually think the wage growth number is welcome and it is probably consistent with our outlook for the economy and what it’s been the last few months,” he said.

Kaplan, who isn’t a voter on the Federal Open Market Committee but participates in the meetings, said he’s in favor of bringing rates up to a range between 2.5% to 2.75%.

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Re: THE FEDERAL RESERVE

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MARKETWATCH

"Fed’s Rosengren says yield curve is not an important indicator"


By Greg Robb

Published: Sept 10, 2018 10:39 a.m. ET

Boston Fed President Eric Rosengren said he does not read much about a possible recession from the shape of the yield curve.

“I don’t take as much information from the yield curve as some other people."


"It is one of many things I look at, but I don’t give it any special attribute in terms of telling us cyclical changes,” Rosengren said in an interview with MarketWatch.

The discussion comes as the flattening of the so-called yield curve has raised fears about the health of the economy, since an inverted curve is often a leading indicator of a downturn.

Rosengren said he wouldn’t focus on the spread between the 10-year Treasury note and the two-year note, with quantitative easing occurring in Europe and Japan and while the Fed has its own big balance sheet.

“I think there are a lot of reasons to believe that that relationship is not constant over people’s balance-sheet changing so much,” he said.

“If we’re growing very rapidly and inflation is picking up very rapidly, and the yield curve is negative, I will still say we should be raising rates,” he said

Rosengren, who will vote on interest-rate policy next year, is a firm believer in more gradual rate hikes over the next year.

He said the gradual pace the Fed has been following – one quarter point move every three months – is appropriate.

“If I’m doing it every other meeting, that’s not happening all that quickly,” he said.

The Fed can ascertain whether there is “some bite” from policy.

“As long as we are able to go gradually, I think it is less likely that we’ll make the kind of mistake [like overtightening],” he said.

Rosengren said he doesn’t favor the suggestion from some of his colleagues, like Dallas Fed President Robert Kaplan, that the Fed hike until rates are at “neutral” level and then pause.

“I don’t think that there is any special nuanced point where we should necessarily stop,” he said.

A neutral level is the level of rates that neither boosts nor restricts growth.

Rosengren’s estimate of the neutral rate is a range between 2.75% and 3%.

Rates are now between 1.75% and 2%.

The Boston Fed president said the economy is “pretty good,” with inflation “right where we want it to be” and strong growth.

“There is no reason to be close” to a neutral level of rates, he said.

“We have the flexibility to go a little bit more slowly because we’re not above our inflation target, but there is no reason not to continue to increase gradually,” he said.

Rosengren said it is reasonable to think that policy will move into restrictive territory.

“It is very reasonable that, given we have slightly accommodative monetary policy and very accommodative fiscal policy, an appropriate policy will be to be a bit above what we think the [neutral] rate is,” he said.

“The goal isn’t to cause the economy to slow down so much that we have a recession,” he said.

Rosengren suggested he didn’t support rewriting the Fed’s policy statement for its next meeting on Sept. 25-26.

“I think people have a pretty good idea of where we’re going right now."

"I think the statement will evolve when we get closer” to neutral, he said.

https://www.marketwatch.com/story/feds- ... 2018-09-10
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Re: THE FEDERAL RESERVE

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MARKETWATCH

"Boston Fed president says financial risks now coming from smaller banks"


By Greg Robb

Published: Sept 10, 2018 12:01 a.m. ET

Boston Fed President Eric Rosengren said there are still financial stability concerns despite the fact that the nation’s biggest banks are healthier.

“There is a tendency to say large banks are well-capitalized and as a result we have no concerns,” Rosengren said in an interview with MarketWatch this weekend.


And yet, the first credit crunch happened in 1990 when a lot of small banks failed, he noted.

“It doesn’t have to be a large bank to fail to cause banking issues, to cause a problem” for the economy, he said.

Community banks have not raised their capital as much in relative terms as large banks and have taken on more risks, he said.

While the Fed’s stress tests have dissuaded large banks from expanding into commercial real estate in a big way, community banks, which don’t have stress tests, have expanded the amount of commercial real estate they’ve taken on, he said.

If the next downturn impacts commercial real estate, “I do have some concerns we could see clustering of community banks failing in a way that he had in the late 1980s or 1990s,” he said.


“We may not have the same kind of problem that we had in 2008, but it doesn’t mean we shouldn’t be concerned about it,” he said.

Rosengren said he regretted the fact that federal regulators don’t have the tools to change risky investor behavior.

“We don’t have a lot of tools to cause people to roll back what they’re doing,” the Boston Fed president said.

The only real “macroprudential tool” the Fed has is the countercyclical capital buffer, and that currently is set at zero, he noted.

“We can talk about it, we can jawbone about it, but we don’t really have very many tools that can actually do something about it except to raise rates,” he said.

Rosengren said this was not an “ideal place to be...but until the U.S. adopts debt-to-income, loan-to-value, other financial stability tools, you are going to be putting a lot of weight on monetary policy,” he said.

https://www.marketwatch.com/story/bosto ... 2018-09-10
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Re: THE FEDERAL RESERVE

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MARKETWATCH

"Fed should buy stocks if there is another steep recession, former IMF economist says"


By Greg Robb

Published: Sept 10, 2018 10:38 a.m. ET

The Federal Reserve buying stocks?

How about financing the federal deficit?

Or buying goods?


These were some of the suggestions for combating the next severe recession given to the central bank by former IMF chief economist Olivier Blanchard at the Boston Fed’s monetary policy conference over the weekend.

There is a general sense the Fed has to re-think its approach to combating recessions given the low-interest-rate environment that is persisting.

The problem facing the central bank is easy to describe.

The Fed’s benchmark short-term fed funds rate is now around 2.875%.

That’s not so much room to cut rates in a downturn considering in a typical post World War II recession, the Fed slashed rates by 5-6 percentage points to turn the economy around after a recession.

Blanchard said the Fed probably has enough tools to handle a run-of-the-mill recession.

But if it is another severe recession like the financial crisis, Blanchard urged the central bank to resort to previously unheard of policies.

In an interview with MarketWatch, Boston Fed President Eric Rosengren said he was not convinced there would be political support for “unusual monetary policy” such as the types Blanchard was describing.


Minutes of the Fed’s last meeting in late July show the central bankers had an extensive discussion of their policy tools.

“We definitely have tools."

"The question is whether we have the sharpest tool in the shed and whether we’re going to be able to deploy them,” Rosengren said.

Some people say the Fed cannot purchase more assets given that its balance sheet is over $4 trillion.

Rosengren said he would be a “strong advocate” of the Fed resuming asset purchases, a policy termed quantitative easing, if the economic downturn was so severe that rates were cut to zero.

“I do think that people are underestimating the resistance that that would entail,” he said.

Even that would require firm leadership from the Fed, he said.

In his speech at the Fed conference, Blanchard said the size of the balance sheet is not a constraint.

“Yes they are scary."

"But that doesn’t mean it cannot be done."

"If we need it, we could clearly double it and nothing terrible would happen,” he said.


At the moment, the Fed can only buy Treasurys and mortgage-related assets.

The best policy would be for the Fed to buy assets with high premiums like stocks, he said.

“This could do the trick and could work even better than buying long bonds,” he said.

If things got really bad, monetary financing of the deficit is something that could work to increase demand, Blanchard said.

“We have this notion that it is only OK for the central bank to buy assets and not goods."

"But that’s a restriction we imposed on ourselves,” he said.

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Re: THE FEDERAL RESERVE

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MARKETWATCH

"Government has less power now to thwart next financial crisis, says former Fed official"


By Greg Robb

Published: Sept 11, 2018 3:08 p.m. ET

A former top Federal Reserve official who played a key role in the response to the financial crisis sounded pessimistic about whether regulators would be able to defuse the next crisis if it occurs in the nonbank sector.

“The political economy is much worse today than before the last crisis” in terms of what regulators can do, William Dudley said Tuesday at a conference at the Brookings Institute.

Dudley, the former president of the New York Fed, wants the central bank to have the power to lend to a systemic nonbank with the requirement that the firm be subject to regulation.

Not only is this power not in place, “it is not even seriously debated,” Dudley said.


Dudley was the head the New York Fed’s markets division during the crisis.

In the wake of the 2007-2009 financial crisis, Congress has limited the Fed’s ability to lend to a single firm that is in trouble.

Dudley was gloomy that the Dodd Frank super-regulator, the Financial Stability Oversight Council, would identify systemic problems and adjust the federal safety net in time to mitigate any damage from a failure.

“I am very skeptical about whether this will actually ever be used” and it is likely to “always be late,” Dudley said.

Regulators have to keep up with financial markets and are likely are going to fail again and again, he said.

“But that is the challenge,” he said.

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Re: THE FEDERAL RESERVE

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MARKETWATCH

"Fed should pay more attention to market signals with next rate moves: Bullard"


By Rachel Koning Beals

Published: Sept 12, 2018 11:32 a.m. ET

Federal Reserve interest-rate setters aren’t paying enough attention to what the bond and stock markets tell them, St. Louis Fed President James Bullard said Wednesday.

Bullard’s preferred approach to monetary policy relies on placing more weight on financial-market signals, such as the slope of the yield curve and market-based inflation expectations, than has been customary in past U.S. monetary-policy strategy, he told the CFA Society in Chicago.


Markets, he said, are also more reactive to real-time factors including government stimulus and trade uncertainty.

His view is based in large part on a belief that the empirical relationship between inflation and unemployment — known as the Phillips curve, and a closely watched relationship by many at the Fed — has largely broken down over the last two decades, leaving monetary-policy makers without a clear guidepost for action.

Bullard does not have a vote on the Fed’s interest-rate panel in 2018 but does vote in 2019.

“Handled properly, current financial-market information can provide the basis for a better forward-looking monetary-policy strategy,” he said, and that includes helping the Federal Open Market Committee better identify the neutral policy rate.

“The flattening yield curve and subdued market-based expectations suggest that the current monetary-policy stance is already neutral or possibly somewhat restrictive,” Bullard said.

Yield-curve inversions have historically predated recessions, though their telling powers aren’t perfect.

Inversions of the Treasury yield curve have preceded the past seven recessions while throwing out two false positives with an inversion in late 1966 and a very flat curve in late 1998, according to the Federal Reserve Bank of Cleveland.

Currently, the yield curve is near its flattest level since 2007.

As for inflation, Bullard said market-based expectations, adjusted to a personal-consumption-expenditures, or PCE, basis, remain somewhat below the FOMC’s 2% target.

The inflation compensation data derived from Treasury inflation-protected securities (TIPS) “suggest that markets do not expect the FOMC to achieve the 2% inflation target on average on a PCE basis over the next decade,” he said.

Bullard said markets are a better reflection of forward-looking views on inflation and better account for factors beyond existing data.

“One of the great strengths of financial-market information is that markets are forward looking and have taken into account all available information when determining prices,” he said.

“Thus markets have made a judgment on the effects of the fiscal package in the U.S., ongoing trade discussions, developments in emerging markets, and a myriad of other factors in determining current prices.”

Bullard, in a television interview earlier this month and in other speeches, has said he considers current interest-rate policy appropriate, especially without more concrete economic data to justify another rate increase.

Yet he appeared then to acknowledge that a majority of Fed members and financial markets are banking on another rate hike.

The Fed meets later this month and is expected to raise the current target rate, which now stands between 1.75% and 2%, by a quarter-point.

Market participants think the Fed will raise rates again in December, although Bullard said he considers longer-run market expectations for rates to be more dovish than the Fed’s own projections.

Fed watchers pointing to tighter rates cite recent data that included an August jobs report showing a healthy clip of job creation and improved news in wages in particular, as the yearly rate of pay increases rose to 2.9% from 2.7%.

Bullard said after the speech that he expects more forecasters to bump up their predictions for U.S. annual GDP growth to the low 2% area for 2019 from a current range up the middle to upper 1% area, especially after a strong start in the first half of 2018.

He has considered making an increase in projection himself but has not yet made the move, wanting to see productivity gains cement that growth view.

Bullard links stronger growth to business optimism tied to tax cuts and changes to the corporate tax structure, a sentiment that he thinks has a firm grip in the economy and is not a short-term blip.

His colleague, the Dallas Fed’s Robert Kaplan, has suggested otherwise.

“I definitely think that political change had an influence."

"This is a pro-business administration and the business community welcomed that,” Bullard told reporters.

Bullard said high levels of household debt relative to GDP growth, especially tied to housing values, are not as alarming as they were pre-financial crisis but warrant close attention should that change.

Any need for concern over the lofty level of stock market valuations relative to GDP is “food for thought,” he said, especially as investors struggle to assign reasonable value to technology stocks.

But the tax-law changes and harvesting earnings overseas are among the bigger factors that justify U.S. stock market strength, he said.

Still, he concedes, “investors are struggling to understand value... will [equity market swings] sweep the entire U.S. economy or the global economy and will the very largest tech companies get their comeuppance?"

"No one really understands and everyone is trying to understand valuations.”

https://www.marketwatch.com/story/fed-s ... 2018-09-12
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Re: THE FEDERAL RESERVE

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MARKETWATCH

"Fed’s Brainard says an inverted yield curve won’t get in way of rate hikes"


By Steve Goldstein

Published: Sept 12, 2018 4:03 p.m. ET

A key Federal Reserve official on Wednesday said that an inverted yield curve would not necessarily point to an imminent recession, despite its historical track record in doing so.

The comment, from Gov. Lael Brainard in a speech to the Detroit Economic Club, isn’t hugely different from comments Brainard made in May on the topic, or from other Fed officials including New York Fed President John Williams.

What her remarks do suggest is the Fed won’t let the prospect of an inverted yield curve deter the central bank from continuing to lift short-term interest rates.

Brainard told the Detroit audience that this time is different.

“Like many of you, I am attentive to the historical observation that inversions of the yield curve between the 3-month and 10-year Treasury rates have had a relatively reliable track record of preceding recessions in the United States,” she said.

However, the current 10-year yield is around 3%, compared with the average of 6.25% before the financial crisis.

Market expectations of interest rates in the longer run are themselves quite low, and also the term premium — the compensation investors require for taking on duration risk — is low.

“If the term premium remains very low, any given amount of monetary policy tightening will lead to an inversion sooner so that even a modest tightening that might not have led to an inversion historically could do so today,” she said.

So, why is the term premium so low?

One reason, she says, is the changed correlation between stock and bond returns, likely associated with changes in expected inflation outcomes.

Another reason is the asset purchases of central banks in major economies.

Brainard, who as a Fed governor gets a vote at every meeting, says further gradual increases in the federal-funds rate will likely be warranted.

“With fiscal stimulus in the pipeline and financial conditions supportive of growth, the shorter-run neutral interest rate is likely to move up somewhat further, and it may well surpass the longer-run equilibrium rate for some period,” she said.

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Re: THE FEDERAL RESERVE

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"Bernanke, Geithner and Paulson ‘have invented alternative history’ of Lehman collapse, professor says"


By Greg Robb

Published: Sept 13, 2018 4:01 p.m. ET

Nearly ten years ago, Lehman Brothers, declared bankruptcy after a frantic weekend of unsuccessful talks to find a buyer at the New York Fed.

Lehman’s collapse followed the takeover of Bear Stearns in early March by J.P. Morgan Chase that was assisted by a Fed loan and the government takeover of Fannie Mae and Freddie Mac.

The outcome has always been controversial.


After rescuing Bear Stearns and the GSEs, no public money was provided Lehman to stay afloat.

Days later, the Fed reversed course, providing assistance to two other investment banks, Goldman Sachs and Morgan Stanley, through access to loan programs.

Goldman’s total borrowing peaked at $69 billion while Morgan Stanley’s peaked at $107 billion.

The Fed also rescued American International Group through an initial $85 billion line of credit.

This was followed by the broad $700 billion bank bailout that Congress passed, known as the Troubled Asset Relief Program.

Ben Bernanke, Timothy Geithner and Henry Paulson have all said that they wished to rescue Lehman but that their hands were tied because Lehman did not have enough collateral to allow the government to provide a financial lifeline.

Laurence Ball, in a new book “The Fed and Lehman Brothers, Setting the Record Straight on a Financial Disaster,” debunks this official narrative.


An economics professor at Johns Hopkins University, Ball says there was no discussion of Lehman’s collateral or the legality of a loan during the crucial weekend.

In addition, he said that Lehman did have enough collateral, if anyone had looked.

Other analysts, including Joseph Gagnon of the Peterson Institute for International Economics, have argued that Lehman was probably deeply insolvent at the time of its bankruptcy.

MarketWatch sat down with Ball to discuss the findings of his book.

Henry Paulson said this recently:

“The thing we get the most criticism for is letting Lehman go down."

"Despite the fact that the three of us have all said, you know, we did everything we could to save Lehman."

"We didn’t believe then and don’t believe now a single authority we had that would have worked."

"Many people say well 'they were able to save Bear Stearns, they were able save AIG, why couldn’t they save Lehman?'“

"We answer it and most people still don’t believe us.”

You don’t believe them.


I don’t believe them.

They have been asked that question again and again and they have given the same answer again and again.

And when I first started researching this I didn’t know what the right answer was — there were such starkly different claims.

But having spent four years looking at the evidence — and there’s a lot of evidence, what Secretary Paulson is saying there is just simply not true.

What the three officials say is that Lehman didn’t have enough collateral so that the Fed couldn’t legally give them a loan.

Yes, that’s the sense of it.

And actually that is absolutely incorrect in two related, but distinct, senses.

First of all, in terms of their decision-making— again there’s a big record from some investigations with subpoena power about what people were discussing in that weekend — they were discussing various economic and political ramifications of letting Lehman fail or not letting Lehman fail.

They were not discussing does Lehman have enough collateral — do we have the legal authority.

So that was not the reason that they made the decision.

In addition, at this point it is possible to go back and put together the numbers, there is enough data on what Lehman’s assets were, what its liquidity needs were, and if one actually does that exercise, it is clear that Lehman did have ample collateral for the loan it needed to survive.

So, if the Fed had asked is there enough collateral, the answer would clearly have been yes.

They could have made a loan, it would have been legal, it would not have been very risky, and probably the whole financial crisis and Great Recession would have been less severe.

Paulson was trying to say to Wall Street, we’re not going to bail out Lehman, let this be a lesson for you.

In essence that’s Elizabeth Warren’s anti-bailout view.

But it didn’t last more than a day or two.


What I, in my opinion, establish with absolute certainty in the book, is that the official explanation about legal authority and collateral was simply not correct.

Again the fact that those three impressive people say it again and again, very strongly, does not make it true.

As far as what then is the real reason, there we have to be a little bit more speculative, and my conclusions there are not terribly original: I think it was political.

Of course, many people have said all along obviously it was political but everything I’ve seen is consistent with that.

It wasn’t just Elizabeth Warren, it was everybody.

It was the one completely bipartisan issue with Bernie Sanders saying this is a giveaways to the rich and conservatives saying this is socialism taking over the banks.

The two presidential candidates, Barack Obama and John McCain, both issued very stern statements.

This was right after the takeovers of Fannie Mae and Freddie Mac.

Obama and McCain issued statements saying we can’t have any more of this nonsense.

So there was tremendous political pressure.


In addition to that, there was an underestimation of the damage the failure would do, maybe some wishful thinking.

And you’re absolutely right that there was a 180 degree turn in a day-and-a-half when they rescued AIG.

I would put a positive interpretation on that.

They made a bad mistake, one that they have not owned up to.

But at least they quickly saw what a bad mistake it was.

Henry Paulson widely was quoted as saying I can’t be “Mr. Bailout.”

But I think he realized pretty quickly that being “Mr. Caused The Worst Depression Since The 1930s” would be even worse, so we’re lucky that he and the other policy makers at least were flexible enough to shift course.

Because Lehman was the accelerant on the financial crisis?

Yes.

Federal Reserve economists several days before the Lehman bankruptcy predicted that the unemployment rate would peak at 6% because of strains on financial markets.

Lehman was the event that caused strains on financial markets to turn into... people use metaphors like tsunami, trainwreck and so on.

Earlier in 2008, in March, Bear Stearns has been rescued.

Lehman failed in September.

What happened in between?


There were the big five investment banks and Bear Stearns was the fifth biggest and they were very invested in real estate.

So there was a lot of speculation that maybe this could happen to another one of these investment banks.

And the fourth biggest, Lehman Brothers, was also heavily invested in real estate, so there was speculation perhaps Lehman Brothers could be the next one to go.


Lehman Brothers actually had a very sharp shift in its business strategy.

Up until the Bear Stearns event, they were continuing to try to expand in real estate.

They actually thought “Gee, this is great."

"Real estate prices are depressed and we will buy low and make a lot of money.”

But after Bear Stearns, they realized they had a big problem and they tried hard to raise capital, they looked for an acquirer, and Secretary Paulson was very involved trying to be a broker for that.

Now I think they talked to basically every global investment bank, every sovereign wealth fund, Warren Buffett, Carlos Slim, anybody with money, and no deal was done.

I think various people I think including Secretary Paulson think the problem was that Richard Fuld, the Lehman CEO, didn’t fully face reality and had an unrealistically optimistic view about what his company was worth and wasn’t going to engage in a fire sale.

Of course that changed at the very, very end, when they faced bankruptcy.

I can certainly understand why Paulson and Fed officials were very frustrated.

They did work very hard for six months to try to arrange at Lehman takeover and were not successful.

The problem with the investment banks is they had long-term investments funded by short-term paper?

The basic mechanism by which they got in trouble is well understood.

It’s really the same story for all five banks: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman and Bear.

They all had similar problems with then quite different outcomes.


But there were three interrelated problems.

Number one, they made these big bets on real estate during the housing boom and they lost a lot of money on those.

Factor number two was they had very low equity and once they started losing money on real estate it didn’t take long before their equity started getting close to zero and people started to question their solvency and their viability.


And then problem number three was exactly what you said: reliance on short-term funding — largely overnight repos — so that once people lost confidence, you had essentially the same phenomenon as a bank run.

The people who were providing them funds on a daily basis said: “We don’t want to be providing funds for somebody who might go bankrupt.”

So Lehman Brothers filed for bankruptcy at 1:45 a.m. on a Monday morning because they were supposed to open for business in a few hours and pay somebody a billion dollars and they just didn’t have billion dollars.

They were out of cash because their short-term financing was not rolled over.

The Fed’s job is to step in when there is a bank run.

That’s right.

According to classic central banking doctrine, going back to Walter Bagehot in the 19th century, the central bank is the lender of last resort, if there is a bank run, a panic.

And again, it could be an old-fashioned bank run with the depositors running and taking their cash out or it could be this 21st century version of repurchase agreements cut off.

The central bank’s job is to provide enough cash to keep things going.

Lehman could have been kept going long enough to work out some kind resolution that was better than just telling them you have six hours to prepare a bankruptcy petition for the largest bankruptcy in U.S. history.

Instead of acting, the two Fed officials, Bernanke and Geithner, deferred to Paulson?

The politics are interesting.

Under the law at the time, it was the Fed’s sole responsibility to decide whether or not to make emergency loans.

There was a procedure in which, if the New York Fed had chosen to, they could have told the Board of Governors in Washington we’d like to make a loan and to get approval for that loan by a vote of the Board of Governors.

The role of the treasury secretary legally in that process was exactly the same as the role of the secretary of agriculture or the mayor of Baltimore.

Now, what actually happened was that Paulson got on an airplane and flew to the New York Fed and started telling Geithner and others what to do, and at some point said: “Lehman has to declare bankruptcy.”

As far as I can tell, just by force of personality, he took over and told people what to do.

I should say Geithner, in his most recent discussions, made the point that the Dodd-Frank Act has limited the Fed’s ability to be the lender of last resort and that’s possibly dangerous as far as handling future crises.

One of the ways in which the Fed’s authority has been limited is now the law says the secretary of treasury has to approve [a loan].

I worry because the treasury secretary is inherently a political appointee that might lead to politically motivated decisions.

I have to say it is ironic that Geithner would bring up that point, because again he chose to follow the instructions of the treasury secretary, even though at the time he wasn’t legally required to do so.

What are the lessons for today?

There are takeaways at several levels I think.

One is I think the whole financial crisis has confirmed the traditional thinking about central banking.

I think we saw how beneficial it was when the Fed did perform its role as a lender of last resort with AIG and Bear Stearns.

We saw how damaging it was when the Fed did not step up to the plate at the key moment with Lehman.

So, one narrow thing we learned is that the part of the Dodd-Frank Act that restricts the Fed’s ability to be lender of last resort was a mistake and that’s dangerous and that ought to be repealed.

Now, of course, in reality a number of parts of Dodd-Frank probably will be repealed and it’s not going to be the lender-of-last-resort part but maybe someday.

I think more broadly, from my research, I became persuaded the financial crisis didn’t have to be nearly as severe as it was.

People have told a story in which there were these big mistakes made involving the real-estate bubble and too much debt and risky behavior on Wall Street and when you sin like that there has to be punishment.

I think the punishment didn’t have to be so bad.

I think if Lehman have been rescued we might be looking back at that episode the way we look back at the savings-and-loan crisis of the 1980s or the dot-com bubble of the early 2000s.

Those were cases in which people made mistakes, financial institutions lost a lot of money, there was some effect on the economy, but much much milder.

The whole Great Recession was not necessary.

I can’t help saying the other thing we learned is you’ve got to really be careful listening to government officials.

Paulson, Bernanke and Geithner are correctly viewed as the class of government officials as far as very intelligent, competent, dedicated public servants, but still the story they’re telling is just not accurate.


If what Paulson, Bernanke and Geithner were saying was “Hey we did a pretty good job overall, yes at 2 a.m. on Sept. 14th we didn’t quite get it right on Lehman Brothers in this incredibly crazy confusing situation,” I would be the last person to insist on perfection in that kind of situation.

But what irks me is that they have not owned up at all to any kind of mistake and they’ve invented this alternative history of what happened on the Lehman weekend that just isn’t accurate.

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