“When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment.”

-Chairman Ben S. Bernanke, Federal Reserve

>

The buzz this morning seems to be all about Bernanke’s speech yesterday, defending Greenspan’s ultra-low rates, and lamenting the lack of regulation and poor supervision over mortgages:

Lax Oversight Caused Crisis, Bernanke Says (NYT)
Bernanke Says Regulation Came ‘Too Late’ to Curb Housing Bubble (Bloomberg)
Fed Chief Edges Closer to Using Rates to Pop Bubbles (WSJ)
Rate hikes not best way to burst bubbles: Bernanke (Reuters)

Unfortunately, it appears to me that the Fed Chief is defending his institution and the judgment of his immediate predecessor, rather than making an honest appraisal of what went wrong.

As I have argued in this space for nearly 2 years, one cannot fix what’s broken until there is a full understanding of what went wrong and how. In the case of systemic failure, a proper diagnosis requires a full understanding of more than what a healthy system should look like. It also requires recognition of all of the causative factors — what is significant, what is incidental, the elements that enabled other factors, the “but fors” that the crisis could not have occurred without.

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages (Yes, I laid all this out in the book).

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

It became readily clear to me once I dug into the data, legislative history, market activities, etc, that there was no one single factor that caused the collapse. Rather, an honest reading of events was that there were many, many failures occurring in a very specific order that contributed to what occurred.

Inadequate regulations and “nonfeasance” in enforcing existing regs were, as Chairman Bernanke asserts, a major factor. But in the crisis timeline, the regulatory and supervisory failures came about AFTER the 1% Fed rates had set off a mad scramble for yields. Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates.

If the Fed Chief wants to avoid seeing this occur again, he needs to recognize that this was not a single factor event; rather, this was a complex event set off by numerous factors.

The sooner we learn that, the better a grasp we will have on what actually happened . . .

Category: Bailouts, Credit, Federal Reserve, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

41 Responses to “Bernanke Still Does Not Understand Credit Crisis”

  1. TripleSigma says:

    Fantastic Post!!! This point is the least talked about, most relevant impact of the low interest rates. I work in the banking industry and am surprised by how few people understand this dynamic. — and needless to say, people on the street do not understand this….

  2. snapshot says:

    http://www.federalreserve.gov/boarddocs/speeches/2004/20040223/

    Bernanke seems to have forgotten this speech by Greenspan 2/23/04.

    “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.”

  3. The Window Washer says:

    Barry,
    The endowment/pension fund effect should be in point 1, oddly many laypeople don’t think of them under the term “fund managers”.

  4. timk says:

    Yes, all these things did happen, but if regulators had required mortgage originators to act like prudent bankers -nipped it in the bud, so to speak – none (or at least little) of the rest would have happened.

    Don’t you think?

  5. wally says:

    The other thing Bernanke did not do is go back before 2002 to trace how we got to where we were. He acted as though that were a given, an unavoidable position… ‘not our fault’. That omission colors his arguments because he then pretends he had no options. The fact that we had already gone over the first hump of the roller coaster is why he argues he had no choice but to go over the second.
    Since that is he argument, prepare for yet another exciting ride.

  6. BenBer, like all FedRes Chairmen, is nothing more than a Political Hack trying to safeguard his institution from appropriate scrutiny..

    The Name of the Game is “misdirection”..
    ~~

    past that, nice post BR..
    ~~

    though, any word on those Pension Fund ‘Managers’ that were buying all of this Horse-Meat?

    as The Window Washer points to..

  7. jjay says:

    I would say that Greenspan and Bernanke knew exactly what they were and are doing, and are most likely laughing their heads off in private, while they tell the public to pay no attention to the man behind the curtain.
    They know full well the system they run is doomed in the long run, and plan to keep injecting adreneline into the heart of the corpse of the US economy as long as they can, while they tell the family in the waiting room everything will be just fine.
    I have heard a story that at one meeting Greenspan was attending, when he thought the microphone was off, he was heard telling someone, “It is all going to collapse, and I can’t wait!” If that is not a true story, it might just as well be.

  8. CTB says:

    BR,

    Could US interest rates have caused real estate the bubbles in Spain, Ireland, etc.? I haven’t seen anyone make that connection yet.

  9. Moss says:

    Unfortunately honesty is in very short supply across the spectrum of our elite class. Low rates gave rise to the deceptive financial ‘innovation’, they were the fuel, to suggest otherwise is completely disingenuous.

  10. davossherman@gmail.com says:

    Good read! Myself, I wouldn’t have limited his lack of understanding to just the housing market. Bloomberg did a hysterical piece last week – Bernake is going to slice and dice the trash he paid cash for and create bonds for it.

    I guess so he will have future buyers to bail out.

    Everyone needs to feel like they have a purpose in life.

    The quintessential question which he failed to ask himself is: Who will the buyers be? Other Purchasers comes to my mind given the saturation of the bond market.

    More QE to the rescue.

    Everyone needs to feel like they have a purpose in life. His is right up there with toilet paper.

  11. I always thought Ben Bernanke, Time’s Person of the Year, knew what he was doing. Either he is lying or he does not know what he is doing. In either case he should not be steering the ship because he does not know what that big round wheel in the captain’s area does and he also does not understand the lever that says go/stop and backwards/forwards.

    It is only the fact that we are back out to sea that these things don’t matter once we get near the harbor they will begin to matter. They will also matter if a storm rises up

  12. flipspiceland says:

    Anyone who thinks that Bernochio does not know precisely what he is saying, doing and otherwise behaving, doesn’t know what they are talking about. He is only a ventriloquist’s dummy.

    Who, for second, really thinks that every single move the bearded, balded one makes is as a result of his own single minded ‘leadership’? Who doesn’t think and know in their gut that this is all a charade, that the MBC (men behind the curtain) aren’t behind his every breath?

    That anyone would now be amazed at his duplicity is simply incomprehensible on a blog that purports to be financially savvy.

    Come on, man.

    BR: have you finally come to the realization that Bernanke isn’t the treasured Fed chief you thought he was? Had you not defended him most of last year? Am I mistaken?

    ~~~

    BR: My position has been that Greenspan was the problem, and that BB was not at the wheel during the period in question. Since then, my honest assessment of him is mixed.

  13. Lugnut says:

    Of course he understands. But if he were to admit the contributory associations his policies have had, then he would also be forced to acknowledge that the continuation of those low interest rates still have negative implications and influences today and going forward. I don’t think Ben wants to say “yes we F’ed up” because in the next breath he would have to say “…and we continue to F up today, and further, we will continue to F up into the forseeable future.”

    By the same token, when all you hold is a hammer, all your problems look like nails.

  14. Mannwich says:

    Doesn’t exactly inspire confidence that they AREN’T blowing yet another bigger, more disastrous bubble, does it?

  15. [...] rates was the impact they had on the world’s bond managers,” Barry Ritholtz writes at The Big Picture,” especially pension funds, large trusts and foundations. Subsequently, there was an enormous [...]

  16. Moss says:

    Spin is a powerful tonic when spun by the worlds master spinmeister.

  17. Steve Barry says:

    I would switch the order of #4 and 5…otherwise, spot on. I always add the caveat that none of this is remotely possible without the Fed allowing a mountain of debt to build, really since the 1950′s, but getting out of control since 1985 or so. Greenspan was appointed in 1987, so the blame goes back to whom again?

  18. cognos says:

    WRONG, wrong, wrong…

    Bernanke gets it right. Low rates are NOT the primary cause of the housing bubble (or associated after effects). The primary cause was classic capitalist risk speculation (commodities, internet, tulips, etc).

    The best fix for this would’ve been to regulate the required down payment. Imagine if regulators had simply said — “we want to see 20% down on all typical prime mortgages and 30% down on all exotics”?

    This was the proper fix. It would’ve done a better job lowering the run-up and at the same time greatly reduced any fallout. I agree with exactly what you say in your post — “until we understand what happened, we cannot move forward in a better way.” Unfortunately focusing on rates is simply hollow. Why have higher rates when we essentially have deflation? This is the recipe for depression.

  19. Steve Barry says:

    I think the best thing we can do now is admit all the problems…we are not doing that. Not admitting it may well cause another leg down. For example…T bill rates are near zero, indicating massive fear in the credit market…yet stocks have soared for months. One market is in for a shock I think. Since stocks have already discounted perfection, even if they are right, upside is limited. Heaven help them if they are wrong…remember, we sit at decade highs in bullishness.

    http://contactgotoguy.googlepages.com/Bull-Bear-ratio.html

  20. maynardGkeynes says:

    Where does China and the savings glut fit in here? Before or after point 1?

  21. primordial_ooze says:

    Cognos,
    It seems obvious that Bernanke and Greenspan (or anyone else) had no interest in preventing bubbles so
    why would they want to require 20% down and nip it in the bud? If he thinks it was because of lax regulation
    then why isn’t he a proponent of strong regulation?

  22. [...] in 2010 – At Risk If You Do, More Risk If You Don’t Fortress Investment Sees Better Times Ahead Ritholtz: Bernanke Still Does NOt Understand Credit Crisis Pension Pulse: 2010 Black Swans or Black [...]

  23. xnycpdx says:

    “It is difficult to get a man to understand something when his job depends on NOT understanding it.”
    - Upton Sinclair

  24. Steve Barry says:

    @xnycpdx

    Perfect qoute for the situation…of course if he understood things, he never would have been appointed in the first place.

  25. cognos says:

    @Primordial Ooze — Thats the WHOLE POINT of Bernanke’s statement. Its NOT about interest rates. But we should’ve prevented the bubble through regulation — higher req downpayments, more penalties/taxes for foreclosures, more transaction taxes on home speculation, more clear disclosure standards on exotic teaser rates.

    China is using these lessons. They have similar bubbles, but instead of raising rates (silly, when low inflation)… they are regulating credit creation and real estate speculation.

    As the Fed has consistently stated — the interest rate is a blunt instrument. When we have bubbles in certain sectors (commodities, real estate) it really is not the right tool… when those bubbles burst the problem is clearly deflation, not inflation. So how do we solve this problem?

  26. Steve Barry says:

    @cognos:

    The only way to solve the problem is to come clean on all losses sitting out there off balance sheet and marked to myth. Somehow apportion the losses equitably (ie. not 100% to the taxpayers). A lot of leverage will go away because, as BR says, we rip the band-aid off. Oh it will be painful. Once the dust settles, re-organize the Fed with specific powers to monitor total credit and adjust rates to keep credit checked and employment high and not worry so much about every little recession.

    The above will never happen, BTW. We will do just what Japan did. Since they are about to implode under their sovereign debt, and people are living in little cubby holes, we have insight to how it will work out.

  27. riverrat says:

    Great capsule summary, exactly why I lurk on this blog.

  28. rootless_cosmopolitan says:

    Barry,

    “(Yes, I laid all this out in the book).

    An honest assessment of the crisis’ causation (and timeline) would look something like the following:

    1. Ultra low interest rates led to a scramble for yield by fund managers;”

    Am I right, if I assume your book finally proves the relationship between Fed Fund target rate as cause and the amount of lending by financial institutions and market interest rates as effect, then? In mainstream macro-economic models, e.g. the FRB/US used by the Fed, this causal relationship is written in the equations. Assuming a causal relationship by writing it in the equations doesn’t prove the validity of the assumption, though. Economic theory has to offer only placeholders like “ripple effect” for the link between central bank interest rates and market interest rates, which doesn’t really explain anything. Why would the Federal Funds target rate, which is the interest rate, for which banks lend each other excess reserves, and which is a marginal parameter (even now: about 1 Terradollars) compared to the total amount of credit in the system (about 50 Terradollars), determine market interest rates?

    A comparison between observed data of market interest rates, e.g. 30 year fixed mortgage rates with the Federal Funds rate, show that the Federal Funds rate rather lags market interest rates [1].

    So, the empirical data are in contradiction to the assumption that market interest rates are determined by the Federal Funds rate. Instead, the empirical data indicate that the Federal Reserve’s monetary policy is rather reactive to the movement in market interest rates.

    If there really was a causal relationship between Fed Funds target rate and the supply of cheap credit and lending in the economy, lending would have ballooned since the Fed lowered the target rate to almost Zero in the current crisis. Nevertheless, the opposite has happened. Private debt is contracting anyhow.

    Coming back to your point 1. Although you may be right about the financial industry was scrambling for yield in an economic environment with low market interest rates, leading to high leverage and the creation of exotic instruments that were highly vulnerable to a change in the economic environment, particularly the saturation of the economy with debt, in your causal chain you just skipped about what Bernanke was actually talking in his speech [2], the Federal Funds target rate. You skipped the causal link between Federal Funds target rate and market interest rate, assuming latter ones were just given with first one. Thus, you don’t really refute Bernanke, if you just start your argument with the market interest rates, even if the following causal chain you have laid out is about right.

    Whether Bernanke’s economic explanations are correct is yet another issue that would have to evaluated separately. One point would be that the neo-classical economic theory, on which his thinking is founded, and the economic equilibrium models, like the FRB/US on which the Fed policies are based, don’t take the relationship between private debt change and demand in the economy into account at all.

    [1] http://mortgage-x.com/general/historical_rates.asp
    [2] http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm

    rc

    ~~~

    BR:
    Read chapter 9, titled, The Mad Scramble for Yield

  29. [...] Chairman Bernanke in denial on the role of the Fed in the credit crisis?  (WashingtonPost, Big Picture, Baseline Scenario, 24/7 Wall St., Crossing Wall [...]

  30. ToNYC says:

    Ben is selling his fix with him in charge of more regulation. Didn’t need any more regulation when busy kicking out the likes of Brooksley Born. They were and are running scared from the truth that this economy with financial services still looked at as a way to make Big Money. The greater fool is dead in the desert. It’s traders vs traders buzzing about in HFT frenzies and skimming the regular pension and IRA allocations for microcents.
    Didn’t anyone read the footnotes in the public AIG filings of $3 trillion derivatives?? Don’t need more regulation than that, Ben the Professor. If the CDO’s squared and cubed that GS Lord Banksaremine and Jamie PM packaged couldn’t be hedged, the music would have stopped cold. Nice touch; the payoff at par.
    The regulators enabled that phenomenal fiasco. The only game in Corporatism is to get next to the rule makers..it’s just not not Capitalism when the free market is shorted out les règles du jour.

  31. Andy T says:

    Yeah…how dare the Fed keep rates low and FORCE those bond managers to reach for yield. C’mon now! Nobody forced those idiots to buy the crappy securities in a reach for the extra yield.

    “Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates.”

    What does that even mean? What is “norm”? Who decides what the “norm” is for the next few decades? Wonder what the Japanese thought the historical “norm” for rates would be back in 90s by using the past as a guide?

    The market is more influential in determining the rates than the Fed ever will be.

  32. algernon says:

    The sine qua non of the crisis was easy money. The Fed & other central banks made that happen.

  33. wally248 says:

    the statement in #3 above is illogical on its face. if, according to #2, the sole purpose of nonbanks was to sell mortgages, they did not control underwriting. they needed a buyer. what killed underwriting standards was the behavior of fannie and freddie. FANNIE AND FREDDIE BOUGHT MORE THAN 80% OF THE LOANS! if they had not loosened their standards in an effort to make more money with the government guarantee, there would have been no mortgage crisis. GOVERNMENT IS THE PROBLEM – PLAIN AND SIMPLE!

    ~~~

    BR
    : Prior to late 2005, Fannie & Freddie were precluded from buying nonconforming (i.e., subprime) loans.

    They eventually changed their purchasing standards (late 2005) when Angelo Mozila threatened to take all of his business away from them, and give it to Wall Street. By the time Fannie & Freddie acquiesced, the boom had already peaked.

    So no, my talking point spouting ignorant little friend, they were not the cause of this.

    But thanks for coming by!

  34. rootless_cosmopolitan says:

    As for my own comment at 12:59 PM.

    A terradollar is a multiple of a dollar as much as a pentagram is a multiple of a gram. It’s teradollar (= trillion dollars = 10^12 dollars).

    Barry, you really are trying to get me to buy your book. ;-) Perhaps, I am going to do it.

    rc

  35. youraveragejoeonthestreet says:

    I agree with Cogno…

    Bernanke or who ever has the right… should adjust down payments to aid in smoothing out the ups and downs of markets where leverage and lending are involved… IE housing… etc. And it is important to time these adjustments to the markets… taking into account deflation….inflation historic changes in price per period… and what real costs should be.

    Right now… we could be giving people 20% of a home’s price for someone to buy in the form of some kind of lien/bond/prefered ownership. As the economy housing stock recovers to normal… reduce it to 0%. As things start to warm 5 then 10 then 15% down could be required… but quick enough up or down to actually stay ahead of bubbles happening or killing the market. Sure… it would take speculators and huge profits out of our nice free market… but I say… too bad… the whole world economy needs to be more stable and not able to be imploded just so Goldman Sachs and 500 other “in the know” smarty pants, can become the first Trillionaires.

  36. lalaland says:

    Greed made it all happen.

    Our regulators, charged with preventing Greed from winning, lost.

    Greed won, and this is what happens. Ben Bernanke, whatever his faults, did not CAUSE the meltdown; he failed to stave it off.

  37. CTB says:

    Good post by Matt Taibbi on the Government corruption vs. Evil Wall Street debate:
    http://trueslant.com/matttaibbi/2010/01/04/fannie-freddie-and-the-new-red-and-blue/

    His take: it’s both, and the partisan bickering is a smokescreen. A lot of it appears to agree with Barry. Maybe he’s a fan?

  38. [...] issue is not explored further.  I believe this is a mistake and agree with Barry Ritholtz’s post on this subject: What Bernanake seems to be overlooking in his exoneration of ultra-low rates was [...]

  39. [...] issue is not explored further.  I believe this is a mistake and agree with Barry Ritholtz’s post on this subject: What Bernanake seems to be overlooking in his exoneration of ultra-low rates was [...]

  40. cognos says:

    Its WIERD that you guys seem to miss the gigantic speculative bubble in housing. This is a totally normal, recurring capitalist phenomenon. It has little or nothing to do with regulation, govt, and rates and nearly EVERYTHING to do with classical economics and human behavior. It will constantly recur. It has already occurred, maybe 5 times in the last 10 years! (Internet, Commodities, Real-Estate, China, …?).

    When we have a speculative bubble in something like Dot-com stocks (remember that one, man!) we dont engender systematic risk. Still plenty of fallout. Debt-deflation. Scandals and frauds (Enron, Worldcom). But regulated entities like banks are not super at-risk. When its real-estate… which seems to bubble every 10-20 years…. then banks will become bankrupt. This is not actually that hard to fix, and has LITTLE to do with interest rates (which apply to the whole economy).

    1. So first we had: Speculative Bubble in Housing. This is predominatly driven by low-down payments, but also by typical market factors: speculators, rates, demographics, catalysts, confluence of factors, etc.

    2. Then we added: Mark-to-Market accounting for banks. Do you know how dumb this is? Imagine someone foreclosing on your house when you are current on your interest payments. You bought for $1M, borrowed $800k. But your neighbors house just sold out of foreclosure for $300k. You must put up $500k or you are “MTM bankrupt”! MTM for illiquid assets is one of the dumbest things ever created by man. It deserves a Darwin award. It is so obvious that in crisis all illiquid assets get marked down an extra 50%. This is a recipe for bankrupting ALL banks. As soon as we took this off, banks went up 200%. The concept is simply insane.

    3. Finally, everyone denied there was a problem (Fed, FDIC, Ben Stein, Bear, Fannie, Freddie, Lehman, Paulson, Congressman and Pundits who naively believed in “the market”). The was ZERO leadership to get in front of the problem. The fault lies 33% with citizen speculators, 33% with banks and brokers, and 33% with regulators and the govt. None wanted to propose a better solution. Foreclose, recover 0.10, repeat. Stick head in sand. Its sad, bc there is probably a better “organized” solution… like splitting the losses btw the 3 parties (homeowner, bank, govt) which kinda quasi gets done through support like TARP. But the frictional costs are very high. Anyway, its over now.

    4. Then finally and this might be the worst. SCREAM for regulation, lower leverage, and blame in the aftermath when it is completely unneccessary. The truth is the capitalist market does a fine job after the crisis. Once the situation is clear, we dont need the regulator. As Jamie Dimon has said — “We need counter-cyclical regulation”.

    At least it created massive opportunity in L/S stocks and massive upside to taking risk in the crisis. It should setup for a strong stock market for years. The herd was long 1-yr ago, and fearful in the crisis, and will now huddle in cash during a long bull market (subject to event risk). Classic.

  41. [...] market, and eventually the Derivatives market (CDOs, CDSs, etc). Look at the 10 steps detailed here on Monday regarding the forming of the credit [...]