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Feds “Be Nice to Banks”, Trumped Recognition of Housing Bubble in 2005

In an interesting bit of synchronicity, we’re getting other “how did we get there” snippets from the global financial crisis today. Bloomberg reports that the Federal Reserve actually did see that a housing bubble was underway, but stuck to its guns of measured interest rate increases. 1. William White of the Bank of International Settlements had been warning central bankers, including Greenspan, of a housing bubble in multiple markets since 2003 2. In June 2005 the Economist had a cover story, with a very detailed analysis, of the rise in housing prices. In other words, the idea that housing prices were frothy was clearly visible to mere readers of the financial press 3. Poole does accurately say that all the Fed did was consider that housing prices would stop rising, not that they might fall. This is another symptom of bubble denial and a major failure of imagination 4. It is not just that the staff warnings were largely ignored in terms of Fed policy, but it did not decide to engage in closer monitoring or do additional forensics. This again reflects the Greenspan “let the markets alone” anti regulatory bias. The Fed had other tools at its disposal besides interest rates. Jawboning or more intrusive inspections of bank would also have sent a message (yes, we know now that CDOs were the big driver of the toxic phase of the market, but a dim Fed view would have also influenced investors and would have led to a concern that the riskier tranches of RMBS were soon to be repriced, since risky debt usually takes it on the chin first when markets turn down. That could have led investment banks to be reluctant to gin up CDOs on a large scale, since they provided warehouse lines to CDO managers as well had exposure to unsold deals) 5. The Fed continued to defend the housing market in public statements. That’s the wrong thing to do; it tells investors and financial firms that the officialdom is on the case and thinks there is nothing to be worried about. For instance, ECONNED took note of this statement in a May 2005 speech, which is after the FOMC discussions in question:

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