The Fed Needs to Focus On Its Core Mission

The Last Mortgage Crisis Financial Panic Froze Global Economic Markets

Third row, Jerome Powell 2018-, to his right Paul Volcker 1979-1987. Front row, fourth from left, Janet Yellen 2014-2018, Alan Greenspan 1987-2005, Ben Bernanke 2006-2014. Photo credit: Federal Reserve Bank website.

Great Financial Crises Are Fomented by Politicians

Recent articles in the Wall Street Journal bemoan the inability of first time home buyers to turn into homeowners. This weakness has led to disappointing earnings announcements from major national homebuilders like Lennar, Pulte and others.

The good news, so far, is that the national giants are themselves offering concessional mortgage rates for first time buyers. Better that the private sector address its own issues. However, it is just a matter of time before progressive politicians come up with their own approach to this new “crisis,” which of course will require reams of public funds and the intervention of public entities, banks and non-profits.

It’s a good time to look back at the last time a politician, namely William Jefferson Clinton, first candidate then President, called for a response to low levels of home ownership. Our global financial system was brought to its knees. The Fed’s role in this crisis besmirched its reputation and compromised its independence. As of 2025 the Fed hadn’t learned its lessons. Lingering effects of past crisis interventions have bloated its balance sheet over several cycles. Today, the Fed is less independent and less focused on its mission than it ever has been.

Recruiting Players for Expanding Subprime Mortgage Lending

Commercial banks weren’t interested in this mission. However, their overarching interest in interstate branch banking, and Bank of America was the first and fastest mover towards this goal. As the regulator and supervisor of banks, the Fed had to bless all bank acquisitions and mergers. The Clinton administration¹ recognized that expanded roles for Government Sponsored Entities (“GSE”) like Fannie Mae and Freddie Mac would greatly increase the pace of subprime mortgage lending.

The Federal Reserve System began losing its independence solely through its own volition and for its own reasons. The Federal Reserve Act of 1913 created the modern Fed whose primary function was to contain financial panics quickly and effectively, and then to exit its policies and restore our system of money and banking to a new equilibrium, minus any residual footprints or sand castles from its interventions. The Fed should be an autonomous body, free of any political ambitions or direction.

Kevin Warsh says,”Since the panic of 2008, central bank dominance has become a new feature of American governance.” Let’s look at that panic, which goes by several different names.

The Great Mortgage Crisis and Panic of 2008

The best research approach we have read over all the intervening years has come from Professors Charles Calomiris and Stephen Haber.² All financial crises are precipitated by politicians and their cronies, who write legislation, regulate and use existing legislation like a bludgeon on uncooperative actors. The late Charlie Munger of Berkshire Hathaway, has always pointed out incentives as being key to explaining the behavior of market actors. Congress always leaves plenty of vigorish for its favored players, namely progressive non-profits.

Tsunamis which ultimately wreak total havoc in shoreline construction, begin as small waves in a deep, far off ocean, building power unseen. Commercial banks wanted to gather deposits and lend to customers on a national scale. Bringing modern banking services and lending to every state seemed a noble goal; however, they also wanted to compete with investment banks for global banking and investment banking services. The collapse of the Glass-Steagall Act created all these institutional mandates for the banks.

What developed over several years was what Calomiris and Haber call, a “grand bargain.” The Federal Reserve was the pivot around which actors entered the field.

Bank of America: Poster Child for Banks Behaving Badly

Bank of America (BofA) was the first of the megabanks to truly create a nationwide national footprint, after completing the acquisition of Fleet Bank to add New England to its network of more than 5,500 branches. Their CEO John Lewis wanted to grow quickly by acquisition. At the height of the financial panic in September 2008, BofA announced the acquisition of Merrill Lynch for $50 billion. The CEO would make one more acquisition which would drive the stock down and cripple its financials.

At the same time, non-bank financial companies( “shadow bankers”) entered the government-blessed subprime lending business. None earned more media ink in the financial press than did Countrywide Financial. It’s founder Angelo Mozilo became the public face of the company, and he came from humble roots as his father had been a butcher. In the runup to financial crisis, Countrywide’s founder would be forced to do lots of fast talking to keep his company afloat.

When politicians announced that American home ownership rates were too low, that could only mean consumers unfamiliar with debt instruments would have to take on mortgages, on terms which they could not understand. In 1977, Congress passed Community Reinvestment Act (CRA) which merely said that commercial banks should look to underwrite more mortgages within their communities. Soon, the political interpretation shifted, to suggest that banks look for borrowers who might have lower FICO stores and make them home owners. Commercial banks would now receive scores which represented how well they were responding to this expanded mandate. These scores were discussed in public and poor scores could mean activists would testify against big executive compensation packages for companies judged as not being serious about helping subprime buyers obtain mortgages.

The Association of Community Organizations for Reform Now (“ACORN”) became the leading non-profit judge and jury for or against giant commercial banks. ACORN went from a sleepy non-profit to a multi-billion realty services business, by using the CRA to bludgeon commercial and investment banks which weren’t moving fast enough to increase mortgage loans. Acorn volunteered to be a facilitator in return for commissions, and neither financial nor securities regulators raised an eyebrow at this clearly shady setup.

Over time, ACORN reorganized itself into a network of similar activist organizations which, instead of railing against rapacious capitalist usurers, decided to charge money for services. Another such organization was the Neighborhood Assistance Corporation of America (“NACA”) ACORN routinely testified in favor of Bank of America’s mergers, such as when it was acquiring Fleet Bank. Calomiris and Haber cite an ACORN executive testifying, “Since 1991, we have done over 30,000 mortgages with Bank of America, and these mortgages are worth over $3 billion.”

Securitization Engine Fueled Growth, Until the Bids Dried Up

Wall Street and investment banks reacted with great gusto by creating a new model of “originating, packaging, and distributing” mortgage backed securities³ to institutional customers who were looking for alternative investment assets beyond stocks and bonds. An issue of MBS would be sliced into tranches. The senior tranches would offer lower rates for a package of lower risk loans. At the other end of the offering would be the junior tranche of higher risk mortgages, which carried compensatory higher rates. Credit ratings were issued for each tranche by rating agencies like Moody’s and S&P. AAA rated tranches abounded.

Even the smartest trading and distressed asset bond desks in places like Lehman Brothers didn’t have the kind of high resolution visibility into the individual mortgages of the hundreds within each tranche.

But, the odds favored the performance of the tranches being lower than the high ratings. One key reason is the origination mechanism. A commercial bank would employ and have control over salespeople, lenders and originators; terms and conditions were not amenable to customization. In the mortgage crisis, those originating the loans were contractors, using teaser rates, with huge rate resets, and fees. The contractors who were royally paid, under no supervision, free of personal liability, and government regulation. This is described below. Aside from Lehman’s research and that of a few independent analysts, Wall Street, the rating agencies and arms of federal financial regulation and supervision were asleep at the wheel.

The Lehman Brothers Bankruptcy

Lehman Brothers was a 150 year-old premier Wall Street investment bank, known for its high quality equity research, trading, and investment banking for high quality corporations in America and Europe.⁴

Under CEO Richard Fuld, the company culture turned to one of “thinking risk” in all their business lines. Larry McDonald ran a joint venture between the firm’s equity and fixed income lines, in which he was a distressed asset trader. He soon realized how dysfunctional Lehman was internally, and he knew it was rotten at the head, CEO “King Richard” Fuld. The firm was undercapitalized because of the incredibly high volumes of mortgage originations and securitizations. If regulators saw this in SEC filings, the firm could be out of business. So the firm raised $10 billion in permanent capital, How? McDonald says that Lehman executed “Repo 101,” where enough low quality assets were shipped offshore to Cayman Island factors,so that the falsified financial statements published showed adequate capitalization for the $10 billion raise. Soon afterwards, the distressed assets came back on the Lehman balance sheet. Lehman auditors and the SEC should have routinely confronted the company for presenting bogus financial statements and for fraud. They too were out to lunch.

In the runup to 2008, McDonald tells of Lehman and others hiring “weightlifters” who preyed on elderly consumers in Arizona and California parking lots prodding them to buy homes or refinance their mortgages with little or no collateral. These agreements had names like “Liar Loans,” or “NINJAs” No income, no job,no assets. The weight lifter originators were paid in cash monthly on the basis ony of signed agreements. The loans were quickly securitized and offloaded from the balance sheet. The MBS tranches were underperforming as soon at they went out the door. As these were sold investors could never know how quickly delinquencies and defaults were rising. But Lehman Brothers knew because the securities were quoted deep underwater on traders’ Bloomberg screens. There were no bids on this merchandise: the markets were frozen.

At this point, the Federal Reserve, the Treasury, the SEC, Comptroller of the Currency, and the surviving public audit firms should have been on high alert. On September 15th, 2008 Lehman Brothers filed the biggest bankruptcy in U.S. history, ten times bigger than Enron and the other top three filings combined.

When senior officers of Lehman’s bankruptcy team approached the Fed about $6 trillion of Collateralized Debt Obligations (CDOs) which were in Lehman’s hands but had not reached the settlement date, the Federal Reserve told them, “We have this under control.” Nothing of the kind. The Federal Reserve Chair and his supporting apparatus were spectators. Treasury Secretary Hank Paulson, former Chairman of Goldman Sachs, was deciding which actors would be bailed out, e.g. Bear Stearns hedge funds, which would be left alone like AIG. By contrast, Lehman would bite the bullet.

Among homeowners who took on too much mortgage debt, relatively affluent buyers gamed the crisis, and lower income, naive buyers cleaned out anything valuable out of their delinquent homes, from carpeting to copper plumbing and fled town after leaving the keys. Debt holders of Fannie Mae and Freddie Mac probably had recoveries, but shareholders got wiped out.

This is not a sober, transparent and even-handed way of keeping our financial markets as efficient platforms for pricing and conducting trades. What the Fed and Treasury did was to cook up a rescue stew of facilities to dispense cash, belonging to taxpayers, present and future.

A Short Bailout Scorecard

I rely on some good economic literature on these issues.⁵

The Troubled Asset Relief Program (TARP), which originated in 2008. The Treasury was authorized to purchase or insure “up to $700 billion of troubled assets in order to bring stability to the financial system.” Within two months, $248 billion was disbursed. Suggestions are that there were offsetting issues of warrants and values of preferred stock received. Preferred stock purchases are referred to in relation to bailing out General Motors Acceptance Corporation, and Chrysler.

Post-crisis, the Federal Housing Authority “remains to this day, the country’s largest subprime lender.” “The costs (of the FHA bailout) were among the largest associated with the crisis.” The FHA was, in my opinion, an irresponsible financial steward during this crisis for guaranteeing $300 billion in new 30 year fixed-rate mortgages for subprime borrowers, for letting Treasury absorb large losses on FHA mortgages that had been insured at below-market rates, and for guaranteeing large volumes of risky mortgages at “highly subsidized rates during the crisis period.”

Fannie Mae and Freddie Mac, the two largest GSEs, became wards of the Federal government, and remain so today.

As traders in major houses were waiting to get bids on their formerly AAA-rated mortgage tranches, which were now unrated, there were no bidders and the commercial paper market was also frozen. It appears that Chinese investors may have supplied liquidity and made money during our great financial crisis.

Could something like this happen again? Having Sarbanes-Oxley in place hasn’t mattered and won’t for the future. The Fed’s balance sheet is again bloated. There was an across the board failure of professional integrity and ethics across audit firms, security regulators, rating agencies, brokerage company analysts, and firms which marketed MBS and the like. One hopes that this across the board failure might be less likely in the future.

High Return Move: Reform the Federal Reserve

The Fed has missed the boat on inflation, and its pronouncements were wildly off the mark. When inflation rates rose, the Fed dismissed them as “transitory.” They weren’t. The dependence the the DSGE (Dynamic Stochastic General Equilibrium models should be abandoned: they have yielded almost nothing of forward looking value, and gives policy makers a false sense of comfort. Kevin Warsh refers to the silliness of being “data dependent” to the third decimal.

The Fed never talks about the monetary aggregates, but they do matter. Monetary policy must be about money in some way or fashion. The old saw about “too much money chasing to few goods” is still worth putting into the mental model library, as Charlie Munger might say.

The discussion of the great mortgage crisis in this post, pointed out two needed adjustments. The line between the Fed and the Treasury in the mortgage crisis was crossed several times in designing and implementing the post-crisis programs. The Fed needs to stick to its remit. The Treasury serves the legislative and executive branches, and its remit lies there.

When Fed forecasters were trying to predict the rebuilding of post-CoVid supply chains, their conclusions shed no light. Sending people out to understand what had happened to the supply of shipping containers on one end, and then look at how ready U.S. ports were to offload a surge of shipments. would have yielded actionable insights. Lehman Brothers fixed income desks sent people out to count, watch, and observe in person the wild men who were signing up new mortgage victims by the thousands: they knew what would be coming.

When central banks talk about the future resource allocations of, say, the U.S. or U.K. for example, they are on shaky ground. Mervyn King of the Bank of England (SUERF Note No, 263) worries about the inadequate resources (labor and capital) provided for future climate change mitigation. Kevin Warsh cautions about our Fed taking positions on climate change not being an appropriate field for an independent central bank. Further for the Fed, which has that poorly formulated goal of “maximum employment,” which has now morphed into employment goals for specific groups. The Fed needs to exit these types of social missions, which are inappropriate intrusions on its core mission.

"…the revealed preference of the body politic is a deep distaste for inflation—and also, for bailouts and power grabs.” Kevin Warsh.

The Fed now has a balance sheet of $7 trillion, an order of magnitude more than the day on which Mr. Warsh joined the Fed. From his early days as a Governor of the Federal Reserve System, he helped innovate and backed QE during the 2008 crisis. QE2 was an unnecessary use of that slippery tool, and in this case Kevin Warsh voted against it and resigned. I agree, and I think he would be a fine replacement when Jerome Powell ends his term.

Postscript

For loyal readers who have come this far, here is a nugget on BofA. In January 2008, BofA bid $4 billion in stock for the assets of Countrywide Financial. Their quants, actuaries, and other experts thought they had a bargain, and with an inevitable economic snapback, they would make a quick buck. Instead, their share price declined by 90%, and the wounds to the balance sheet continued to bleed.

1. See Phil Gramm and Mike Solon, “The Clinton-era Roots of the Financial Crisis,” The Wall Street Journal, August 12, 2013.

2. Calomiris, Charles and Haber, Stephen, “Fragile by Design: The Political Origins of Financial Financial Crises and Scare Credit,” (Princeton University Press, 2014) See also, “The Housing Crisis: What’s the Fed’s Excuse?” by the same authors in the WSJ online edition, accessed 2/6/2014 @ 1:32 pm EST

3. I use MBS as a shorthand because they were a well known product, but eventually there was an alphabet soup of products, like CDOs and the rest.

4. I highly recommend reading “A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers,” Lawrence McDonald & Patrick Robinson (New York: Random House, 2012) It is both educational and great storytelling.

5. See Lucas, Deborah and Robert McDonald (2006), “Evaluating the Cost of Government Credit Support,” The OECD Context,” Economic Policy, Vol 29:79, pp. 553-597 (2014)

Frame, W.Scott, Andreas Fuster, Joseph Tracy and James Vickery (2015), “The Rescue of Fannie Mae and Freddie Mac,” Journal of Economic Perspectives, vol 29:2, pp. 29-52, =

Deborah Lucas is Professor of Finance at MIT’s Golub for Finance and Policy. Much of what I write is taken from her May 2017 paper, where I don’t have the title page.