Even as late as August 2007, members of the Federal Reserve Open Market Committee were not convinced that we were headed into a period of severe economic and financial distress.
Spreads were blowing out for Countrywide derivatives. Those two Bear Stearns hedge funds were blowing up. The subprime market was dead. Ratings agencies were downgrading every CDO they could remember having rated. Corporate credit spreads, especially high yield and bank loans, were moving out sharply. Stocks were falling.
But there was still a good deal of doubt about whether this was a sign of impending collapse or just a mild rise in "downside risks to growth." The alarm bells weren't quite ringing, according to the transcript of the meeting that began August 7, 2007.
One of the things that seemed to placate Fed officials was the continued availability of liquidity for much of the market. Credit had not yet, well, crunched. What's more, recent experience seemed to imply that this might be a momentary hiccup, much like what the FOMC members had seen in December of 2010 and February of 2011.
But the newest member of the committee Eric Rosengren, the new President of the Federal Reserve Bank of Boston, was not as jaded. And his first words about prevailing financial conditions now seem high prescient.
From the transcript (emphasis added):
MR. ROSENGREN. The credit derivative swaps for Countrywide and some of the other mortgage providers spiked up very appreciably at the end of last week, and they were accompanied by announcements that the companies were having no trouble rolling over their financing. Some of the Boston hedge fund managers have observed that one dependable correlation has been that the announcement of no problem seems to be highly correlated with the actual problem's occurring with a lag of one to two weeks. [Laughter] I am curious whether you are worried about the possibility that Countrywide and some of the largest mortgage lenders might have difficulty in the next two weeks rolling over financing, which would obviously have a broader impact.
In light of what we saw in 2008, those Boston hedge fund managers really understood what was going to happen.
By the way, this was the answer to Rosengren's question.
MR. DUDLEY. They certainly could. Their problem is that they have a very large mortgage finance subsidiary and a small thrift. If the mortgage finance subsidiary were in the thrift, then there would be other ways of financing all their assets. So far they are able to maintain their liquidity. But a lot of this is about perception, and that could change at any time. The good news about Countrywide is that people view them as having a strong franchise. They also have a very large loan-servicing portfolio, which might actually be worth a bit more because the duration of those mortgages is extending. They are not just a mortgage originator whose business has evaporated; they also have other parts of their business, which I think people view as potentially quite valuable.
The Fed's open market committee voted to leave rates unchanged at the end of the meeting.
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