A Look Inside the Fed on Verge of Crisis

So what was on the mind of central bankers as the U.S. housing bubble popped and the financial crisis began to unfold in 2007?

The Federal Reserve Friday released the transcripts of its main policy committee meetings from 2007, following a policy it adopted recently of releasing these materials with a five-year delay.

Next year we'll get the 2008 minutes,which will show the discussions and debates of the Federal Open Market Committee at the height of the crisis.

All told the transcripts and materials amount to thousands of pages. But they will offer important insights into how well monetary policy makers anticipated the coming crisis and responded to it.

Many key players of the coming crisis show up. Ben Bernanke was chairman of the Federal Reserve and the FOMC. Tim Geithner, then president of the New York Fed, was vice chair of the committee.

The transcript of the very first meeting of 2007 shows that Fed officials were aware of a potential disaster looming in the housing market.

William Dudley, the former Goldman Sachs economist who took over the New York Fed when Geithner became Treasury Secretary, was then the new head of the N.Y. Fed's unit that buys and sells government securities. In his opening remarks, he warned that the subprime market "seemed particularly vulnerable."

If credit spreads in the securitized market spike because loan performance is poor, a sharp downturn in lending could result as the capital market for securitized subprime mortgage products closes. This constriction of credit could put downward pressure on prices and lead to more credit problems among borrowers. The result would be additional credit quality problems, wider credit spreads,and a further contraction of credit.

Perhaps unfortunately, Dudley's next words were: "Fortunately, to date the news is still fairly favorable."

Later in the meeting, Geithner questions whether a vulnerable subprime market is a serious problem.

Bill, could you or Dave remind us what share of the total outstanding stock of mortgages consists of subprimes or what share of the housing stock do we think is financed at the subprime level? My recollection is that the share is still small even though it has been a large part of the recent flows.

The answer at the time was that subprime accounted for just 13 percent of outstanding mortgages, although it was nearly a quarter of new mortgages. This way of looking at the market helped some policy makers underestimate the ultimate impact of the mortgage meltdown and fail to anticipate the financial crisis that would follow.

Indeed, when members of the the FOMC discuss mortgages in that meeting, it's clear that they don't see the coming calamity.

Minneapolis Fed President Gary Stern, for example, predicted that the biggest impact from mortgage delinquencies would be political rather than economic.

"In any event, as Bill Dudley mentioned, mortgage delinquencies and foreclosures are rising, albeit starting from a fairly low level, and though that probably won't have a significant effect on economic performance, it could be a political issue in Minnesota and elsewhere in the District," Stern says at the January meeting.

The transcript of the first meeting along with the accompanying materials run to 255 pages. There is likely to be a lot for the public to discover in these documents.

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