US Fed missed warning signs in 2007 as crisis gathered steam

Even as crisis signals started flashing red with the freezing of credit markets during the summer, Fed officials believed the troubles would be moderate and short-lived, according to transcripts of the 2007 meetings released on Friday with a customary five-year lag.

U.S. Treasury Secretary Timothy Geithner, then president of the New York Federal Reserve Bank, said during an emergency telephone call on Aug. 10 of that year that most of Wall Street was still doing fine.

“We have no indication that the major, more diversified institutions are facing any funding pressure,” Geithner said. “In fact, some of them report what we classically see in a context like this, which is that money is flowing to them.”

Similarly, Fed Chairman Ben Bernanke underestimated the risks of a looming financial blow-up.

“I do not expect insolvency or near insolvency among major financial institutions,” he said in December 2007.

By then, the Fed had already launched emergency liquidity measures and begun cutting interest rates, which by December of 2008 would be brought all the way down to effectively zero.

William Dudley, who replaced Geithner as head of the New York Fed, but at the time headed its market operations desk, cited Washington Mutual and Countrywide — two firms that eventually collapsed — as trouble spots during the August phone call.

After the call, in an effort to calm financial markets, the Fed announced it was prepared to provide liquidity, marking the start of the Fed's crisis response.

Earlier in 2007, the Fed had been sailing head on into the financial crisis apparently unaware of what was about to happen.

The year started off with officials citing inflation risks that led the Fed's policy committee to maintain a bias for tighter monetary conditions — a signal they were more likely to raise interest rates than lower them — as late as August when the crisis began to emerge.

By May, housing and growing stress in the subprime mortgage market had emerged as the economy's biggest threat.

While policymakers were split on whether home prices would ultimately stabilize or decline, the general mood was that it would pull through without much pain.

“Housing remains weak, and it is the greatest source of downside risk. Whether the demand for housing has stabilized remains difficult to judge, in part because of subprime issues,” Bernanke said.

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