The Government, The FED, and the current recession

Let me start with a little bit of history:

“Remarks by Governor Ben S. Bernanke
At the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois November 8, 2002″

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

He was wrong, they did it again several times but the current recession is by far the worst. Milton and Anna Friedman had said for years that the FRB caused the Great Depression. Bernanke was admitting it and apologizing. I’m going to have to skip over the Community Reinvestment Act (CRA), the amendment to it, Fannie Mae and Freddy Mac, the House committee on Federal Enterprise Housing (Barny Frank & Maxine Waters), and Chris Dodd and get to late 2007 – November, I think.

At any rate, it was a month before the market crashed late in 2007. The FED did two things: they raised the reserve requirement to 8% and changed to “mark to market” accounting. The change in the reserve rate froze up credit immediately as lenders scrambled for cash to bring their reserves up for the credit they already had out. The M2M caused AIG to lose tens of billions of dollars as they revalued the mortgage assets they were holding. On October 7th, 2008 Robert B. Willumstad in a statement to the House Committee on Oversight and Government Reform said:

However, when the market for the underlying bonds froze toward the end of 2007, accounting rules required AIG to “mark to market” the value of its swaps. But the market was not functioning. The way the accounting rules were applied in this unprecedented situation forced AIG to recognize tens of billions of dollars in accounting losses in the fourth quarter of 2007 and the first two quarters of 2008, even though, as far as I am aware, AIG has made very few payments on any of the credit default swaps it wrote and the vast majority of the securities underlying the swaps are still paying and are still rated investment grade or better by the rating agencies.

In my view it was largely as a result of these unrealized mark to market losses that the rating agencies downgraded AIG’s credit rating. The downgrade and the low accounting valuations on the bonds required AIG to post billions of dollars of additional collateral to its credit default swap counterparties as security for AIG’s promise to pay if the underlying securities did not. In the unprecedented market wide crisis of the week of September 8, fears of a further downgrade and the frozen credit markets fed into the crisis of confidence that led AIG to need the liquidity ultimately provided by the Federal Reserve plan.

I think that’s enough to show that the FED pulled the trigger that caused the crash to happen when it did. Congress contributed to the crash, though. In 1999 they passed the Gramm/Leach/Bliley Act which gutted the Glass/Steagall Act and allowed banks to to mix with investment firms. The uptick rule was rescinded and the stage was set for an economic collapse when the FED pulled the trigger.

The Financial Crisis Inquiry Commission released its report dated January 2011 available here as a 662 page PDF file. In “Conclusions of the Financial Crisis Inquiry Commission” on page xvi it says:

In this report, we detail the events of the crisis. But a simple summary, as we see it, is useful at the outset. While the vulnerabilities that created the potential for crisis were years in the making, it was the collapse of the housing bubble—fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages— that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008. Trillions of dollars in risky mortgages had become embedded throughout the financial system, as mortgage-related securities were packaged, repackaged, and sold to investors around the world. When the bubble burst, hundreds of billions of dollars in losses in mortgages and mortgage-related securities shook markets as well as financial institutions that had significant exposures to those mortgages and had borrowed heavily against them. This happened not just in the United States but around the world. The losses were magnified by derivatives such as synthetic securities.

The crisis reached seismic proportions in September 2008 with the failure of Lehman Brothers and the impending collapse of the insurance giant American International Group (AIG). Panic fanned by a lack of transparency of the balance sheets of major financial institutions, coupled with a tangle of interconnections among institutions perceived to be “too big to fail,” caused the credit markets to seize up. Trading ground to a halt. The stock market plummeted. The economy plunged into a deep recession.

That’s just the tip of the iceberg. Like I said, it has 662 pages.