Don't we need to fix the Fed?

I somehow missed this April op-ed piece in which hedge fund manager Michael Burry — who made a fortune betting against subprime mortgages and was even astute enough not to place his bets with Bear Stearns or Lehman Brothers — asked “I Saw the Crisis Coming. Why Didn’t the Fed?”.

Burry claims he wasn’t reading tea leaves… he was blinded by gaudy neon signs flashing “DANGER, DANGER!”:

I had begun to worry about the housing market back in 2003, when lenders first resurrected interest-only mortgages, loosening their credit standards to generate a greater volume of loans. Throughout 2004, I had watched as these mortgages were offered to more and more subprime borrowers — those with the weakest credit. The lenders generally then sold these risky loans to Wall Street to be packaged into mortgage-backed securities, thus passing along most of the risk. Increasingly, lenders concerned themselves more with the quantity of mortgages they sold than with their quality.

Meanwhile, home buyers, convinced by recent history that real estate prices would always rise, readily signed onto whatever mortgage would get them the biggest house. The incentive for fraud was great: the F.B.I. reported that its mortgage fraud caseload increased fivefold from 2001 to 2004.

At the same time, I also watched how ratings agencies vouched for subprime mortgage-backed securities. To me, these agencies seemed not to be paying much attention.

So he was shocked that the most powerful financial institution in America, and perhaps the world, was completely blindsided:

I have often wondered why nobody in Washington showed any interest in hearing exactly how I arrived at my conclusions that the housing bubble would burst when it did and that it could cripple the big financial institutions. A week ago I learned the answer when Al Hunt of Bloomberg Television, who had read Michael Lewis’s book, “The Big Short,” which includes the story of my predictions, asked Mr. Greenspan directly. The former Fed chairman responded that my insights had been a “statistical illusion.” Perhaps, he suggested, I was just a supremely lucky flipper of coins.

Mr. Greenspan said that he sat through innumerable meetings at the Fed with crack economists, and not one of them warned of the problems that were to come. By Mr. Greenspan’s logic, anyone who might have foreseen the housing bubble would have been invited into the ivory tower, so if all those who were there did not hear it, then no one could have said it.

Burry is incredulous that Greenspan in 2004 encouraged — and in 2005 praised — a move away from 30-year-fixed mortgages in which “lenders made interest-only adjustable-rate mortgages readily available to subprime borrowers. And within 18 months lenders offered subprime borrowers so-called pay-option adjustable-rate mortgages, which allowed borrowers to make partial monthly payments and have the remainder added to the loan balance.”

It’s a shocking indictment of the Federal Reserve, akin to — but far more consequential than — the SEC receiving repeated detailed explanations of Bernie Madoff’s Ponzi scheme and failing to investigate.

I wonder whether the Fed’s problem is incompetence or industry capture. The Fed serves the interests of the largest U.S. banks. And bankers didn’t want their profit streams interfered with, even though the “profits” they were “earning” were illusory and would eventually produce massive losses (for taxpayers, since bankers succeeded in socializing their immense losses).

If Greenspan’s correct, the entire Fed failed to see the housing bubble. Has anything changed over the past few years to make us more confident in the Fed’s ability to protect us against, say, massive derivative contract losses?

Posted by James on Wednesday, June 09, 2010