–Fannie, Freddie Played Big Role in Causing Financial Crisis
–Lacker’s Prepared Text Does Not Mention Economy, Monetary Policy
By Steven K. Beckner
FRANKFORT, Ky. (MNI) – Richmond Federal Reserve Bank President
Jeffrey Lacker said Friday that the government’s stance of “constructive
ambiguity” with regard to how much support it would give financial
institutions if they got in trouble helped lead to the financial crisis
and said this “constructive ambiguity” needs to end.
As an example, Lacker cited the role that implicit federal
guarantees for government sponsored enterprises Fannie Mae and Freddie
Mac played in incentivizing excessively risky mortgage lending and
securitization.
Lacker, in remarks prepared for the Kentucky Economic Association,
made no comments on the economy or monetary policy three days after the
Fed’s policymaking Federal Open Market Committee met and left monetary
policy unchanged. Lacker is not a voting member of the FOMC.
“The difficult dilemmas that policy makers faced in the fall of
2008 were in part the legacy of a financial safety net policy that
ultimately proved unworkable,” said Lacker. “Often referred to as
‘constructive ambiguity,’ this approach encouraged financial firms and
their creditors to behave as if they were not protected — by not
publicly acknowledging implicit support — while policymakers actually
were standing ready to act in a crisis,” he said.
“Constructive ambiguity essentially sought to obtain the ex ante
benefits of commitment without giving up the discretion to act freely ex
post,” Lacker continued. “While constructive ambiguity was never
formally adopted by name as official policy, I believe it is a fair
description of the approach to policy followed in the decades since the
Continental Illinois bailout.”
Lacker said “shifting investor beliefs about the government’s
intention to provide or limit support was a leading source of contagion
and market volatility in a number of key episodes — especially during
the weeks in September, 2008, that saw distinctly different treatments
of Lehman Brothers, American International Group Inc. (AIG), Washington
Mutual Inc., and the former Wachovia Corp.”
Lacker argued for a more certain, less discretionary climate within
which financial institutions can operate.
“The experience of the last three years should finally put an end
to the notion of constructive ambiguity as a plausible approach to
financial stability,” he said, adding, “The Dodd-Frank Wall Street
Reform and Consumer Protection Act in many ways reflects recognition of
this fact.”
“The Dodd-Frank Act presents a golden opportunity for a regime
change that leaves behind the dangers of constructive ambiguity,” he
said.
But he expressed some misgivings, observing that “the Act embodies
two contradictory approaches to resolving the time consistency dilemma.”
“On one hand, it sharply constrains and strengthens accountability
around government funded rescues of financial firms, which would tend to
limit instances of intervention,” he said. “On the other hand, it also
provides more discretionary tools to intervene to prevent the ex post
distress associated with bankruptcy, which would tend to exacerbate the
time consistency problem. Reducing financial instability will require
clarity and commitment.”
Lacker had particularly sharp criticism for the GSEs, reform of
which was not addressed by Dodd-Frank. He blamed them for spurring
excessive subprime mortgage lending.
“Financial institutions that benefitted from implicit government
guarantees — notably Fannie Mae, Freddie Mac, and several European
banking institutions — fueled the demand for securities backed by risky
subprime mortgages,” he said. “The implicit support of these
government-sponsored entities (GSEs) led them and their creditors to
underweight tail risk which in turn distorted incentives for a broad
range of participants in the distribution chain, from credit rating
agencies to originators to loan brokers.”
“The resulting oversupply of subprime mortgage lending contributed
to over-appreciation in home prices and overinvestment in new housing,”
he continued. “Maturity transformation outside of traditional deposit
banking made many financial firms vulnerable to runs when their exposure
to unanticipated mortgage-related losses was suspected.”
“Ambiguity about the extent and likelihood of safety net support
meant that declining to rescue would cause investors to pull away from
other similar financial firms,” he continued. “Policymakers faced
agonizing choices between bad precedents that would weaken market
discipline and the financial market fallout of rapidly realigning
investor expectations regarding future government support.”
** Market News International **
[TOPICS: M$U$$$,MMUFE$,MGU$$$,MFU$$$,M$$BR$]
