Bernanke: Housing was trigger of crisis, not cause

WASHINGTON (MarketWatch) � Subprime mortgages and the housing bubble were the trigger while high leverage, unstable funding and deficient risk management and supervision were the vulnerabilities that led to the financial crisis, Federal Reserve Chairman Ben Bernanke said Friday.

Bernanke, speaking in New York at a conference about perspectives of the crisis, didn�t address monetary policy, either from a historic or current perspective. He built on comments he made to the Financial Crisis Inquiry Commission nearly two years ago. Read MarketWatch's coverage of Bernanke's FCIC testimony.

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The central bank chief on Friday explained why subprime mortgages helped trigger a crisis despite their relatively small volumes. Bernanke famously told Congress that the subprime crisis was �well-contained.� Read Bernanke's outlook on economy before Great Recession.

�Judged in relation to the size of global financial markets, aggregate exposures to subprime mortgages were quite modest,� Bernanke told the conference presented by the Russell Sage Foundation and The Century Foundation.

�By way of comparison, it is not especially uncommon for one day�s paper losses in global stock markets to exceed the losses on subprime mortgages suffered during the entire crisis, without obvious ill effect on market functioning or on the economy. Thus, losses on subprime mortgages can plausibly account for the massive reaction seen during the crisis only insofar as they interacted with other factors � more fundamental vulnerabilities � that served to amplify their effects.�

Even the nation�s housing bust wasn�t mostly to blame, Bernanke said, because much of the decline has occurred since the most intense phase of the crisis.

The vulnerabilities, Bernanke said, laid with the so-called shadow banking system. The use of short-term wholesale funding and excessive leverage wasn�t checked by either the firms themselves or regulators.

�In the case of dot-com stocks, losses were spread relatively widely across many types of investors. In contrast, following the housing and mortgage bust, losses were felt disproportionately at key nodes of the financial system, notably highly leveraged banks, broker-dealers, and securitization vehicles,� Bernanke said. �Some of these entities were forced to engage in rapid asset sales at fire-sale prices, which undermined confidence in counterparties exposed to these assets, led to sharp withdrawals of funding, and disrupted financial intermediation, with severe consequences for the economy.�

Regulators didn�t appreciate or sufficiently respond to the buildup of risk, in part because the rules weren�t well-suited to addressing key vulnerabilities, and also because the rules that were in place weren�t used effectively.

Question of prudence

�Much shadow banking lacked meaningful prudential regulation, including various special purpose vehicles, [asset-backed commercial paper] conduits, and many nonbank mortgage-origination companies. No regulatory body restricted the leverage and liquidity policies of these entities, and few if any regulatory standards were imposed on the quality of their risk management or the prudence of their risk-taking,� Bernanke said.

Reuters Fed chief Ben Bernanke.

The Securities and Exchange Commission supervised the largest broker-dealer holding companies, but it did so only through an opt-in arrangement that lacked the force of a statutory regulatory regime, he added.

While American International Group Inc. AIG �was supervised and regulated by state and international insurance regulators as well as the now-defunct Office of Thrift Supervision, oversight of the arm that got it into trouble � AIG Financial Products � was extremely limited in practice.

Bernanke also said, in essence, that regulators focused on the trees instead of the forest. �A broader failing was that regulatory agencies and supervisory practices were focused on the safety and soundness of individual financial institutions or markets � what we now refer to as microprudential supervision,� he said.

While Bernanke gave the Fed and other central banks low marks for preventing the crisis, he effectively praised the response.

�The Federal Reserve�s responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options, given the absence of a legal framework for winding down such firms in an orderly way in the midst of a crisis � a framework that we now have,� he said.

Bernanke, asked whether his predecessor, Alan Greenspan, deserved blame for the housing crisis, said the academic literature �doesn�t put heavy weight on monetary policy� as a culprit, noting that there isn�t a good correlation between rate policy and house price moves on an international level. He said the rate impact on house payments was �trivial.�

He added the first defense against new bubbles is at the regulatory and supervisory level.