Geithner’s View from the Top of the Bubble
Thursday, September 6, 2012
On February 28, 2006, Timothy Geithner— then president of the Federal Reserve Bank of New York and now secretary of the Treasury—addressed the topic of risk management in the U.S. financial system, in a speech to the Global Association of Risk Professionals in New York. It was a few months before the very top of the massive housing bubble. How did things seem when viewed from the top?
“We are now in the midst of another wave of innovation in finance,” he observed. “These developments provide substantial benefits to the financial system. Financial institutions are able to measure and manage risk much more effectively.”
“These changes,” he continued, “have contributed to a substantial improvement in the financial strength of the core financial intermediaries and in the overall flexibility and resilience of the financial system in the United States. And these improvements in the stability of the system … have probably contributed to the acceleration in productivity growth in the United States and in the increased stability in growth outcomes.”
These statements, so ironic in retrospect, seemed plausible at the time, though they reflected an obliviousness to the looming disaster.
Still, the speech was not merely optimistic, but also complex. “These generally favorable judgments require some qualification, however,” Geithner pointed out. “These changes … have not eliminated risk. They have not ended the tendency of markets to occasional periods of mania and panic.”
This is so right, but does not mention that the markets were, at that very moment, at the height of an immense credit mania.
‘We still face considerable uncertainty about how market liquidity will behave in the context of a major deterioration in credit conditions or a sharp increase in volatility.’
Geithner offered this sensible and sophisticated analysis: “In a context of very low realized credit losses, low expectations of future default risk, a high degree of confidence in the financial strength of the major banks and investment banks … we know less about how these markets will function in conditions of stress.” Thus: “The most sophisticated tools available for measuring potential losses have less to offer than they will with the benefit of experience with adversity.” And: “We still face considerable uncertainty about how market liquidity will behave in the context of a major deterioration in credit conditions or a sharp increase in volatility … and this uncertainty is hard to quantify and therefore hard to integrate into the risk management process.”
All this was very true and vividly demonstrated by subsequent events. Yet at the time, financial history provided plenty of experience with adversity and scores of examples of how markets function—or cease to function—in conditions of extreme stress with major deterioration in credit conditions. Among the sharp lessons of history is that these conditions produce discontinuous financial behavior and are therefore very hard indeed to quantify or integrate into bureaucratic processes.
“The frontier of challenges in the risk management process lies principally in the discipline of stress testing and scenario analysis to capture potential losses in adverse conditions in the ‘tail’ of the distribution,” said Geithner. “This has been and will continue to be a principal focus of our supervisory efforts.”
It hardly needs to be said that these efforts utterly failed.
Overall, this speech at the top of the bubble was a careful, informed, balanced, and intelligent discussion of risk management, which nonetheless entirely missed the main point about the extreme risk of the time. While recognizing the inevitability of manias and panics, it had not a word about house prices, overconcentration in real estate risk, or the hyper-leveraging of mortgage credit which was then ubiquitous.
“Risk is the price you never thought you would have to pay,” an old banker told me long ago. How right he was. Geithner’s view from the top of the bubble shows how difficult it is even for extremely intelligent and very well-informed experts to anticipate how big that price is going to be.
Alex J. Pollock is a resident fellow at the American Enterprise Institute.
FURTHER READING: Pollock also writes “Who Knew When about the LIBOR Problems?,” “The Pension Benefit Guaranty Corporation: Who Will Guarantee This Guarantor?,” “Who Will Guarantee This Guarantor? Part Two,” and “North America: Living in the Political Wake of the U.S. Housing Bubble.” Edward Pinto discusses “Government Housing Policy: The Sine Qua Non of the Financial Crisis.” Joseph Gyourko outlines “The Government’s Overleveraged Housing Bet.” Peter J. Wallison says “Tim Geithner Remains Stuck in 2008.”
Image by Darren Wamboldt / Bergman Group