When Janet Yellen became president of the Federal Reserve Bank of San Francisco in June 2004, a massive real estate bubble was building in the vast nine-state area that it oversees.
Her staff alerted her that banks were overinvesting in speculative commercial real estate at a time when housing prices in the region were ballooning. But as chief regulator in the Federal Reserve’s largest district, Yellen conveyed two starkly different messages.
In public remarks across the Western region’s nine states, she downplayed risks that were building in the financial sector, reporting positive economic signs even as warning signals began to emerge.
Behind the scenes at the Fed, she contends that she and her staff were "pleading with Washington" to issue supervisory guidance that would enable bank examiners to take a tougher line on risky real estate lending.
Yellen, who was nominated earlier in October to be the next chair of the U.S. central bank, played a little-examined role at the Fed in expressing unease about what she dubbed the "600-pound gorilla" – her reference at a Fed meeting in June 2007 to the real estate bubble and signs it could turn into a bust. When the bust came it led directly to the financial crisis.
The difference between her public remarks and internal Fed role could draw scrutiny when the Senate Banking Committee holds a hearing on her nomination in mid-November.
Yellen declined to comment for this article when contacted through the Fed.
She certainly had a front row seat on the real estate bubble. Yellen’s region included three of the four states hardest hit by foreclosures – Nevada, Arizona and California. The same states also led the nation in the percentage of consumer bankruptcies.
Eight banks supervised by her team failed, the second-highest number among the Fed’s 12 regional banks. A big culprit was unchecked investments in real estate, including speculative land development loans.
But Yellen confronted the limits of quietly leaning on Washington for corrective action. As she later told a panel probing the roots of the crisis, she felt one Fed action – an advisory opinion in 2007 that asked banks to control commercial real estate lending – was worthless. One could "rip it up and throw it in the garbage can," she said. "It wasn’t a tool that was of any use to us in controlling this risk."
Yellen, 67, has been credited with seeing signs of the crisis before many other Fed officials. When she landed the regional Fed job after teaching at the University of California, Berkeley, housing prices were climbing to alarming levels.
In Los Angeles and San Diego, home prices more than doubled between the beginning of 2000 and when Yellen took on the job in the summer of 2004, according to Standard & Poor’s/Case-Shiller index data. In Las Vegas, they jumped 50 percent in the previous year alone. And in San Francisco, prices had risen nearly 40 percent since the dot-com crash of 2000-2001.
The 54 banks under the San Francisco Fed’s supervision were leveraging too much of their capital in real estate, Yellen later observed.
The San Francisco Fed kept thick case files on the banks it supervised; she described reviewing a grocery cart full of records when she first came on the job. But regulatory policy was set by the central bank’s board in Washington, and the role of the regional Fed banks was to enforce it.
Yellen later told the financial crisis panel that in dealing with the Fed’s board, she privately urged clear guidance. "As worried as we were, we never simply went into banks and said, ‘We insist you’ve got to have a higher capital requirement.’ Did we have the power to do that? I think we felt we did not," she told the commission.
Stephen Hoffman, the officer in charge of bank supervision at the San Francisco Fed during Yellen’s tenure and now a managing director at consulting firm Promontory Financial Group, corroborated Yellen’s account.
"Was she going in and pounding on the table somewhere? No. But she was clearly making people aware that things were building and that there was a risk there, that if things went wrong there could have been significant challenges," he said.
The Fed did not issue an advisory to banks about commercial loans until January 2007 and it stopped short of a full-fledged order.
By then, recalled Bruce Norris, president of California real estate investment firm The Norris Group, some experts were questioning if regulators were asleep on the job. "Yellen had a lot of company," he told Reuters. "I just could never figure out why they weren’t more concerned until it was too late."
If a crisis was looming, Yellen gave little hint of it as she traveled around her district speaking to banking and business groups. She reassured audiences that there were nuanced but optimistic signs even as recession closed in.
In 2004, the new president told risk managers in San Francisco that closer supervision had "made our financial system far more resilient to shocks." In Phoenix that year, she reported "more positive signs in the economy." She flagged real estate as a concern in March 2005, telling a banking group in Hawaii that her staff was examining commercial lending and was concerned about the "easing of credit standards and terms on loans" for home mortgages.
But Yellen ended optimistically, concluding that "we don’t think widespread problems are likely" and that "industry conditions in many respects are stronger now than they’ve ever been."
By October 2005, real estate experts debated whether the Fed needed to intervene to control the surging "bubble" in home prices by raising interest rates.
Yellen said her staff had begun to realize by then that "there might well be a bubble." But as she concluded in an October 2005 speech, "the arguments against trying to deflate a bubble outweigh those in favor of it."
"My bottom line is that monetary policy should react to rising prices for houses or other assets only insofar as they affect the central bank’s goal variables – output, employment, and inflation," she said.
Yellen’s views have not changed dramatically. Earlier this year, she expressed a "strong preference" to use regulation as the main defense against bubbles. But she no longer unequivocally rules out the use of monetary policy.
U.S. home prices peaked in July 2006. In California, the median price of a previously owned home reached $556,430 in 2006, about nine times the annual median income; the national median price was just $221,900, or about four times median income.
Yellen, however, still saw cause for optimism.
In March 2006, she spoke via satellite to Australian economists and noted that "overall the economy has shown considerable resilience."
At that point, the economy was buoyant. After a hit from Hurricane Katrina in late 2005, growth spiked to a 4.9 percent annual rate in the first quarter, though it slipped back to 1.3 percent over the next three months. The unemployment rate in March stood at a low 4.7 percent, with muted price pressures.
Yellen emphasized that a housing boom reversal "could have a very restrictive impact." But she concluded optimistically: "While we face a great deal of uncertainty, the economy appears to be approaching a highly desirable glide path."
A month later, Yellen noted that Bay area home prices were six times higher than they were in 1982. She urged monitoring of what she termed "highlights and shadows" in forecasts.
In a 2006 speech to bankers in California’s agricultural belt, she encouraged banks to reach out to immigrants and other underserved populations, touting programs like one that encouraged home ownership for low-income families. A few years later, the farming area would be particularly hard hit by mortgage foreclosures.
But it wasn’t until early 2007 that the national housing market began crashing. That March, prices and sales recorded their steepest drops since the savings and loan scandal in 1989.
Mark Zandi, chief economist of Moody’s Analytics, later pinpointed the beginning of California’s recession as May 2007. The entire nation would tip into recession in December that year.
Home price declines were not the only warning signs.
In February 2007, HSBC Group, one of the world’s largest banks, said it would book a bad debt charge of $10.6 billion because of a big spike in delinquencies on subprime loans. Four months later, two hedge funds operated by Bear Stearns warned of major losses, and both collapsed within weeks.
When France’s largest bank, BNP-Paribas, froze assets on three funds with big exposure to the U.S. mortgage market in August 2007, global central bankers realized markets were at risk of freezing up.
But when the Fed’s monetary policy panel met in June 2007, officials generally felt the economy was weathering the storm despite Yellen’s concerns about housing. "In terms of risks to the outlook for growth, I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector," she said, according to the transcript of that meeting, adding: "The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst."
At the time, Fed Chairman Ben Bernanke was playing down the systemic risk of weakening real estate prices. Worried about inflation risks, Fed officials stood pat at the meeting, unanimously voting to hold interest rates steady, and they did the same at the August 7 meeting. Yellen was a non-voting participant at the two meetings.
Within three days, however, as the BNP-Paribas events roiled financial markets, officials held an emergency conference call to discuss strains building in credit markets and announced they were ready to provide liquidity to banks.
At their next scheduled meeting in September, they slashed overnight rates by a steep half of a percentage point, the first move in a dramatic series that took them to near zero by the end of 2008. In an October 2008 speech, Yellen tackled head-on the question of how the Fed missed the warning signs. She described a miscalculation in the interplay of "key features of the financial system."
Under questioning by Republicans in 2010, after Obama nominated her to be Fed vice chair, Yellen said she and other regulators failed to "connect the dots" between loose lending practices and a overpriced housing market.
Senator Richard Shelby of Alabama asked about her region’s "breakdown of regulatory oversight."
When Yellen at first defended the San Francisco Fed’s supervision as "careful and appropriate," Shelby shot back, calling it "lax and inappropriate."
She ended by citing lessons learned. "What we have learned in hindsight is it was very hard for all of the regulators involved to take away the punch bowl in a timely way."
With additional reporting by Jonathan Spicer of Reuters.