This interview with former Federal Reserve Vice Chair Donald Kohn is jaw dropping.  It reveals just how unfit the Fed was and still is for the purpose of responding to a financial crisis.  Specifically, it shows the Fed’s PhD Economists to be systemically incapable of recognizing opacity in the financial system and understanding how it disrupts the global financial markets.

I’ll pick up the interview where Mr. Kohn begins discussing the Great Financial Crisis.

So, it was really August of ’07 when, I guess BNP Paribas said there was so much uncertainty about subprime mortgages, they couldn’t price their funds that specialized in that. That followed in June a Bear Stearns thing in which they stepped back from one fund, but made good on another fund. So, this thing had been building all year.

He leads with an incredible observation.  BNP Paribas, one of the largest banks in the world, says their funds that specialize in investing in subprime mortgages couldn’t price the securities holding these mortgages.

Once you make this observation, isn’t the obvious follow-up question:  why could’t they price these securities?  (Regular readers know they couldn’t price these securities because they were and still are opaque.)

Mr. Kohn doesn’t tell us.  Instead, he goes on to describe what happened next. (Together, these strongly suggest nobody at the Fed bothered to ask and answer the obvious follow-up question.)

But, what started in Europe actually in this French bank quickly spread to interbank markets everywhere.  So, people realized that it was impossible really to know what the value of these subprime, particularly derivatives and tranches were. They didn’t know who was holding them, and all of a sudden the Interbank funding markets became disrupted and banks were holding back on lending to other banks in these funding markets.

Mr. Kohn observes it became apparent to market participants it was impossible to value either subprime derivatives or tranches of subprime securities.  And this created a problem.  The problem of not being able to value subprime securities magically spread to the interbank markets.

The obvious follow-up question to ask is why being unable to value subprime securities spread to the interbank markets.

Mr. Kohn and the Fed get this one partially right.  As he observed, it spread to the interbank funding markets because no-one knew who was holding these securities.  The banks with funds to lend could not determine the level of exposure to these subprime securities the opaque banks looking to borrow had and therefore if the borrowing banks could repay the loan.

What Mr. Kohn and the Fed missed is why the lending banks didn’t know who was holding the subprime securities.  The reason was the opacity of the banks.

At this point, you realize there is something systemic in the failure of the PhD Economists at the Fed to recognize opacity.

And that happened in August of ’07 and our first response was, “Well, this is a liquidity problem for these banks that are having trouble borrowing. The money markets aren’t working very well, it’s a classic thing where the Central Bank should intervene and make liquidity available.”

Except this wasn’t the right conclusion about what the real problem was.  If any of the Fed’s PhD Economists asked the obvious follow-up questions, they would have quickly realized the real problem was an opacity driven solvency issue.  The Great Financial Crisis was an earthquake along the opacity fault line in the global financial system.  The lack of liquidity was a symptom.  A symptom the Fed went all in on to address.

So how does Mr. Kohn explain how the Fed got it so wrong?

But, the other thing to say about coping with a crisis situation like this. It’s not only the incoming economic data, but it’s interpreting what’s happening in the financial markets and knowing, trying to get good information from people in the markets about what they’re seeing, who’s frozen out, who’s got access, who do they expect to be in trouble next, how might the authorities react to that.

Once again he makes a terrific observation.  It isn’t enough to have the data, you also have to have the ability to interpret this data.  Despite an army of PhD Economists, the Fed does not have this ability.

Why?

Because the army of PhD Economists doesn’t understand how the financial system is designed and where financial crises come from.

Regular readers know financial crises originate in the opaque corners of the financial system.  By definition, the securities in these areas don’t provide the information investors need in order to know what they own.  These securities are sold based on a valuation story told by Wall Street.  When the valuation story is called into doubt, there is no information to dismiss the doubt.  Investors quickly realize the lack of information also means there is no way to value the securities.  Hence, there is no logical stopping point in the decline of the price of these securities other than zero.  Investors understand this and in the classic financial crisis panic run to sell to try to get their money back.

When you don’t understand either the design of the financial system or where financial crises originate, you don’t have any basis for independently assessing what is happening in the financial markets.  This is a significant problem.  Without the ability to conduct an independent assessment, the Fed had and has no way to evaluate the story it is told by Wall Street about what is happening and why it is happening.

Interpreting the incoming information is very, very hard, and you have to keep in mind that everybody you’re talking to has an agenda. And they want you to think in a particular way because their firm is in trouble, or maybe their firm is strong and the other firm is in trouble and they see a business opportunity.

Shorter:  the stories bankers tell about what is happening are designed to benefit the bankers.

And you have to have knowledgeable people around you.

So, I would say, one thing to say about this period is there was a triumphant at the Fed. So Chairman Bernanke, myself, and Kevin Warsh met daily, often multiple times a day trying to figure out what was going on, what the right next steps were.

And, Kevin Warsh was really important to this because he had had experience in Morgan Stanley and financial markets, he had great contacts and financial markets, and he helped us interpret … figure out what was happening.

A quick check of Mr. Warsh’s background shows he worked in mergers and acquisitions while at Morgan Stanley.  Not exactly the background for someone who could interpret what was happening in the global financial markets by himself.  So, naturally he turned to his great contacts for help.  Help Wall Street was only too willing to provide as it allowed the bankers to shape the financial crisis narrative and influence monetary policy.

If this wasn’t bad enough, the Fed’s internal ability to figure out what was happening was actually worse.

Also, important in this, is that in my view is to have bank supervisors around. So, the bank supervisors inside the Fed were familiar with a lot of the banks and their problems.

Having been trained in bank supervision at the Fed and having worked for a Too Big to Fail bank, I can assure you the bank supervisors in 2008 were not familiar with each bank’s problems or their ability to recover.

Confirmation of this statement was provided by the 2012 JP Morgan London Whale episode.  The bank supervisors testified to Congress they were unaware of the existence of a very large derivative portfolio that would result in losses in excess of $6 billion.  And this was after 3 years of far greater supervisory oversight than occurred in the run-up to the financial crisis.

There is no reason to think the bank supervisors could assess the value of each bank’s subprime securities/derivatives exposure.  After all, the bank supervisors were not privy to any more information than the market participants who specialized in valuing these securities.

In addition, the bank supervisors would have had to evaluate the impact of contagion on each bank’s solvency.  There is no chance this occurred as the banks themselves did not know all their exposures to the other banks (this is still waiting for adoption of the legal entity identifiers).

Based on the findings in the Nyberg Report on the Irish Banking Crisis, bankers probably told their bank supervisors they could recover from their problems.  The bank supervisors were happy to relay this story as it made them look like they were on top of the situation as oppose to the reality of having no clue. (This is entirely consistent with Bernanke’s observation the Fed didn’t have the information it needed so it accepted the banks telling it they had passed the first stress test.)

Now, remember the Bagehot’s dictum is to lend that penalty rate to lots of folks, but solvent folks. So you could turn to the supervisors and say, “Do you think bank X is fundamentally solvent? That once this crisis is through they’ll be back on their feet? Or are they so sick and so impaired that they’ll never recover and we need to think of other ways of dealing with this?”

If the banks were so healthy, why did the Fed not follow Bagehot’s dictum and lend at penalty rates?  Led by Mark Pittman, Bloomberg sued the Fed to get it to disclose it hadn’t lent trillions of dollars at penalty rates.  Instead, it appears the Fed lent at rates that were well below existing market rates.  Below market rate lending allowed the Fed to transfer in excess of $12 billion of taxpayer money to the bankers.

But, it’s the fog of war absolutely. Things are much clearer in retrospect than they are at the time.

For some of us, it was clear at the time what had to be done to end the financial crisis with minimum damage to the real economy.

I tried to share this clarity with Mr. Kohn on or about October 15, 2008.  I used a physical model of two securities:  a clear plastic bag representing a transparent security and a paper bag representing an opaque security.  I pointed out how in each area of the global financial system that froze, like subprime and banks, the securities were opaque.  The areas of the global financial system that didn’t require intervention were all transparent.  So the solution was to bring transparency to the opaque areas.  A solution that was previously implemented in the 1930s and ended the worst of the Great Depression.

His response:  the Fed managed the US economy using data that was often out of date, there was no reason investors couldn’t value the opaque securities based on old, out of date data.

My response was perhaps they could, but given the markets for opaque securities had all frozen, it was apparent investors refused to do so.  They were on a buyers’ strike to get the information they needed to know what they owned.

And the Fed, in its lender of last resort role, was positioned to force the release of the information investors wanted and needed to know what they own.

The idea that what investors cared about was what was inside the paper bag security (be it a subprime security or bank) right now didn’t carry the day.

In the case of the Great Financial Crisis, the fog of war was the result of the opacity of large corners of the global financial system.  The fact senior Fed officials had no idea transparency is used to cut through the fog and end financial crises highlights how the Fed and its army of PhD Economists are not fit for purpose.