The Fed?s Culpability in Financial Crisis ? Washington Post

The Federal Reserve’s regulatory approach, rather than protecting financial institutions from insolvency, actually left banks exposed for the current financial crisis, according to a report Monday in the Washington Post.

The Post said that the Fed started relying more on the banks’ own internal risk managers — who each had their own rules – rather than regulators examining the banks as closely as they had, cutting back their own exams well before the financial crisis. Former Federal Reserve Chairman Alan Greenspan in the mid-1990s and again in 2000, said that regulators had to focus more on risk management procedures than on actual  portfolios, because government regulators couldn’t do the latter.

The lack of oversight by the Fed and other regulators is one of the driving forces behind the approved legislation in the House – and expected to pass in the Senate – that would overhaul the financial system and put much of the regulatory power from the Fed in the new Consumer Financial Protection Agency.

Due to its lack of close scrutiny of the financial institution’s books, the Fed didn’t see the problems starting to surface on balance sheets until the crisis hit. Some large financial institutions, like National City, Wachovia and Washington Mutual, made large plays in the risky subprime credit market and were caught flatfooted when California and other overheated housing markets collapsed.

They and other lenders were also hurt by loans like variable payment products that enabled borrowers to pay less than the interest owed each month, meaning the amount owned on the mortgage grew rather than shrunk every 30 days. When home values stopped increasing, defaults ensued, the Post pointed out.

As consumers defaulted, loan pools created by Citigroup and other financial institutions started to lose value. The banks’ capital was under tremendous pressure, so many chose  to charge off much of their credit, subsequently selling it to collection firms. With so much delinquent credit sold on the market, prices dropped precipitously.

Though the financial health of many of the lenders has strengthened – with some of the largest able to pay off government bailout funds – they’re still holding credit very tight. Many reports say that even consumers and businesses with “good” financial histories and the capacity to repay loans can’t get credit in the current economic climate. Most experts don’t expect that situation to change until employment picks up and interest rates start to increase – perhaps by the middle of 2010.