The minutes for the August 7th Fed meeting came out yesterday. The reading suggests that the Fed had little anticipation of the coming storm over the next two weeks. There was a section on the illiquidity of sub-prime structures and the fact that investors were seeing a erosion of value, but there was no connecting of the dots to conclude that there would be a credit crunch problem or that Fed help may be needed. In fact, in an earlier section of the document there was a comment that in spite of the softness in the housing market household wealth was increasing. Without sounding like Mr. Edwards and his “two Americas” speech, there was little discussion of the bifurcation of the mortgage market between long-term home owners sitting on gains and new owners in the ARMs markets facing financial difficulties. There also was no discussion about speculative behavior in the housing market.
Of course, we may all sound brilliant in hindsight. We can finger-point to what should have been done and what we saw in the market tea leaves, but at the end of the day many investors were unable to properly anticipate or act on this credit crunch. We knew there were credit problems but we were missing the potential for contagion or the sensitivity of investors to valuations. From my perspective, it will require more vigilance of factors that are normally not included in macro models.