So, was it underwriting that led to these changing values? Or was it monetary policy? Did the rating agencies that gave these securities AAA ratings err in their estimation of the underwriting standards, or did they err in their forecasts of monetary policy?
Re-imagine these graphs if the Fed had stabilized GDP growth in the summer of 2008, or the spring, or in late 2007, then re-consider the question of whether the outcomes for these securities were more due to underwriting or to monetary policy. If you are tempted to respond that earlier stabilization would only have encouraged more recklessness, remind yourself that by the time these securities were trading below full value, origination markets for private securitizations were effectively dead. That ship had sailed.
If we count the closing down of mortgage issuance to middle and lower-middle portions of the market that continued after GSE conservatorship, literally years worth of destabilizing policies were implemented after new issues for the private securitization market died. The reversal of any of those policies that happened after these securities started trading at discounts would have decreased the damage done.
At the September 2007 FOMC meeting, Bernanke notes in The Courage to Act (p. 162):
As in August, we again discussed the issue of moral hazard – the notion, in this context, that we should refrain from helping the economy with lower interest rates because that would simultaneously let investors who had misjudged risk off the hook. Richard Fisher warned that too large a rate cut would be giving in to a “siren call” to “indulge rather than discipline risky financial behavior.” But, given the rising threat to the broader economy, most members, including myself, Don Kohn, Tim Geithner, Janet Yellen, and Mishkin, had lost patience with this argument. “As the central bank, we have a responsibility to help markets function normally and to promote economic stability broadly speaking,” I said.In the end, the Richard Fishers' won and the rest of us lost. The oddity is that it seems to me that the consensus, even in hindsight, remains with Fisher.