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The data from the Federal Reserve audit is full of frightening revelations about U.S. economic policy and those who implement it. When Wall Street went off the rails in the fall of 2008, policymakers told the public we had a certain kind of problem, knowing all along that the actual nature of the problem was very different—and far more severe. This was a terribly destructive lie. Had policymakers fully explained the scope of Wall Street’s 2008 troubles, today’s problems with foreclosure fraud would simply not exist.

Here’s the basic issue. As Lehman Brothers, AIG and other major financial firms teetered on the verge of collapse, the Fed and the Treasury Department insisted that the trouble on Wall Street was one of “liquidity.” That’s a finance term meaning, “the banks are fine, but everybody is confused.” Banks have lots of money in long-term assets, but can’t convert those long-term assets into short-term cash.

In retrospect, that view was clearly an error. The bank held hundreds of billions of dollars worth of subprime mortgage assets, which were not merely worthless in the panic-stricken view of the financial mob, but worthless, full stop. At the time many people argued that the financial system faced not a liquidity crisis, but a liquidity crisis and a solvency crisis. That is to say, even if the government had helped the banks deal with day-to-day problems, the banks were still fundamentally unable to pay their debts. They were not merely illiquid, but insolvent.

I stole this perspective on the financial crisis from Mike Konczal, and the same basic framework was portrayed very forcefully by Nobel Prize-winning economist Paul Krugman in 2008 and 2009. Krugman’s major concern was that the U.S. would end up with a handful of dominant “zombie banks”—firms which were kept alive by government aid, but which were fundamentally insolvent, and unable to support the economy with productive lending.

The truth has been far worse than Krugman predicted. Not only are today’s major banks unable to support the economy, they are actively sabotaging the middle class with fraudulent foreclosures. This is a direct result of policymakers’ failure to address the fundamental solvency problem in 2008 and 2009. And what’s worse, it appears that the Federal Reserve was aware of the solvency problem, even as its top officials publicly insisted that the bailed out banks were fine.

To fix a liquidity crisis, the Fed has had a longstanding policy of offering short-term, low interest loans. In exchange for these loans, the Fed demands high-quality collateral. That’s as it should be: if a bank is truly experiencing a liquidity crisis, there is a public interest in keeping it afloat so it can meet its financial obligations.

And so in 2007 and 2008, the Fed created several facilities to ease liquidity based on this principle. The trouble is, starting on Sept. 15, 2008—right when Lehman Brothers was going under—the Fed started accepting total garbage as collateral for its loans. Not just a little bit of garbage, either. According to data released by the Fed yesterday, the central bank accepted $1.32 trillion in collateral rated “junk bond” status or lower, starting Sept. 15, through it Primary Dealer Credit Facility alone. That compares to $8.95 trillion in total loans extended through the Primary Dealer outlet from March 2008 through May 2009. From Sept. 15 onward, the Fed lend out $7.60 trillion through this window alone, meaning that a full 17 percent of its lending from this point was backed by junk bonds, or worse.

These total figures are somewhat exaggerated—the facility in question offered overnight loans, and many banks chose to roll-over their loans from one day to the next. Nevertheless, the collateral comparison is apt. However you measure it, nearly one-fifth of the Fed’s lending through this facility was backed by junk bonds.

What does all this mean? The Fed knew it was facing a solvency crisis, even as it publicly insisted that Wall Street was merely dealing with a liquidity issue. If the Fed had truly believed Wall Street only faced liquidity troubles, it would not have allowed major banks to pledge junk bonds as collateral for loans. And indeed, for months, the Fed did not allow banks to put up junk bonds as loans. But things changed when Lehman Brothers went under.

The Fed and the Treasury had to do something in the fall of 2008. But to fix liquidity without fixing solvency was a grave error. By denying the solvency crisis, major bank executives who had run their companies into the ground were allowed to keep their jobs, and shareholders who had placed bad bets on their firms were allowed to collect government largesse, as bloated bonuses began paying out soon after.

But the banks themselves still faced a capital shortage, and were only kept above those critical capital thresholds because federal regulators were willing to look the other way, letting banks account for obvious losses as if they were profitable assets.

So based on the Fed audit data, it’s hard to conclude that Fed Chairman Ben Bernanke was telling the truth when he told Congress on March 3, 2009, that there were no zombie banks in the United States.

“I don’t think that any major U.S. bank is currently a zombie institution,” Bernanke said.

As Bernanke spoke those words banks had been pledging junk bonds as collateral under Fed facilities for several months. From March 4, 2009 through May 12, 2009, when the Fed data stops, only two institutions borrowed money from the Fed’s Primary Dealer window: Bank of American and Citigroup. They borrowed almost every day, pledging junk bonds as collateral. Bernanke either knew this, or should have known it as a major public official.

This is the heart of today’s foreclosure fraud crisis. Banks are foreclosing on untold numbers of families who have never missed a payment, because rushing to foreclosure generates lucrative fees for the banks, whatever the costs to families and investors. This is, in fact, far worse than what Paul Krugman predicted. Not only are zombie banks failing to support the economy, they are actively sabotaging it with fraud in order to make up for their capital shortages. Meanwhile, regulators are aggressively looking the other way.

The Fed had to fix liquidity in 2008. That was its job. But as major banks went insolvent, the Fed and Treasury had a responsibility to fix that solvency issue—even though that meant requiring shareholders and executives to live up to losses. Instead, as the Fed audit tells us, policymakers knowingly ignored the real problem, pushing losses onto the American middle class in the process.

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