Now, I am not defending the Fed under Greenspan. Clearly there was an overly loose policy in 2003-2004 that aggravated the housing bubble. While Bernanke and others justified this on "complexity" grounds of worrying about asymmetries associated with a possible Japanese-style deflation (which we are now facing much more seriously), my cynical side says it was Greenspan wanting to help W. get reelected so that he, Greenspan, would not be on the receiving end of the sort of whining he got from W.'s dad after he supposedly was responsible for Clinton beating him in 1992 on an "It's the economy, stupid!" campaign. However, I think that in the last two and a half years, the leaders of the Fed have been aware that trouble was coming and were preparing for it, with their immediately rolling out alternative lending bodies and policy approaches immediately upon the eruption of troubles in the subprime markets in August, 2007.
A further piece of evidence is the speech that then New York Fed president, Timothy Geithner, gave in Hong Kong on September 15, 2006, "Hedge funds and derivatives and their implications for the financial system". While the opening part of the speech was pretty pollyannaish, the latter half of it was pretty scary, given the nature of Fedspeak, never wanting to spook the markets and trigger a crash that might be avoided. I shall close by simply quoting from it.
Understanding and evaluating “tail events”—low probability, high severity instances of stress—is a principal, and extraordinarily difficult, aspect of risk management. These challenges have likely increased with the complexity of financial instruments, the opacity of some counterparties, the rapidity with which large positions can change, and the potential feedback effects associated with leveraged positions.
Yes, folks, the Fed knew.