Speech

THE FEDERAL RESERVE

AND THE FINANCIAL CRISIS

Lecture 3:

The Federal Reserve's Response

to the Financial Crisis

The Two Main Tools of Central Banking

• Lender of last resort powers

- For financial stability: Central banks provide

liquidity (short-term loans) to financial institutions

or markets to help calm financial panics.

• Monetary policy

- For macroeconomic stability: In normal times,

central banks adjust the level of short-term

interest rates to influence spending, production,

employment, and inflation.

• Today's lecture will focus on lender-of-last-resort

policy during the financial crisis. Monetary policy

will be covered in the next lecture.

Financial System

Vulnerabilities Before the Crisis

• Private-sector vulnerabilities

- excessive leverage (debt)

- banks' failure to adequately monitor and manage

risks

- excessive reliance on short-term funding

- increased use of exotic financial instruments that

concentrated risk

• Public-sector vulnerabilities

- gaps in regulatory structure

- failures of regulation and supervision

- insufficient attention paid to the stability of the

financial system as a whole

An Important Public-Sector Vulnerability:

Fannie Mae and Freddie Mac

• Fannie Mae and Freddie Mac are private

corporations that were established by the

Congress and are referred to as governmentsponsored enterprises, or GSEs.

• They are the largest "packagers" of individual

mortgages into mortgage-backed securities

(MBS), which they guarantee against loss.

• Fannie and Freddie were permitted to operate

with inadequate capital to back their guarantees

- a point recognized by the Fed and others prior

to the crisis.

• Their balance sheets grew rapidly, including

through purchases of subprime MBS, exposing

them to additional risks.

A Key Trigger:

Bad Mortgage Products and Practices

• Exotic mortgages (such as "exploding ARMS") and

sloppy lending practices (such as no-doc loans)

proliferated before the crisis.

• Repayment of these loans depended on continually

rising house prices.

• Rising house prices created home equity for

borrowers, allowing them to refinance into morestandard mortgages after a few years.

• When house prices stopped rising, however,

borrowers could neither refinance nor meet the

(typically increasing) payments on their exotic

mortgages.

Examples of Bad Mortgage Practices

- interest-only (IO) adjustable-rate mortgages (ARMs)

- option ARMs (permit borrowers to vary the size of

monthly payments)

- long amortization (payment period greater than 30

years)

- negative amortization ARMs (initial payments do not

even cover interest costs)

- no-documentation loans

The Deterioration of Lending Practices

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The Financing of Exotic

and Subprime Mortgages

• Many types of financial institutions "packaged"

exotic and subprime mortgages into securities.

- Some securities were relatively simple in

structure—for example, most GSE-backed MBS.

- Other securities were very complex and opaque

derivatives—for example, collateralized debt

obligations, or CDOs.

• Rating agencies gave AAA ratings to many of

these securities.

• Many of these securities were sold to investors.

• Financial institutions also retained some of these

securities - often in off-balance-sheet vehicles,

financed by cheap short-term funding like

commercial paper.

• Companies like AIG sold "insurance" to protect

investors or financial firms that held these

securities.

• These financial system practices amplified the

risks of low-quality lending.

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The Crisis: A Classic Financial Panic

• A financial panic occurs when providers of shortterm credit (think depositors in a bank) suddenly

lose confidence in the ability of the borrower

(think the bank) to repay; providers of short-term

credit then quickly withdraw their funds.

• As house prices fell, it became clear that the

values of many mortgage-related securities would

fall sharply, imposing losses on financial firms,

investment vehicles, and credit insurers (like AIG).

• Because of complexity of many securities and

poor risk monitoring, however, investors and

even the firms themselves were unsure about

where losses would fall.

• Runs began, as financial firms and investors

pulled funding from any firm thought to be

vulnerable to losses.

• These runs generated huge pressures on key

financial firms and disrupted many important

financial markets.

Large Financial Firms Came Under Intense

Pressure in 2008

• Bear Stearns: Forced sale, March 16

• Fannie and Freddie: Placed in conservatorship,

liabilities guaranteed by the U.S. Treasury, Sept. 7

• Lehman Brothers: Filed for bankruptcy, Sept. 15

• Merrill Lynch: Acquisition by Bank of America

announced, Sept. 15

• AIG: Received emergency liquidity assistance from

the Fed, Sept. 16

• Washington Mutual Bank: Closed by regulators,

acquisition by JP Morgan Chase announced, Sept. 25

• Wachovia: Acquisition by Wells Fargo announced,

Oct. 3

Policy Response: Overview

• Lessons from the Great Depression

- In a financial panic, the central bank needs to lend

freely to halt runs and restore market functioning.

- Highly accommodative monetary policy helps

support economic recovery and employment.

• Heeding those lessons, the Federal Reserve and

the federal government took vigorous actions to

stem the financial panic, support key financial

markets and institutions, and limit the

contraction in output and employment.

• Similar actions were taken by foreign central

banks and governments.

Global Response

• On October 10, 2008, G-7 countries agreed to

work together to stabilize the global financial

system. They agreed to

- prevent the failure of systemically important

financial institutions

- ensure financial institutions' access to funding and

capital

- restore depositor confidence

- work to normalize credit markets

• The international policy response averted the

collapse of the global financial system.

- After the announcement, the interest rates banks

paid to borrow short-term funds dropped

dramatically.

Interbank Rates Fall after Oct. 10, 2008

Cost of Interbank Lending

[For the accessible version of this figure, please see the accompanying HTML.]

Federal Reserve Actions:

The Discount Window

• The Fed lends to banks through a facility called

the discount window.

• As the crisis built, the maturity of discount

window loans was extended and the interest rate

reduced.

• Regular auctions of discount window funds were

conducted to encourage broad participation by

financial firms.

Federal Reserve Actions:

Special Liquidity and Credit Facilities

• New programs allowed the Federal Reserve to

provide liquidity to a variety of financial

institutions and markets facing runs or other

illiquidity problems.

• All loans were required to be "secured" by

adequate collateral.

• The purpose was to

- enhance the stability of the financial system

- promote the availability of credit to U.S.

households and businesses and thereby support

the recovery

• This is the traditional lender-of-last-resort

function of central banks.

Institutions and Markets Covered by the

Fed's Lender-of-Last Resort Actions

• Banks (through the discount window)

• Broker-dealers (financial firms that deal in

securities and derivatives)

• Commercial paper borrowers

• Money market funds

• Asset-backed securities market

Case Study: Money Market Funds

and the Commercial Paper Market

• Money market funds (MMFs) are investment

companies that sell shares and invest the

proceeds in short-term assets.

• MMFs historically have almost always maintained

stable $1 share prices.

Money Market Funds

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Case Study: Money Market Funds

and the Commercial Paper Market

• Although MMF shares are not insured, investors

use MMFs like checking accounts and expect to

be able to earn interest and redeem shares on

demand for $1.

• MMFs invest heavily in commercial paper (CP)

and other short-term assets.

Commercial Paper

• Commercial paper (CP) is a short-term (typically

90 days or less) debt instrument issued by

corporations.

• CP is used by nonfinancial corporations to pay for

immediate expenses such as payroll and

inventories.

• CP is used by financial corporations to raise funds

that they then lend to ordinary businesses and

households.

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Lehman Bros., Money Market Funds,

and Commercial Paper

• Lehman Brothers was a global financial services

firm.

• Like other securities firms, Lehman relied heavily

on short-term borrowing (for example, CP) to

fund their investments.

• During the 2000s, Lehman invested extensively in

mortgage-related securities and commercial real

estate (CRE).

• As house prices fell and delinquencies and

foreclosures rose, the value of Lehman's

mortgage-related assets fell.

• Lehman's CRE holdings also were showing large

losses.

• As Lehman's creditors lost confidence, they

withdrew funding (for example, ceased

purchasing Lehman's CP) and curtailed other

business with Lehman.

• With losses mounting, Lehman could not find

new capital or another firm to acquire it.

• On September 15, 2008, Lehman filed for

bankruptcy.

The Run on MMFs

• After the collapse of Lehman Brothers, one MMF

that held CP issued by Lehman failed to maintain

a $1 share price.

• This led to a rapid loss of confidence by investors

in other MMFs and a sudden flood of

redemptions—another example of a run or panic.

• In response, the Treasury provided a temporary

guarantee of the value of MMF shares.

• Acting as lender of last resort, the Fed created a

program to provide backstop liquidity. Under this

program, the Fed lent to banks who in turn

provided cash to MMFs by purchasing some of

their assets.

• These actions ended the run within a few days.

The Run on MMFs

Net Flows to Prime Money Market Funds

[For the accessible version of this figure, please see the accompanying HTML.]

Dislocations in the CP Market

• MMFs responded to the run by curtailing their

purchases of short-term assets, including CP.

• Consequently, the demand for newly issued CP

dried up and interest rates on CP soared.

• This episode is an example of how a financial

crisis can spread in unexpected directions

(Lehman ^ MMFs ^ CP).

• Strains in the CP market contributed to an overall

contraction in credit available to financial

institutions and to nonfinancial businesses.

• The Federal Reserve established special programs

to repair functioning in the CP market and restart

the flow of credit.

CP Rates Soared during the Crisis

Cost of Short-term Borrowing"

[For the accessible version of this figure, please see the accompanying HTML.]

Support of Critical Institutions:

Bear Stearns and AIG

• In March 2008, a Fed loan facilitated the takeover

of the failing broker-dealer, Bear Stearns, by the

bank JP Morgan Chase.

• In October 2008, the Fed intervened to prevent

the failure of the nation's largest insurance

company, AIG.

Case Study: AIG

• In September 2008, AIG—a multinational

insurance and financial services firm—faced

serious liquidity problems that threatened its

survival. Many losses came from the insurance it

sold on bad mortgage-related securities.

• Because AIG was interconnected with many other

parts of the global financial system, its failure

would have had a massive effect on other

financial firms and markets.

• However, AIG also owned sizable assets that

could be used as collateral. To prevent its

collapse, the Federal Reserve loaned AIG $85

billion, using AIG assets as collateral. Later, the

Treasury provided additional assistance.

• The rescue of AIG prevented even greater shocks

to the global financial system and global

economy.

• Over time, AIG stabilized. It has repaid the Fed

with interest and has made progress in reducing

Treasury's stake in the company.

• The problems at Lehman, AIG, and other

companies highlighted the need for new tools to

deal with systemically critical financial institutions

on the verge of failure.

Consequences of the Crisis for Spending,

Output, and Employment

• Spending and output contracted sharply in

response to reduced credit flows, skyrocketing

borrowing costs, and plummeting asset values.

- GDP fell a total of more than 5 percent from its

peak to its trough.

- Manufacturing output declined nearly 20 percent,

and new home construction plummeted 80

percent.

- More than 8-1/2 million people lost their jobs.

- Unemployment rose to 10 percent.

• Many of our trading partners were also hit by

recessions—it was a global slowdown.

• Threat of a second Great Depression was very real.

Comparison to the Great Depression

• In terms of economic consequences, the Great

Depression was considerably more severe than

the recent recession.

• The forceful policy response to the recent

financial crisis and recession likely averted much

worse outcomes.

Comparison to the Great Depression

S&P 500 Composite Index

[For the accessible version of this figure, please see the accompanying HTML.]

Comparison to the Great Depression

Industrial Production

[For the accessible version of this figure, please see the accompanying HTML.]

Lecture 4

• Lecture 4 will discuss the aftermath of the

financial crisis:

-

the recession and monetary policy response

the sluggish recovery

changes in financial regulation following the crisis

implications of the crisis for central bank practice

THE FEDERAL RESERVE

AND THE FINANCIAL CRISIS