American Economic Association
Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis
Author(s): Stephen G. Cecchetti
Source: The Journal of Economic Perspectives, Vol. 23, No. 1 (Winter, 2009), pp. 51-76
Published by: American Economic Association
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Journal ofEconomie Perspectives?Volume 23, Number 1?Winter 2009?Pages 51-75
Crisis and Responses: The Federal
Reserve in the Early Stages of the
Financial Crisis
Stephen G. Cecchetti
In summer 2007, U.S. and global financial markets found themselves facing a
potential financial crisis, and the U.S. Federal Reserve found itself in a
difficult situation. It was becoming clear that banks and other financial
institutions would ultimately lose tens or even hundreds of billions of dollars from
their exposure to subprime mortgage market loans. Bank lending is closely tied to
bank capital
or net worth?specifically, bank regulators require that loans not
exceed a certain multiple of capital. Thus, the Federal Reserve faced the danger of
a sharp contraction in credit and bank lending in a way that threatened a deep
recession or worse.
When this kind of event happens, the job of the central bank is to assure that
financial institutions have the necessary funds to conduct their daily business; that
theyhave the "liquidity" theyneed tomake timelypayments and transfers.Modern
financial institutions need to replenish their funding every day. In theUnited States
alone, literally trillions of dollars are transferred between banks each day to support
the $50 trillion credit outstanding in the economy as a whole. Commercial banks
require funds to initiate themortgages, auto loans, and credit card debt they then
sell into financial markets, while investment banks finance much of their activity
with daily borrowing.
In the
early stages of the crisis, the situation often arose in which a well
capitalized bank was forced to make sudden large loans based on previously
committed lines of credit. In this circumstance, central bank actions can ease
Stephen G. Cecchetti isEconomic Adviser and Head of theMonetary and Economic
Department, Bank for International Settlements,Basel, Switzerland. At thetimethisessaywas
written, he was Barbara and Richard M.
Rosenberg Professor of
Global Finance, Interna
tional Business School, Brandeis
University, Boston, Massachusetts, and a Research Associ
ate, National Bureau
of
Economic Research, Cambridge,
Massachusetts. His e-mail address
is (Stephen.cecchetti@bis. org).
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52 Journal ofEconomie Perspectives
liquidity constraints by supplying banks with the funds theyneed in the short term.
In fall 2007, the Federal Reserve provided short-term funding liquidity by, in effect,
allowing banks to exchange their holdings of Treasury securities for cash. This
policy enabled the banks tomeet the credit line commitments theyhad outstanding.
However, it became clear in October and November 2007 that traditional
central bank tools were of limited use. Realizing these failings, Fed officials created
innovative, new lending procedures in the form of the Term Auction Facility and
the Primary Dealer Credit Facility, as well as changed their securities lending
program, creating the Term Securities Lending Facility. I describe how these new
systems work, how each is intended to inject liquidity into the financial system,
providing some time for institutions and markets to stabilize.
But before getting into the details, it is important to understand that there is
a limit towhat central bank tools can accomplish. When losses erode bank capital
to the point where regulatory constraints become binding, private lending can only
begin to grow again when capital has been replenished. A return to normalcy
requires
that banks either raise new
equity
from outside investors or receive a
transfer from the fiscal authorities. Since the Fed is fundamentally not in the
business of making such transfers, its ability to ease capital constraints is limited.
However, as we will see, some of the less-traditional Fed actions taken
during
the
crisis had a fiscal flavor to them and may be interpreted as an indirect attempt to
subsidize banks in need.
The paper begins with a discussion of the traditional tools ofmonetary policy
and how theywork, using the balance sheet of the Federal Reserve as a device for
understanding the conduct ofmonetary policy. We then turn to the early stages of
the financial crisis, describing the symptoms and speculating about the causes, and
layout the early rounds of the policy responses used by the Federal Reserve. This
essay was written in Spring 2008 and only describes events and responses through
May 2008. While these policies may have helped in reducing the risk of a short-run
financial crisis, Federal Reserve policies have not been able to keep the problems
in the financial system from having an effect on real economic activity. This
outcome is unsurprising. Financial intermediaries did in fact incur substantial
losses, and changes in central bank lending practices will not overturn this fact.
The Federal Reserve Balance Sheet and Policy Tools
Monetary policymakers affect the quantity of funds available in the financial
systembymanipulating the assets and liabilities held by the central bank, which in
turn affects the
price
of those funds?the interest rate. The Federal Reserve
publishes balance sheet information weekly on its website. Table 1 reports a
stripped-down version of the Federal Reserve System's balance sheet in early July
2007, prior to the onset of the crisis. To highlight the changes that occurred, we
startwith a whirl-wind tour of the liabilities and the assets as they existed before the
crisisbegan. The discussion then turns tobasic principles ofmanaging a balance sheet
and how theyare related to tools ofmonetary policy like open-market operations and
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Stephen G. Cecchetti 53
Table 1
The Balance Sheet of the Federal Reserve, July 2007
(in billions ofdollars)
Assets Liabilities
Securities
Held outright $790.6
Repurchase agreements $30.3
Loans
Primary lending $0.19
Foreign exchange
reserves $20.8
Gold $11.0
Other assets $27.5
Total assets $880.4
Federal Reserve notes
Commercial bank reserve balances
Liabilities related to
foreign official
and U.S. Treasury deposits
Other liabilities
Total liabilities
$781.4
$16.8
$42.4
$5.7
$846.3
Capital (= Total assets
?
Total liabilities) $34.1
Source: Federal Reserve Statistical Release H.4.1, Table 2, (www.federalreserve.gov/releases/h41/); and
quarterly Treasury and Foreign Exchange Report., April-June 2007, Federal Reserve Bank of New York
(www.ny.frb.org/markets/quar_reports.html).
Note: With the exception of the value of foreign exchange reserves, which is for June, 30, 2007, all
numbers are as of July 4, 2007.
changes in discount rates. In what follows, I will use the unqualified term "bank" to
refer to a commercial bank rather than to the central bank or to an investment bank.
Liabilities: Currency and Reserves
Starting with the liability side of the balance sheet inTable 1, the amount of
currency in circulation represents roughly $2,600 per U.S. resident. Even after
accounting for the underground economy and amounts of currency held by
retailers, this total seems extremely high. But as reported inU.S. Treasury (2006),
one-half to two-thirds is held outside the country. Because currency plays
no role in
the
episode
at hand, we move to the
entry for commercial bank reserve balances.
Banks hold reserves at the Fed for three interrelated reasons: 1) they are required
to do so; 2) theyneed them todo business, so they can meet customer demands for
withdrawals and make payments to other banks; and 3) it is prudent to do so
because reserves act as the bank's emergency fund, ready
in case disaster strikes.
Table 1 shows that inJuly 2007 the level of reserve balances was $16.8 billion.
This total is relatively small?approximately one-tenth the level held by European
banks in the national central banks of the
Eurosystem.
U.S. banks
keep
reserve
balances as low as
possible
because
they traditionally
receive no interest on such
reserves, while
European
banks are
paid something
close to the
overnight
inter
bank
lending rate.1
1
On October 13, 2006, the U.S. Congress passed the Financial Services Regulatory Relief Act of 2006
(Public Law 109-351), authorizing the Federal Reserve to pay interest on reserves beginning
on October
1, 2011. The Federal Reserve Board has not yet announced whether itwill do so, but there is a strong
suspicion itwill.
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54 Journal ofEconomie Perspectives
Two additional liabilities appear on the balance sheet in Table 1. The first
concerns
deposit
accounts that
belong
either to the U.S.
Treasury
or to
foreign
governments
and central banks. These institutions need bank accounts
just
like any
other person
or business, and the Federal Reserve offers them this service.
Finally,
the verymodest category of "other liabilities" includes deposit balances of interna
tional organizations like the International Monetary Fund and theUnited Nations,
as well as those of federal government agencies
such as Fannie Mae and Freddie
Mac.
Assets: Securities Holdings, Loans, and Foreign Exchange Reserves
Moving to the asset side of the balance sheet, the Fed holds securities both
outright
and as
part of
repurchase agreements,
or
"repos"
for short. Securities that
the Fed owns
directly
are
composed entirely
of U.S.
Treasury bills, notes, and
bonds. Before the financial crisis began, these outright securities holdings com
prised about 90 percent of the Fed's assets.
In July 2007, repos accounted for $30.3 billion, or just 3.4 percent, of total Fed
assets. However, repurchase agreements
are
extremely important,
because
they
are
themethod the Fed uses to adjust the level of reserves in the banking system from
day
to
day.
For
example,
when one reads that the Federal Reserve Bank of New
York's Open Market Desk put $38 billion into the banking system on August 10,
2007, itwas done with
repurchase agreements.
A dictionary-style description of a repurchase agreement goes something like
this: it is a short-term collateralized loan inwhich a security is exchanged for cash
with the
agreement
that the
parties
will reverse the transaction on a
specific
future
date at an
agreed upon price,
as soon as the next
day.
In more intuitive terms,
perhaps
the easiest way to think about a
repo is as an
overnight mortgage (because
amortgage, like a repo, isfully collateralized). In the same way thatyou pledge your
house to the bank in exchange for a loan, a financial institution pledges
a bond to
the Federal Reserve in
exchange
for funds?and also
promises
to reverse the
transaction and
provide
cash for the bond in the near future.
The Fed carries out these transactions through the Federal Reserve Bank of
New York's Open Market Desk. The desk engages in repurchase agreements every
morning (usually at 8:30 a.m. or 9:40 a.m.). The quantities normally range from $2
billion to $20 billion dollars. The desk sends out amessage to 19 "primary dealers,"
most of which are investment banks, stating the term of the repo and the type of
collateral that itwill accept. The primary dealers, the only parties qualified to
participate
in these
daily operations,
send their
offers?quantities, prices,
and
collateral?and then theNew York Fed decides how much to accept. (For a current
list of the primary dealers see
(http://www.ny.frb.org/markets/pridealers_
current.html)). Three types of collateral are allowed under law: U.S.
Treasury
Securities, U.S. agency securities (issued by entities like Fannie Mae and the Small
Business Administration), and AAA-rated and insured
mortgage-backed
securities.
The total quantity of securities offered by the primary dealers (at all interest rates)
averages roughly
five times what is
accepted
for
Treasury securities, ten times for
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Crisis and Responses: The Federal Reserve in theEarly Stages of theFinancial Crisis 55
agency securities, and 15 times formortgage-backed securities. While most offers
are overnight, it is standard to engage in repos with maturities as long as 14 days.
By conducting repos on a daily basis, the Fed accomplishes two things. First, it
keeps a fraction of its assets very short term, ensuring flexibility to expand and
contract the quantity quickly. This allows policymakers to add or drain reserves
from the system immediately ifthe need arises. Second, by operating every day, the
Fed is in contact with market participants on a regular basis. If short-term funding
markets start to experience strains, the Fed will find out immediately through the
offers it receives from primary dealers in itsdaily operations.
Loans are the next
entry
on the asset side of the balance sheet.
Historically,
banks have been
extremely
reluctant to borrow from the central bank. Prior to the
start of the crisis, borrowings averaged less than $200 million per day. Even for the
first seven months of the crisis, from August 2007 through mid-March 2008, the
quantity of discount window borrowing averaged just over $1 billion.
The stigma attached to borrowing from the Fed probably arises from several
sources. Prior to 2003, banks could be admonished by the Fed for overuse of
discount window borrowing, which created a distinct disincentive. Over the years,
the Fed has tried to emphasize that borrowing from the central bank should be a
normal part of business. Even so, banks continue to fear that if theyborrow from
the central bank, other banks and financial institutions will draw negative conclu
sions about their financial strength. Artu? and Demirlap (2007) provide a useful
overview of the modest literature on discount window
borrowing.
Continuing
on the asset side, foreign exchange
reserves are the next
entry.
As
of June 30, 2007, the Fed held $13.1 billion in euro-denominated assets and $7.7
billion in Japanese yen in a combination of marketable securities and deposit
accounts at foreign institutions. The Federal Reserve holds half of the foreign
exchange reserves of theUnited States, with the other half on the balance sheet of
the U.S.
Treasury's Exchange
Stabilization Fund. In the rare event of an interven
tion in the foreign exchange market, the quantity is evenly split between the two.
The next entry is gold. This item represents the Treasury's gold stock held in
Fort Knox, which is carried on the books at a fixed value of $42.22 per troyounce.
Finally, the sizeable "other assets" category includes a variety of items: the land,
physical premises, and operating equipment of the Federal Reserve banks; special
drawing rights certificates issued by the International Monetary Fund; coins issued
by theU.S. Treasury; accrued interest on U.S. Treasury securities held outright; as
well as items in process of collection associated with the Fed's check clearing
business.
Two General Principles of Balance Sheet Management
Two
general principles
are associated with the management of a central bank's
balance sheet. First, policymakers control its size. If the Federal Reserve wishes, it
can create liabilities to
purchase
additional assets.
Open
market
operations
work in
thisway: To purchase
a security, the Fed creates a reserve
liability, crediting the
deposit account of a commercial bank. The central bank can
expand its liabilities
without limit?although an
expansion of liabilities will reduce the price of those
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56 Journal ofEconomie Perspectives
liabilities, which is the interest rate. In other words, a
change in the quantity of
liabilities and assets can affect the level of the risk-free interest rate by altering the
quantity of reserves supplied to the banking system.
Second, the central bank controls the
composition
of the assets on its balance
sheet. Given the overall quantity of assets itwishes tohold, the Federal Reserve can
decide whether itwants to hold
Treasury securities, foreign exchange reserves, or
other assets. Changes in the composition of central bank assets will not affect the
risk-free interest rate, but
they
have the
potential
to influence relative
prices?one
currency relative to another or one bond relative to
another?by changing
the
relative supply or desirability of holding one specific asset over another. Within
certain legal limits, the Fed can adjust the composition of its assets along various
dimensions like thematurity structure of itsportfolio and the exact bonds that it
owns. Sterilized
foreign exchange intervention, where a central bank sells a bond
denominated in one
currency and uses the
proceeds
to
buy
a bond denominated
in another currency, is a classic
example
of a decision related to the
composition,
but not the quantity, of the assets that the central bank holds.
Open Market Operations and Discount Rates
A textbook treatment of monetary policy focuses on three traditional tools,
each of which is based directly on actions related to the central bank's balance
sheet: open market
operations, balance sheet size, and the federal funds interest
rate
target; lending
to commercial banks, the fraction of assets held as loans, and
the discount rate; and the level of commercial bank reserves, the composition of
liabilities, and the reserve requirement. As I describe in Cecchetti (2008, p. 420),
changes
in reserve
requirements
are not a tool used
by
the Federal Reserve in the
twenty-first century,
so we focus here on the other two tools. The
descriptions
that
follow describe the state of theworld before the financial crisis of 2007-2008 began.
In the case of open market
operations,
the Federal Reserve's
policymaking
body, the Federal Open Market Committee (FOMC) sets a target for the federal
funds rate?the (market-determined) rate banks
charge
each other for
overnight
loans of the excess reserves theyhold at the Fed. Then, through a daily adjustment
of the securities
holdings
and
repurchase agreements
on its balance sheet, the
Open Market Desk, as themonopoly supplier of bank reserves, works to keep the
federal funds rate near its desired target.
Commercial banks can borrow from the Fed at what is technically called the
"primary lending
rate" and ismore
commonly
known as the "discount rate." Each
of the 12 Federal Reserve banks has a
standing offer to lend to the banks in their
district that they deem to be sound (as measured by supervisory ratings). Before
2003, theprimary lending ratewas setbelow the targetfederal funds rate. From January
2003 up to the startof crisis in 2007, the primary lending rate was one percentage
point, or 100 basis points, above the target federal funds rate. As long as a bank is
financially sound and willing to pay the penalty interest rate, itcan receive a loan. A
borrowing bank can re-lend the borrowed funds to another bank, ifitwishes to do so.
Lending through the "discount window" isdesigned both to provide funds at
the end of the day, allowing banks to meet their payment obligations without
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Stephen G. Cecchetti 57
overdrawing
their reserve account, and also to enable institutions to borrow
against
collateral that themarket will not otherwise finance. The second of these purposes
is associated with the classic lender-of-last-resort function.
Discount borrowing is collateralized, which means that the borrowing bank
must have assets of sufficient value that, in the event of default, the Federal Reserve
will not suffera loss. The Federal Reserve will accept virtually anything as collateral.
In one case in 1985, the Fed lent the Bank of New York $23 billion and took
the entire bank?buildings, furniture, and all?as collateral (Cecchetti, 2008,
p. 336). For details on the pledging and valuation of collateral, see
(http://
www.frbdiscountwindow.org/index.cfm).
Since both open market operations and discount lending involve changes in
the Fed's balance sheet that result in
expansion
or contraction of commercial bank
reserves, they
are often
presented
as different tools with identical effects. But there
are two
important practical
differences between them. First, any bank can borrow,
while only 19 primary dealers can participate in open market operations. Second,
the Federal Reserve allows a discount loan tobe collateralized by a verybroad range
of assets, while only a narrow set of very high quality securities qualify for repur
chase in
regular open market
operations.
The Crisis Hits
A complete chronology of the recent financial crisis might start in February
2007, when several
large subprime mortgage
lenders started to
report losses. It
might then describe how spreads between risky and risk-free bonds?"credit
spreads"?began widening inJuly 2007. But the definitive trigger came on August
9, 2007, when the large French bank BNP Paribas temporarily halted redemptions
from three of itsfunds because itcould not reliably value the assets backed byU.S.
subprime mortgage debt held in those funds. When one major institution took
such a
step,
financial firms worldwide were
encouraged
to
question
the value of a
variety of collateral they had been accepting in their lending operations?and to
worry about their own finances. The result was a sudden
hoarding
of cash and
cessation of interbank lending, which in turn led to severe liquidity constraints on
many financial institutions.
The contraction in the supply of short-term funds caused overnight interest
rates in Europe to shoot up, and the European Central Bank responded the same
day with the largest short-term liquidity injection in its nine-year history? 94.8
billion ($130 billion at the time) worth of overnight repos. The following day, as
these
overnight repurchase agreements expired,
the
operation
to renew them was
two-thirds the size?a still very large 61.1 billion. Meanwhile, the Open Market
Trading Desk of the Federal Reserve Bank of New York used one-day repurchase
agreements to inject $24 billion in reserves into the U.S. banking system on
Thursday; and when those expired on Friday, the desk upped the amount to $38
billion for theweekend.
Symptoms of the turmoil in financial markets that began inAugust 2007 are
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58 Journal ofEconomie Perspectives
Figure 1
Spread between 3-month LIBOR and 3-month Expected Federal Funds Rate,
January 2007 toMay 2008, Daily
120
100H
80
2
c
"o
CL 60
40
20
?-v*^?!
?i?i?i?i?r? ?i?i?i?i?i?i?i?i?i?r
? >^ >^ &^ ?L S0 // /d /^ v^
*> ??> ^ ?> ??> <?> o> o> o> o>
*>0> ->0>
u6> "?* U<9 "*
Source: LIBOR data are from the British Bankers' Association
(www.bba.org.uk). The expected federal
funds rate data are from Exhibit 2.10 of Greenlaw, Hatzius, Kashyap, and Shin (2008). Note that because
the LIBOR rate isdetermined at 11a.m. U.K. time, which is 5 a.m. Eastern U.S. time, I plot the expected
federal funds rate on date tminus LIBOR at t
?
1.This avoids spurious spikes thatwould occur on dates
when the Federal Open Market Committee made unexpected, inter-meeting changes in the target
federal funds rate.
evident in a variety of places. One place to look is the interbank lending market.
U.S. commercial bank borrowing exceeds $2 trillion. To remain flexible in adjust
ing the size and composition of assets they hold, banks tend to keep most of this
short term. As a result, if banks
suddenly
become
unwilling
to lend, problems
arise.
Distress in thismarket is evident from the behavior of the London Inter-Bank
Offered Rate. LIBOR is the benchmark rate on interbank lending set by a group of
16
large
banks each
morning.
It is a
key
interest rate used to
price
various consumer
and business loans, including
various kinds of mortgages.
LIBOR can be compared to the federal funds market because both involve
uncollateralized loans. Figure 1 plots the difference between the three-month
fixed-rate LIBOR and the expected interest rate thatwould accrue from repeatedly
rolling
over a loan at the
overnight
federal funds rate for three months (known as
an Overnight Indexed Swap or "OIS"). The divergence between these two rates is
typically less than 10 basis points. This small gap arises from an arbitrage that allows
a bank to borrow at LIBOR, lend for three months, and hedge the risk that the
overnight rate will move in the federal funds futuresmarket, leaving only a small
residual level of credit and liquidity risk that accounts for the usually small spread.
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Crisis and Responses: The Federal Reserve in theEarly Stages of theFinancial Crisis 59
Figure 2
Spread between U.S. Agency and Treasury Securities, January 2007 toMay 2008, Daily
100 -i
i di
Source: Citigroup, Inc.
Note: Based on averages across a broad spectrum of available maturities of large, liquid, issues of
government-sponsored enterprise and agency debt.
But on August 9, 2007, the difference between these two interest rates jumped to
40 basis points. The "LIBOR spread" then fluctuated between 25 and 106 basis
points through fall 2007.2
A second symptom of the financial crisis comes from looking at the average
difference between U.S. government agency securities?those issued
by
Fannie
Mae, Freddie Mac, and the like?and U.S.
Treasury
securities of
equivalent
matu
rityplotted in Figure 2. Normally the securities from government agencies are
viewed as only very slightlymore risky and less liquid than Treasury issues them
selves. But again, starting inAugust 2007, the gap doubled from its typical range of
15 to 25 basis points tomore than 40 basis points. As the crisis intensified through
the fall and winter, the so-called "agency spread" exploded tomore than 90 basis
points in March 2008. The change represented a
"flight to quality," in which
2
This arbitrage is imperfect for an
important reason that could explain at least a part of the increased
spread. The problem is that the federal funds futures market allows a
potential lender to hedge
movements inwhat is known as the "effective" federal funds rate?that is, the quantity-weighted average
of transactions in the overnight interbank lending market during the day. A bank cannot, however,
guarantee that itwill be able to borrow at the effective rate.
Importantly, since August 9, 2007 the
intra-day volatility of the federal funds rate has risen by
a factor of four?from 5 to 20 basis points. As
a result, the risk of financing
a three-month loan by borrowing overnight for three months rose
substantially, suggesting that this "term spread" would rise as well.
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60 Journal ofEconomie Perspectives
investors and financial institutions shunned
everything
but U.S.
Treasury
securities
themselves.
In both of these examples?the LIBOR spread and the U.S. government
agency spread?the
relevant market threatened to become almost
functionally
illiquid. The banks that participate inwhat is called "fixing" the LIBOR rate have
no
obligation
to borrow or lend at those rates. No data exists on the
quantity
of
interbank lending, but anecdotal evidence strongly suggests that few loans were
actually occurring
at these rates.
Similarly,
the market for securities of U.S. gov
ernment agencies threatened to become illiquid.
In one market, the market for commercial paper, data on both
prices
and
quantities
are available. Figure 3 plots the behavior of 30-day commercial paper
interest rates and quantities outstanding beginning inJune 2007. Panel A compares
the evolution of the rate on
high-grade, AA-rated, nonfinancial commercial paper,
issued by large corporations like General Electric and Coca Cola, with that of
asset-backed commercial paper (often abbreviated as "ABCP"). Asset-backed com
mercial paper is issued by firms that hold things like the securities backed by
mortgage pools
as assets?and thus the risk
premium
on asset-backed commercial
paper
can
give
us a sense of beliefs about losses that may
occur in real estate
markets. By June and July 2007, asset-backed commercial paper was commanding
a
premium
of 5 basis
points.
In
mid-August 2007, the
premium
on asset-backed
commercial paper had risen to 86 basis points, and in early December 2007, it
peaked atmore than 150 basis points.
In terms of
quantities,
the amount of commercial paper grew
at a
nearly
10 per
cent average annual rate from 2002 to 2007, reaching $2.2 trillion at the startof the
crisis.Asset-backed commercial paper accounted formore than half of this total in
August 2007, peaking at nearly $1.2 trillion.On any given day,more than two-thirdsof
all outstanding commercial paper has a maturity of five business days or less. Starting
inmid-August, borrowers had trouble rolling over maturing issues. The quantity of
commercial paper outstanding dropped precipitously, falling by nearly $300 billion in
thefirst twomonths of the crisis and by a totalof $400 billion by the end of 2007. Panel
B of Figure 3 shows that the decline isentirely accounted forby the fall in asset-backed
commercial paper outstanding. To guard against short-term illiquidity of specific
institutions, issuers of commercial paper typicallyhave available to them backup lines
of creditwith banks. During the lastfivemonths of 2007, total commercial bank credit
extended rose by $575 billion (according to the Federal Reserve Board's H8 statistical
release, page 2, line 5), more than offsetting the fall in commercial paper, as issuers
called upon these bank credit lines.
Finally, themarket for repurchase agreements also exhibited symptoms of the
financial crisis. Large financial institutions that hold various types of assets use
repos
to finance their short-term
liquidity
needs?and those needs have grown
astronomically.
For the 19 investment banks that serve as
primary dealers, repos
outstanding rose by a factor of four over the last decade, reaching $4 trillion at the
dawn of the crisis inAugust of 2007. As the crisismoved into early 2008, this repo
market
began experiencing
severe
disruptions.
The
overnight
rate on
Treasury
securities plotted in Figure 4 illustrates the change. This interest rate iswhat a
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Stephen G. Cecchetti 61
3
Commercial Paper, June 2007 toMay 2008
A: 30-Day Interest Rates
6.5n
5.5
5
4.5
4
3.5
3
2.5
2
1.5
AA nonfmancial commercial paper
AA asset-backed commercial paper
'K-v^rvN
tf tf tf > > 6> cP & 3 Sn Sn /> /> /> A A A A. v> v> c? c? A A ^ ^
?> o> 0> 0> 0> o> 0> 0>
o^0^f^^^0f-0f-0>o& o& o& o& o& o& o& o& o& o&
B: Quantities Outstanding
2250
h-~-'"
2000 J
1750
o
S 1500
PQ
1250
1000
750
\ _
?
Total commercial paper
?
Asset-backed commercial paper
^
^ <*
<*
Source: Board of Governors of the Federal Reserve System, (www.federalreserve.gov/releases/cp/).
Note: Interest rate data are
daily, and quantity data are
weekly. The data are not seasonally adjusted.
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62 Journal ofEconomie Perspectives
Figure 4
Overnight Treasury Securities Repo Rate
-Overnight repo rate
-Target federal funds rate
Source: Federal Reserve Bank of New York.
borrower has to
pay for an
overnight
loan collateralized
by
a U.S.
Treasury security.
Because a repo is collateralized and a federal funds loan is not, the repo rate is
normally between 5 and 10 basis points below the federal funds interest rate. But
at the end of February 2008, with the federal funds rate target at 3 percent, the
Treasury repo rate fell to 1.95 percent?a difference of 105 basis points. On March
19, 2008, investors and financial institutions became so desperate toget theirhands
on U.S. Treasury securities that theywere willing to hold them with virtually no
compensation
at all, and the repo
rate fell to 0.20 percent.
These pieces of evidence suggest a chronology: Starting in early August 2007,
fear led to hoarding of cash and a broad increase in risk premia. Matters then
seemed to improve from late September until the end of November, when it
became clear that financial institutions were
experiencing large
losses. A
compila
tion of these losses from news reports in late 2007 suggested that commercial and
investment bank losses in the
subprime mortgage market had
surpassed
a com
bined total of $150 billion, while estimates several months later exceeded $400
billion (Greenlaw, Hatzius, Kashyap, and Shin, 2008). Risk spreads widened again
in December 2007 and continued to deteriorate with investors' and institutions'
continued flight to safe securities into the winter of 2008.
Why did the interbank lending market dry up? There are twopossible explana
tions for theunwillingness to lend.One is that lenders perceived a substantial increase
in credit risk?that is, an increased risk that more borrowers will default. The alter
native is that banks that normally would have been willing to lend faced a combi
nation of uncertainties and constraints related to the size of their own balance
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Crisis and Responses: The Federal Reserve in theEarly Stages of theFinancial Crisis 63
sheets. This concern could have arisen from fears about both
involuntary lending
that banks might be forced tomake because of prior commitments on credit lines,
and fears of the declines in the value of assets that the banks were holding.
It isdifficult to gauge the relative importance of these explanations. However,
evidence in both McAndrews, Sarkar, and Wang (forthcoming) and Bank of
England (2008) suggest that, through the end of 2007, funding problems associ
ated with concerns over bank
capital
were the dominant concern, but that
starting
in
early 2008 concerns over borrower creditworthiness were the cause of the
continued high risk premia.
Consistent with this conclusion is that, through fall 2007, banks increased
credit extensions dramatically?from August 8 toDecember 26, 2007, bank credit
rose $544 billion, or more than 6 percent. After that time, bank credit outstanding
increased only $60 billion over the firsteight weeks of 2008. Although we only have
anecdotal evidence to back this up, it is plausible that the burst of lending in the
fall of 2007 was associated with lines of credit that banks had extended as insurance
to the entities that had been issuing asset-backed commercial paper but who were
not able to issue such paper because of a lack of buyers afterAugust 9.
Added to the pattern of bank lending is the fact that by mid-2007, severe
difficulties were arising in valuing a broad array of complex securities. Subprime
mortgages had been combined into broader securities and then carved up into
complex financial products. Investors had relied on the ratings agencies such as
Moody's and Standard and Poor's to certify that parts of resulting asset pools had
lower or higher risks. However, starting in fall 2007, rating agencies steadily
downgraded
their views on the credit
quality
of these instruments. For
example,
on
January 30, 2008, Standard and Poor's issued a
single report in which it down
graded over 8,000 securities backed by assets of various kinds (at (http://
www2.standardandpoors.com/spf/pdf/media/subprime_action_rmbs_cdo.pdf)).
This pattern of uncertain and diminishing values is characteristic of a financial
crisis, and it has
important consequences. Bankers that do not know the value of their
own balance sheets are also unsure of their
lending capacity.
In addition, increased
volatility
in markets drove up conventional measures of risk, forcing
banks to move
toward less
risky
assets and to contract the overall size of their balance sheets.
As the financial crisis progressed intowinter and spring 2008, previous lending
commitments must have eventually exhausted their limited lifetimes, hence the
drop in bank credit growth. In addition, problems with asset valuations must have
been to some extent resolved?or at least were
coming
into clearer focus. Thus, at
some point, the overriding consideration in the refusal of banks to lend to one
another must have become the concern over credit risk?that is, the risk that
borrowers would fail to
repay.
Federal Reserve Interventions
Under the Federal Reserve Act (section 2A, at (http://www.federalreserve.
gov/Generallnfo/fract/)), "The Board ofGovernors of the Federal Reserve System
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64 Journal ofEconomie Perspectives
and the Federal Open Market Committee shall maintain long run growth of the
monetary and credit aggregates
commensurate with the
economy's long
run
po
tential to increase
production,
so as to
promote effectively
the
goals
of maximum
employment,
stable
prices,
and moderate
long-term
interest rates." What tools did
Federal Reserve policymakers have to "maintain long run growth of themonetary
and credit aggregates" starting in fall 2007? Is there anything that the Fed can do to
bring theLIBOR spread down or tohelp provide banks with financing atmaturities of
roughly threemonths? Can officials prevent liquidity constraints from causing asset
sales that furtherdepress prices and cause the crisis to broaden and deepen?
Table 2 divides the policy actions taken by the Fed between August 9, 2007, and
May 2, 2008, into two groups: those that fit the conventional textbook definitions
of aggressive monetary policy and those that do not. The firstgroup, listed in the
top panel of the table, is comprised of the seven cuts in the target federal funds rate
totaling 3V4 percentage points. Each of these comes with a cut in the primary
(discount) lending rate.
It would seem that the standard monetary tools?the cut in the cost of discount
borrowing and the increase in the term of the loans announced on August 17, 2007,
followed by cuts in the federal funds rate target starting inmid-September 2007?
should have addressed the problem. After all, offering discount loans of up to 30
days at an interest rate only 50 basis points above the federal funds target should
have given banks access to the liquidity they needed to carry on their day-to-day
operations. Lowering the federal funds rate should help banks profit from their
"maturity
transformation" business of
issuing
short-term liabilities and
making
longer-term
loans.
While these steps may have aided banks a bit, there was no return to
normalcy. Moreover, the problems of risk and credit shortage?as illustrated by
the
rising spread
between U.S. agency and
Treasury
securities in
Figure 2?wors
ened through late fall 2007 and early winter 2008. Thus, Fed officials began a
series of less conventional actions that are not in the current textbook
descrip
tions of monetary policy (although they will presumably be in future text
books!). These actions include reducing the premium on
primary (discount)
lending from 100 to 50 and then to 25 basis points above the federal funds rate
target, as well as an increase in the term of the lending from overnight to 30 and
then 90 days; the creation and then enlargement of the Term Auction Facility
(TAF) ; the extension of $24 billion in credit to the European Central Bank and the
Swiss National Bank, eventually raised to $62 billion; the change in the pre-existing
securities lending program to initiate theTerm Securities Lending Facility (TSLF) ;
extension of credit to primary dealers through the newly created Primary Dealer
Credit Facility (PDCF) ;and the authorization of lending to support theJPMorgan
Chase
purchase
of Bear Steams. To
appreciate
how each of these
policies works, we
need to link each one to the Fed's balance sheet and toolbox discussed earlier.
Term Auction Facility
By late 2007, itwas clear that the changes in the discount lending policy put in
place inmid-August were not working. Banks continued to be unwilling to borrow
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Stephen G. Cecchetti 65
Table 2
Major Federal Reserve Policy Actions, August 9, 2007 toMay 2, 2008
Conventional actions:
Simultaneous cuts in the target federal funds rate and primary lending rate
September 18 50 basis point cut at regularly scheduled FOMC meeting
October 31 25 basis point cut at regularly scheduled FOMC meeting
December 11 25 basis point
cut at regularly scheduled FOMC meeting
January 21 75 basis point cut at an unscheduled FOMC meeting
January 30 50 basis point cut at regularly scheduled FOMC meeting
March 18 75 basis point cut at
regularly scheduled FOMC meeting
April 30 25 basis point cut at regularly scheduled FOMC meeting
Unconventional actions
Increase in the level of temporary open market operations
Cut in primary lending rate from 100 to 50 basis points above the federal funds
rate target; an increase in the term of discount lending from overnight to a
maximum of 30 days
Announced creation of the Term Auction Facility (TAF) and the swap lines
with the European Central Bank and the Swiss National Bank of $20 billion
and $4 billion, respectively.
First TAF auction: $20 billion, 98 bidders
Announced intention to conduct 28-day repos cumulating
to $100 billion.
Announced an increase in the size of the TAF from $60 billion to $100 billion
outstanding at any given time.
Announced creation of Term Securities Lending Facility (TSLF) and the
intention to lend $200 billion worth of Treasury Securities to primary
dealers. Increase in the swap lines with the European Central Bank and the
Swiss National Bank to $30 billion and $6 billion, respectively.
Announced approval of loan to Bear Steams through JPMorgan Chase.
Announced creation of Primary Dealer Credit Facility (PDCF); announced
approval of $30 billion loan to JPMorgan Chase for the purposes of
purchasing Bear Steams; cut in primary lending rate from 50 to 25 basis
points above the federal funds rate target; an increase in the term of
discount lending from a maximum of 30 days
to a maximum of 90 days.
Increase in the size of the TAF to $150 billion. Increase in the swap lines with
the European Central Bank and the Swiss National Bank to $50 billion and
$12 billion, respectively. Expansion in the collateral that can be pledged in
the TSLF to include AAA-rated asset-backed securities including student
loans, credit card debt, and auto loans, as well as securities backed by
residential and commercial mortgages.
Source: Board of Governors of the Federal Reserve System and Federal Reserve Bank of New York, various
press releases. The FMOC is the Federal Open Market Committee.
August 9
August 17
December 12
December 17
March 2
March 7
March 11
March 14
March 16
May 2
from the Fed. As a result, problems in the interbank funding market continued.
Figure 1 showed that, through fall 2007, the spread between three-month LIBOR
and the three-month expected
federal funds rate continued to rise.
As Federal Reserve officials searched for alternative mechanisms to inject
funds into the banking system, they found themselves reconsidering some proce
dures firstdiscussed in 2001. During 1999 and 2000, the annual federal budget was
operating in surplus, reducing the quantity of Treasury securities outstanding.
Long-term forecasts at the time suggested that the level of government debt might
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66 Journal ofEconomie Perspectives
decline in a way that there would be an insufficient supply of federal government
securities to supply the assets of the Federal Reserve. Federal Reserve System staff
undertook a studyof possible alternative operating procedures. One of the suggestions
was to supply reserves through
an auction mechanism (Federal Reserve System Study
Group on Alternative Instruments for System Operations, 2002, Chapter 3). In
December, thisprocedure was implemented in the form of theTerm Auction Facility.
The idea behind theTerm Auction Facility was to remove the stigma associated
with discount borrowing and in thatway toget reserves tobanks thatneeded them.As
the name suggests, the TAF auctions funds for a certain term. Through it, the Fed
started lending reserves in substantial quantities for relatively long periods?initially
$20 or $30 billion, then $50 billion, and then $75 billion per auction for termsof 28 or
35 days. Importantly, as the Fed increased lending, it reduced itsoutright securities
holdings in equal measure, leaving the total size of the Fed balance sheet unaffected.
Here ishow theTerm Auction Facility works: Any of themore than 7,000-plus
commercial banks in the country
can bid in the auction, stating
what interest rate
itwill pay forwhat quantity of funds. The minimum bid rate isdetermined by the
expected
federal funds rate in the market over the term of the auction. An
individual bank's bid cannot exceed 50 percent of the value of the collateral that
it has available for discount window borrowing. A bank receiving funds cannot
prepay, so ifthe loan turns out tobe expensive because interest rates fall during the
term of the loan, the borrower is stuck with it (for a
description, see (http://
www.newyorkfed.org/markets/Understanding_Fed_Lending.html)).
The procedures of the Term Auction Facility?including the choice of a
uniform- or
single-price auction, the restriction that no bidder can be allocated
more than 10 percent of the total being auctioned, and the fact that settlement
occurs two
days
after the date of the
auction?helps
to ensure
anonymity
for the
banks and that the bidders will not be branded as being in desperate need of
immediate funds (Armantier, Kreiger, and McAndrews, 2008). As a result, banks
have been willing tomake use of the auction in a way theyhave refused to do with
themore traditional "discount window" or primary credit facility.
Starting in December 2007, the auctions were held twice a month, with total
reserves supplied rising to $150 billion by the beginning ofMay 2008. Between 52 and
93 banks participated in thefirstdozen auctions and the totalquantity bid was just less
than twice the totalquantity of funds offered.With only a few exceptions, the interest
rate
paid
was near or below the
expected primary lending rate.3
There is some evidence that theTerm Auction Facility helped at first to reduce
the spread shown in Figure 1. The Term Auction Facility started its auctions in
mid-December. Figure 1 shows that the difference between the three-month
3
The Federal Reserve's weekly balance reports Term Auction Facility lending separately by Federal
Reserve District. Roughly two-thirds of the loans are
going to banks in theNew York district, the location
of most U.S. subsidiaries of foreign banks. This outcome isat least consistent with the possibility that the
Term Auction Facility loans are
going primarily to European banks. See the line labeled "Term Auction
Credit" in Table 3 of the H.4.1 weekly release.
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Crisis and Responses: The Federal Reserve in theEarly Stages of theFinancial Crisis 67
LIBOR and the three-month Treasury bill rate declines sharply from early Decem
ber 2007 until mid-February 2008.
Itmay seem surprising that the Term Auction Facility would succeed, because
all the auctions do is change the composition of the Fed's assets leaving the quantity
unaffected. Specifically, the Term Auction Facility involves a shift from securities,
held either
outright
or in
repurchase agreements,
to loans. Such a shift carries no
implication at all for the federal funds target rate.A widespread belief, built on past
experiences, has been that changes in the composition of the Fed's assets have little
or no real effect.4 For example, during the early 1960s, the Fed attempted to reduce
the gap between short-term and long-term interest rates (that is, flatten the yield
curve) by selling short-term Treasury bills and buying long-term Treasury bonds in
what came to be called "Operation Twist." As Volcker (2002) discusses, this seemed
to have little or no effect. Sterilized foreign exchange intervention, whereby the
central bank sells securities denominated in one
currency and
buys
securities in
another?something theUnited States has not done since September 22, 2000?is
another example of a policy where there is a broad consensus that such portfolio
shifts in and of themselves have little or no effect.
But during fall 2007, central banks became aware of something
on which they
had not previously focused. While well-established mechanisms existed for injecting
reserves into a
country's
financial system, officials had no
way
to
guarantee that the
reserveswould reach the banks thatneeded them. In theUnited States, standard open
market operations can put reserves into the hands of 19 primary dealers?but this
does not mean that the funds will then be distributed across the banking system.
The problem turns out to be particularly acute when the banks that are short dollar
reserves are not American banks. This insight provided the rationale for the foreign
exchange swaps inwhich the Fed supplied the European Central Bank and Swiss
National Bank with dollars, which those two central banks went on to auction to
their banks. Thus, perhaps the Term Auction Facility operated to reduce the
difficulties of specific institutions thatwere
having particularly acute problems.
But theTerm Auction Facility does more thanmerely distribute funding to the
banks that need it.The rules of the Term Auction Facility allow banks to pledge
collateral thatmight otherwise have littlemarket value. Under the rules of the
auctions, TAF loans must be over-collateralized
by
at least a factor of two, but in
reality the Fed is taking collateral at a
price that is almost surely above its actual
market price (Tett, 2008). The result is two-fold. First, liquidity reaches places
where itwasn't going on its own, which helps to address potential liquidity con
straints on individual institutions; and second, banks gain the time they need to
value the assets theyhave. This action has a fiscal policy flavor, as ithas the potential
to provide a capital subsidy to borrowing banks.
Recalling that the officials implemented the Term Auction Facility in the
4
Taylor and Williams (2008) argue that the Term Auction Facility has been ineffective as
they find no
impact
on the LIBOR-expected federal funds rate spread on the day of banks' bid for funds in the
auction. By contrast, McAndrews, Sarkar, and Wang (forthcoming) suggest that there was an
impact, but
itwas on the day of the auction announcement.
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68 Journal ofEconomie Perspectives
hopes of reducing the gap between the three-month LIBOR and the three-month
expected federal funds rate, we can see from Figure 1 that ithad a limited impact.
After the spread fell from over 100 basis points in early December 2007 to less than
30 basis points in late January 2008, stress increased again in February 2008. By
March 2008, this spread once again exceeded 70 basis points. The Federal Reserve
then increased the size of the Term Auction Fund, but as of spring 2009, this
particular spread
remained elevated.
Term Securities Lending Facility
In winter 2008, a simmering problem hit the financial system with full
force: U.S.
Treasury
securities of all varieties became
extremely
scarce. The
primary symptom of this is the dramatic decline in the interest rate on
repurchase agreements
collateralized
by
U.S.
Treasury securities
plotted
in
Figure 4. As noted earlier, inmid-March 2008 this rate fell to 0.20 percentage
points. Investors were willing to hold U.S. Treasury securities with virtually no
compensation.
In response to this extreme flight to quality, the Federal Reserve showed its
capacity for innovation yet again by creating the Term Securities Lending Facility
(TSLF). For several decades, going back to 1969, the Fed has lent Treasury
securities to primary dealers on an overnight basis (Fleming and Garbade, 2007).
This
lending
seeks to reduce the number of failed securities transactions.
Treasury
dealers routinely sell and promise to deliver securities that they do not own,
counting on their ability to procure the rightTreasury bill, note, or bond in time
to
complete
the transaction. Sometimes
they miscalculate. However, when a
pri
mary dealer is unable to obtain the specific issue ithas promised to deliver, that
dealer can go to the Fed in the early afternoon and borrow what itneeds. There is
a small fee, and the borrower is
expected
to return the
security
the next
day.
Since the Fed holds some of nearly every Treasury issue, it can lend whatever is
needed, thereby ensuring thatmarkets function smoothly. In February 2008, for
example, the Federal Reserve held 210 of the 238 distinct Treasury issues
outstanding (exact Fed holdings are available at
(http://www.ny.frb.org/markets/
soma/sysopen_accholdings.html)).
The Term Securities Lending Facility takes this existing lending program
and transforms it in three ways. First, while the traditional program lends
overnight,
the new one
provides
securities for 28 days. Second, the Term
Securities Lending Facility dramatically broadens the collateral accepted. Until
March 2008, lending meant swapping one Treasury security for another. By
contrast, the Term Securities Lending Facility explicitly allows dealers to obtain
Treasury securities in exchange for "AAA/Aaa-rated private-label residential
MBS [mortgage-backed securities] not on review for downgrade" (as announced
at
(http://www.ny.frb.org/newsevents/news/markets/2008/rp080311.html)).5
5
Broadening the allowable collateral beyond that accepted in standard open market operation required
that the Federal Reserve Board invoke Section 13(3) of the Federal Reserve Act, cited in the discussion
of Bear Steams below.
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Stephen G. Cecchetti 69
Finally, the Fed announced itswillingness to loan up to $200 billion through the
Term Securities Lending Facility.
Operationally, the Term Securities Lending Facility is an auction where
primary dealers bid forTreasury securities. Potential borrowers of the securities bid
the fee (the interest rate) they are willing to pay, with a minimum thatdepends on
the collateral acceptable in the auction. In the first auction on March 27, 2008, the
Federal Reserve offered $75 billion face value of securities, received $86.1 billion in
bids and the winning bid was 33 basis points. Thus, for 33 basis points, a dealer
could exchange a residential mortgage-backed security. In mid-March, the benefit
of this was obvious as the repo
rate on
Treasury's
was several hundred basis
points
below that on the mortgage-backed securities. The majority of the succeeding
weekly auctions have been undersubscribed, with the amount offered exceeding
the total quantity forwhich primary dealers are bidding. Fed officials view this as a
sign of success, because it signals that there is no longer a desperate demand for
Treasury
securities.
Like the Term Auction Facility, the securities lending program changes the
composition of the Fed's asset holdings without affecting their size.While this goal
isnot explicit, the Fed isessentially selling Treasury holdings and buying residential
mortgage-backed
securities. Like other
changes
in asset
composition,
this one is
directed at reducing the relative price of various securities. The Term Auction
Facility was aimed at the gap between term and overnight interbank lending rates;
the Term Securities Lending Facility is directed toward the premium paid to
hold U.S. Treasury
securities relative to
mortgage-backed
securities.
Fleming,
Hrung, Keane, and McAndrews (forthcoming) estimate, and Figure 3 confirms,
that the Term Securities Lending Facility was extremely effective in raising the
Treasury repo rate back to levels close to the federal funds rate immediately
upon implementation.
Bear Steams
On March 13, 2008, itbecame apparent that the investment bank Bear Steams
was on the verge of shutting down. A letter one week later, from Securities and
Exchange Commission Chairman Christopher Cox (2008) to Dr. Nout Wellink,
Chairman of the Basel Committee on Banking Supervision, reports that Bear
Stearns's "liquidity pool"?assets such as Treasury securities that can be quickly
converted to cash?had dropped from $18 billion to $2 billion from Monday to
Thursday.
The firm was unable to obtain short-term loans to continue
conducting
business. As Cox's letter
emphasizes,
in
mid-May
the firm continued to remain
solvent. Public disclosures in "10-Q filings" confirm this: twoweeks earlier, at end
of February 2008, Bear Steams had had roughly $12 billion in capital to support just
under $400 billion in assets (Bear Sterns, 2008).
The sudden bankruptcy of Bear Steams would almost surely have been cata
strophic. Again, public documents tell us that on
February 29, 2008, the firm had
$14.2 trillion of notional value in derivative contracts?futures, options, and
swaps?outstanding
with thousands of
counterparties. Clearly,
the firm was a
part
of a complex interconnected network of financial arrangements. If Bear Steams
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70 Journal ojEconomie Perspectives
had failed, itwould then need to sell itsassets into amarket that lacked the liquidity
to handle it, so prices for those securities could collapse in a way thatwould affect
the entire financial system.
Since Bear Steams was not a commercial bank, it had no way to use its
collateral to obtain liquidity from the Federal Reserve. While Fed officials did not
care about Bear Steams itself, their concern for system-wide financial stability led
them to invoke Article 13(3) of the Federal Reserve Act, which gives the Board of
Governors the power
to authorize Federal Reserve banks to make loans to
any
individual, partnership,
or corporation provided that the borrower is unable to
obtain credit from a banking institution.
On March 14, 2008, the Federal Reserve Bank of New York made a loan
directly to Bear Steams. Data released on March 20, 2008, combined with press
reports that the loan was repaid on March 17, imply that Bear borrowed approxi
mately $12.9 billion.
By anymeasure, this action was extraordinary. Not since the 1930s had the Fed
actually made a loan based on Article 13(3). Then, over the next weekend, central
bank officials brokered a deal inwhich JPMorgan Chase purchased Bear Steams for
a total of approximately $3 billion. Included in the deal is a loan from the Federal
Reserve Bank of New York.
The Fed's participation in the deal isdescribed in congressional testimony by
Federal Reserve Bank of New York President Timothy Geithner (2008, Annex III).
The basics are as follows: The Federal Reserve Bank ofNew York made a $29 billion
10-year loan at the primary lending (discount) rate to a newly formed limited
liability company created to hold $30 billion worth ofmortgage-backed securities
previously owned by Bear Steams. JPMorgan Chase put in $1 billion and assumed
the first loss. Unlike standard discount lending, where the Fed has recourse to go
after the entire borrowing bank's assets if the pledged collateral is insufficient to
cover the loan, here there is no recourse. This means that if the value of the assets
placed in thisnew company turn out tobe less than $29 billion, the Federal Reserve
would suffer a loss.
But the credit risk associated with this extraordinary loan clearly belongs to the
U.S. Treasury. A March 17, 2008, letter from Secretary of the Treasury Henry
Paulson to Geithner reads, in part, "that if any loss arises out of the special
facility
. . . the losswill be treated by the FRBNY as an expense thatmay reduce the
net earnings transferred by the FRBNY to theTreasury general fund." The standard
practice is thatFederal Reserve System revenue?including interest on its securities
portfolio,
net of
operating expense?is
turned over to the U.S.
Treasury. Thus, any
losses arising from the credit facility created to support the J.P. Morgan Chase
purchase of Bear Steams will reduce the amount of that transfer rather than the
level of the Fed's capital.
The subsidy implicit in the loan to Bear Steams is clearly a fiscal, not a
monetary, operation. The Federal Reserve iseffectively acting as the fiscal agent for
theTreasury. As an aside, note that actions inwhich the fiscal authority dictates how
the central bank holds its assets can run the risk of compromising central bank
independence
if
they
become a
regular
occurrence.
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Crisis and Responses: The Federal Reserve in theEarly Stages of theFinancial Crisis 71
There has been substantial criticism of the Bear Steams action. Reinhart
(2008) calls it a "bailout" and believes that ithas dealt a fatal blow to the Fed's
ability
to act as an honest broker in
encouraging private-sector
solutions to
prob
lems posed by failing institutions, as itdid in 1998 when confronting the failure of
Long Term Capital Management (Lowenstein, 2001). At first glance, this accusa
tion of a bailout may
seem
peculiar,
because Bear Stearns's shareholders and
employees took huge losses, and the price paid by JPMorgan Chase may well be
below Bear Stearns's net worth. Nevertheless, there is a
good argument that the
holders of Bear Stearns's bonds and other liabilities were in fact bailed out. A
disorderly collapse of the firm could verywell have left this group repaid with even
less. As a result, lenders may
now feel safe in
making
loans to other investment
banks, encouraging
the borrowers to take more risk than
they
should.
As for the Fed's ability tomarshal the private sector into cooperating when
circumstances demand, we will have to wait and see. What we can
say is that the
decision to extend the Fed's lending facility to investment banks is likely to lead to
increased regulation and supervision of entities in this business.
Primary Dealer Credit Facility
The evening of March 16, 2008, the Federal Reserve used itsArticle 13(3)
powers for a second time in three days to create the Primary Dealer Credit Facility.
The 19 primary dealers authorized to participate in daily open market operations
and the
Treasury
auctions are not banks.
They
are investment banks and brokers.
None of them have access to either traditional discount loans or the Term Auction
Fund. Starting inmid-March they could borrow from the Federal Reserve. Like
discount loans made to commercial banks, the Primary Dealer Credit Facility allows
borrowers to
pledge
a
relatively
broad set of collateral
including "investment-grade
corporate securities, municipal securities, mortgage-backed
securities and asset
backed securities for which a price is available" (see (http://www.ny.frb.org/
newsevents/news/markets/2008/rp080316.html)).
The Primary Dealer Credit Facility was immediately popular. For the first three
weeks of its existence, borrowing averaged over $30 billion per day, before gradu
ally declining to around $10 billion by the end ofMay 2008.
Lending directly to primary dealers serves two objectives: First, it ensures
short-term
funding
for investment banks. The
experience
with Bear Steams, which
sustained a sudden loss of short-term
funding
but looks to have remained solvent,
made Fed officials realize that lender-of-last resort
operations
needed to be ex
tended beyond commercial banks (although the full implications of thishave yet to
be worked out). Second, the Primary Dealer Credit Facility seeks to reduce interest
rate
spreads
between the asset-backed securities that can be used for collateral in
these loans and U.S. Treasury securities, thereby improving the ability of investors
to buy and sell asset-backed securities in financial markets. Since primary dealers
can now take a relatively broad set of bonds to the Fed and obtain immediate cash,
these securities should be more
readily acceptable
as collateral in
private borrowing
arrangements. If thisworks, all the Fed should have to do isannounce the program;
it should not have to make many, if any, loans.
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72 Journal ofEconomie Perspectives
Looking back at Figure 2, notice that the gap between the interest rate on
government agency and U.S. Treasury securities fell immediately on March 17,
2008, with the creation of the Primary Dealer Credit Facility and continued to
decline, although much more modestly, as the Term Securities Lending Facility
began operation. By the end ofMay 2008, the spread on government agency debt
(normally 15 to 25 basis points above the Treasury rate) was still 50 basis points?
not great, but better than the spread of 90 basis points inmid-March. There are
several reasons the spread could have fallen at this time. It also could have been
because of the reduction in Fannie Mae's and Freddie Mac's capital requirements
announced on March 19 or Goldman Sachs' and Lehman Brothers' release of their
quarterly earnings on March 18, 2008. But the new Federal Reserve programs
probably played
a role, too.
The Evolution of the Federal Reserve's Balance Sheet
To understand the comprehensive impact of all of these changes in Fed
operations,
we return to the balance sheet. Table 3 shows the evolution of Fed
assets over the nine months from July 2007 toMay 2008; and the changes are
enormous.6 Because the liabilities of the Federal Reserve have not changed in any
material way, they
are omitted from this table.
Before the crisis, the Fed held nearly $800 billion in securities outright. By the
end ofMay 2008, that had fallen to almost $500 billion, ofwhich roughly one-fifth
was committed to the Term Securities Lending Facility. Repurchase agreements
used to be around $30 billion; by spring 2008, they exceeded $100 billion. Prior to
December 2007, loans were inconsequential. Nine months into the crisis, the Fed
was lending over $170 billion through a variety ofmechanisms. Interestingly, from
the beginning ofApril, with the discount rate penalty cut to 25 basis points above
the federal funds rate target, discount borrowing skyrocketed, reaching $19 billion
by the end ofMay 2008. All thewhile, the size of the Federal Reserve balance sheet
hardly changed, rising
at the end of the year
to accommodate seasonal demand for
currency, but then falling back. Everything Federal Reserve policymakers had done
was aimed at changing the composition of assets they held, not the size of their
balance sheet.
Conclusion
On August 9, 2007, the global financial system started to crack. Financial
institutions everywhere were forced to confront the reality that their substantial
holdings ofmortgage-backed securities were worth less than they thought and had
6
Aid to commercial banks does not end with the changes in Federal Reserve practice. The little-known
Federal Home Loan Banks have been another source of funding. During second half of 2007, these
government-sponsored enterprises provided commercial banks with roughly $230 billion in loans. These
loans are for longer
terms than the discount window, are
cheaper than discount loans even at a
penalty
spread of 25 basis points, and allowed for a broad range of mortgage-based collateral.
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Stephen G. Cecchetti 73
Table 3
Federal Reserve Assets on Various Dates
(in billions ofdollars)
July 4, 2007 Jan 2, 2008 Mar 19, 2008 May 28, 2008
Securities
Held outright
Uncommitted $790.6 $740.6 $660.5 $384.8
Committed to TSLF $106.3
Repurchaseagreements $30.3 $56.3 $62.0 $115.0
Loans
Primarycredit $0.19 $4.9 $0.12 $19.0
Term auctioncredit $40.0 $80.0 $150.0
Primary dealer credit $28.8 $10.1
Foreignexchange reserves $20.8 $27.3 $27.3 $25.2
Foreignexchange swaps $24.0 $62.0
Gold $11.0 $11.0 $11.0 $11.0
Other assets $27.5 $21.6 $21.0 $22.4
Total assets $880.4 $925.7 $890.7 $905.8
Source: Board of Governors of the Federal Reserve System, Release H.4.1, various dates.
Note: "TSLF" isTerm Securities Lending Facility.
become very difficult to value. Banks' uncertainty about both their own level of
capital and their ability to borrow made them unwilling to lend. Some financial
intermediaries began to have trouble finding the short-term financing that was
essential for them to carry on their daily business.
Central bank policymakers worked to respond appropriately. Traditional
interest rate instruments proved to be ineffective, so Fed officials innovated in a
number of ways. By lending both cash and securities based on collateral of ques
tionable value, the Fed tried to bring order back to financial markets. The amounts
involved are massive. By the end of May 2008, the Fed had committed nearly
two-thirds of its$900 billion balance sheet to these new programs: $150 billion to
theTerm Auction Facility; $100 billion (of the $115 billion total) to 28-day repo of
mortgage-backed securities; a maximum of $200 billion to the Term Securities
Lending Facility (ofwhich $106.3 billion were
outstanding); $62 billion to foreign
exchange swaps; $29 billion to a loan to support the sale of Bear Steams (to be
made at the end ofJune 2008); and a
potentially unlimited amount to the Primary
Dealer Credit Facility.
Was itprudent for the Federal Reserve to refashion itspolicy tools in thisway?
The amount committed by the Federal Reserve has been so large that it isnatural
towonder what would happen if the Fed were to run out of capacity to engage in
transactions that change asset composition without changing the federal funds rate
target. Does the size of the Fed's balance sheet pose
a constraint on the amount of
lending it can do? Ip (2008) reports that Fed officials were concerned about this
possibility and have examined several mechanisms to increase lending capacity
should the Fed need it.The simplest approach is to have theTreasury increase the
size of itsdeposit account, with the Fed then using the proceeds as they see fit.
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74 Journal ofEconomie Perspectives
There is also the possibility that, even without further legislation, the Federal
Reserve could issue its own debt.
The financial crisis of 2007-2008 raises a number of substantial and difficult
questions: What should policymakers do when prices of leveraged assets boom?
How should central banks respond to declines in the price of riskyassets and the
associated increase in riskpremia? Should monetary policymakers react to illiquid
ity in themarket for specific assets, and if so, how? When a
highly leveraged and
complex
financial institution
experiences losses, what is the central bank's respon
sibility? Should a central bank take on credit risk in its lending operations, or
should this function belong to the U.S. Treasury? Perhaps with experience and
research, the answers to these
questions
will become clear. Once the crisis is
safely
past,
we
might
want to reassess the role of the central bank. But in the financial
crisis of 2007-2008, the Federal Reserve was the only official body that could act
quickly and powerfully enough to make a difference. Given the very real and
immediate dangers posed by the financial crisis that began inAugust 2007, it is
difficult to fault the Federal Reserve for its creative and aggressive responses.
Among thevast number ofpeople I spokewith inpreparing thisessay,I wish especially to
thankDavid Archer, Peter Fisher, Michael Fleming, Jens Hilscher, Spence Hilton, Anil
Kashyap, JamieMcAndrews, Kim Schoenholtz,Andrei Shleifer,JeremyStein, TimothyTaylor,
and Paul Tucker
for
their
insights
and comments. An earlier version
of
this essay
was
presented as theEdgeworth Lecture at the 2008 Annual Meeting of theIrish Economic
Association.
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