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Federal Reserve documents 29 page

 

 

LIKE MOST EARLIER CRISES, the panic of 2007–2009 followed a credit boom, in this case concentrated in mortgages made to borrowers with lower credit scores but showing up in other areas, such as commercial real estate, as well. Also like earlier crises, the panic began with identifiable triggers, such as the BNP Paribas announcement in August 2007 that investors would not be allowed to withdraw their money from three of its funds. This announcement and others contributed to investors’ growing realization that subprime mortgages, and the structured credit products that bundled them, could suffer significant losses in spite of high credit ratings.

The defining characteristic of a panic is a widespread run on financial firms. The introduction of federal deposit insurance in 1934 had supposedly eliminated the possibility of bank runs. But that did not take into account the evolution of the market for short-term funding in the years before the crisis, particularly the growth in wholesale funding such as repo agreements and commercial paper.

 

The search by firms and institutional investors for better ways to manage their cash holdings fueled the growth of wholesale funding. Someone with extra cash to lend can always deposit it in a bank, but deposit insurance (limited, before the crisis, to $100,000 per account) afforded little protection to holders of much larger amounts of cash. Corporations, pension funds, money market funds, insurance companies, and securities dealers looked for alternatives to bank deposits. Both commercial paper and repo agreements were widely viewed as safer and more convenient than uninsured bank deposits.

 

Meanwhile, interest in wholesale funding on the other side of the market—firms looking to borrow cash—was also growing. Banks found wholesale funding a cheap and flexible (and less tightly regulated) supplement to ordinary deposits. The nonbank financial institutions at the core of the shadow banking system (such as investment banks, securities dealers, and structured investment vehicles) could not accept insured deposits. They depended heavily on wholesale funding. They used it to finance holdings that included longer-term, illiquid securities. By the eve of the crisis, the financial system’s reliance on


wholesale funding exceeded its use of insured deposits. At the end of 2006, insured deposits totaled $4.1 trillion, while financial institutions’ wholesale funding amounted to $5.6 trillion, including repos of $3.8 trillion and commercial paper of $1.8 trillion. In addition, banks held uninsured deposits (including foreign deposits and large certificates of deposit) of $3.7 trillion.

Because much wholesale funding—including asset-backed commercial paper and repos—was directly or indirectly collateralized, firms and regulators saw little risk of runs. But collateral reassures lenders only if it is known to be of good quality and can be easily sold. Treasury securities, which carry no credit risk and are traded in a deep and liquid market, are ideal collateral. But wholesale funding grew more rapidly than the available supply of Treasuries and other high-quality collateral. At the same time, high-quality securities were greatly prized by global investors seeking security and liquidity, including foreign central banks and sovereign wealth funds. The result was a shortage of safe, liquid assets.



 

In response, Wall Street firms, seeing a profit opportunity, employed financial engineers to convert riskier and less liquid assets into seemingly safe assets in large quantities. To do so, they packaged loans and securities of varying credit quality, then sliced the packages into lower- and higher-quality components. The higher-quality tranches carried AAA credit ratings, bestowed by rating agencies that were paid by the securities issuers and that often consulted with the issuers on the securities’ design. These structured credit products provided both new collateral and seemingly attractive assets for investors around the world, including many financial institutions, looking for higher-yielding but also highly rated securities.

But, while structured credit products seemed for a time to meet the heavy demand for safe assets, they had a critical defect: The cash flows they gave investors depended in complicated ways on the performance of hundreds or thousands of varied loans or securities. This complexity reduced the ability of investors to independently judge the structured products’ quality. Some potential purchasers insisted on more information and greater transparency, but most took the easy way and relied instead on the credit ratings. When AAA-rated securities that contained subprime mortgages began to go bad, those investors did not have their own analysis to fall back on. Contagion reared its ugly head. Just as depositors in 1907 ran on any bank with a whiff of a connection to the bankrupt stock speculators, investors a century later pulled back en masse from any structured credit product that might carry the subprime virus.

 

The most intense runs took place in the market for asset-backed commercial paper, which had shrunk rapidly after the BNP Paribas announcement in August 2007. In the repo market, runs did not always take the form of a complete refusal to lend. For example, repo lenders might demand more collateral for each dollar lent, refuse to accept certain types of securities as collateral, or be willing to lend only overnight instead of for longer periods. And, because repo lending is based on the current market value of the collateral, declines in asset values led immediately to declines in available repo funding. Overall, wholesale funding for all financial institutions fell from $5.6 trillion at the end of 2006 to $4.5 trillion by the end of 2008, with most of the decline coming at nonbank institutions.


The investment vehicles set up to hold complex structured securities, like Citigroup’s structured investment vehicles, were particularly hard hit by the run. Most were forced to seek assistance from the financial institutions that created them. Ultimately, the losses in off-balance-sheet vehicles would be almost entirely absorbed by their sponsors.

 

In addition to the run on wholesale funding, financial firms confronted other demands for cash. Banks that had offered credit lines to their institutional and corporate customers now saw those lines drawn to their limits. Counterparties to derivatives contracts demanded more collateral. Hedge funds and other institutional customers of investment firms closed their accounts, withdrawing cash and securities. Banks refused to lend to each other in the interbank market. In a panic, cash is king. Investors and firms try to maximize their holdings of short-term, safe, and liquid assets.

 

The funding crunch forced fire sales—particularly of the structured credit products that no one now wanted. The prices of those assets plummeted, forcing financial institutions to mark down the value of similar assets still on their books. As the panic progressed, illiquidity morphed into insolvency. The firms that were most thinly capitalized or had taken the greatest risks either failed or teetered on the brink of insolvency, increasing the fear in the markets.

 

The interconnectedness of the financial system also promoted contagion: The failure of Lehman directly touched off a run on money market funds because one of them, the Reserve Fund, had suffered significant losses on its holdings of Lehman’s commercial paper. Investors eventually refused to finance securities backed with assets completely unrelated to mortgages, like credit card debt, student loan debt, and government-insured small business credit—assets that they should have had no reason to fear, except for the contagion sweeping the markets.

The skyrocketing cost of unsecured bank-to-bank loans mirrored the course of the crisis (Figure 1). Usually, a bank borrowing from another bank will pay only a little more (between a fifth and a half of a percentage point) than the U.S. government, the safest of all borrowers, has to pay on short-term Treasury securities. The spread between the interest rate on short-term bank-to-bank lending and the interest rate on comparable Treasury securities (known as the TED spread) remained in the normal range until the summer of 2007, showing that general confidence in banks remained strong despite the bad news about subprime mortgages. However, the spread jumped to nearly 2-1/2 percentage points in mid-August 2007 as the first signs of panic roiled financial markets. It soared again in March 2008 (corresponding to the Bear Stearns rescue), declined modestly over the summer, then shot up when Lehman failed, topping out at more than 4-1/2 percentage points in mid-October 2008. As the government’s policy response took effect, the spread declined toward normal levels by mid-2009.


 

 

FIGURE 1: The Cost of Interbank Borrowing Soared During the Crisis


 

 

The line tracks the TED spread, a measure of distress in credit markets. It is the difference between the rate paid on three-month interbank loans as represented by the London Interbank Offered Rate (LIBOR) and the interest rate paid on three-month Treasury bills. The TED spread showed that credit risk increased sharply at key points in the crisis. Source: Federal Reserve Bank of St.

 

Louis

 

All this financial turmoil had direct consequences for Main Street America. The recession began in December 2007, a few months after the onset of the crisis. Even so, job losses (Figure 2) were relatively moderate until the panic accelerated in early fall 2008. Then the job market collapsed. During the last four months of 2008, 2.4 million jobs disappeared, and, during the first half of 2009, an additional 3.8 million were lost. Payrolls continued to decline through the rest of the year, but less precipitously.

 

 

FIGURE 2: The Job Market Collapsed After the Crisis Intensified


 

The bars show modest gains in U.S. payrolls through 2007, moderate declines as the Great Recession began, and then a very steep drop when the crisis intensified in September 2008. Job losses slowed as financial stability returned. Source: Bureau of Labor Statistics

 

 

Household consumption also tracked the course of the financial crisis. Adjusted for inflation, it was about flat in the first half of 2008. However, consumption fell by 2.9 percent (at an annual rate) in the third quarter of 2008, with the biggest decline in September, the month Lehman failed. As the crisis intensified, consumption dropped at a whopping 4.7 percent rate in the fourth quarter—the biggest quarterly drop since Jimmy Carter’s credit controls (intended as an inflation-fighting measure) caused a collapse in consumer spending in 1980. Consumption continued its decline, at about a 1.6 percent rate, in the first half of 2009. Capital investment by businesses fell even more sharply, with the largest declines coming in the fourth quarter of 2008 and the first quarter of 2009. In short, the close correspondence between the intensification of the financial crisis and the worsening of economic conditions offers strong evidence that the magnitude of the panic at the height of the crisis was the most important reason for the severity of the Great Recession. The experiences of many countries, as documented by academic studies (including my own work on the international experience during the Depression), demonstrates that serious financial crises are typically followed by deep and protracted downturns.

 

The conclusion that the financial panic deeply hurt the economy does not rule out other contributing causes to the recession. The unwinding housing bubble that preceded the panic certainly reduced residential construction and, by lowering the value of homeowners’ equity, depressed household wealth and spending. Indeed, the same historical and international evidence that links financial crises and ensuing economic slumps typically finds that those slumps are worse if the crisis is combined with a crash in real


estate prices.

 

Some economists, though, believe the collapse of the housing bubble alone can explain the depth and persistence of the recession, and that the subsequent financial crisis was mostly a sideshow. It’s more than an academic debate. Its resolution has strong implications for the choices we made in fighting the panic of 2007–2009 and for the decisions policymakers might make in the future. If the crisis truly was mostly a sideshow, then policymakers devoted too much of their effort and resources to stabilizing the financial system. Instead, according to this view, they should have focused almost exclusively on helping homeowners whose houses were worth less than their mortgages.

 

I agree that more should have been done to help homeowners, although devising effective policies to do that was more difficult than many appreciate. However, it seems implausible that the financial crisis had little to do with the recession. The timing alone argues against that hypothesis. The recession, which began in December 2007, followed the onset of the crisis in August 2007, and it became a truly deep recession only after the panic reached its peak, in September and October 2008. The plunge in fourth-quarter economic activity, at the peak of the panic, was the worst in a half century. The economic contraction ended in June 2009, shortly after the financial crisis calmed.

 

Moreover, the housing-only view takes as given the sharp decline in house prices over this period. Absent the financial crisis, it’s not clear that house prices would have fallen so far or fast. They flattened out in 2006 but did not decline much initially (Figure 3). When the crisis emerged, in August 2007, they were only about 4 percent lower than they had been at the beginning of 2006. Conceivably, if not for the panic, the housing bubble might have deflated more gradually, as Fed forecasters had anticipated.

 

But by the time Bear Stearns was sold to JPMorgan, in March 2008, house prices had fallen nearly 10 percent from their pre-crisis level, and by the collapse of Lehman they had fallen an additional 9 percent. From Lehman, in September 2008, to May 2009, house prices fell 11 percent further. They remained basically flat through 2011 before starting to recover. This pattern suggests that at least some of the speed and depth of the house price decline can be attributed to the crisis and its economic effects, including falling employment and income, tighter credit, and shattered confidence. Indeed, likely because of the crisis and the force of the recession, house prices seem to have overshot on the way down. (They rose more than 25 percent from May 2009 to early 2015.) In short, the financial crisis appears to have significantly accelerated and worsened the decline in house prices.


 

 

FIGURE 3: Home Prices Plummeted Only After the Crisis Began


 

The figure shows that home prices in 20 major U.S. cities fell only modestly from the start of 2006 until August 2007 when the crisis began. The decline accelerated through the crisis but prices stabilized in May 2009, as the crisis abated. Home prices rebounded beginning in early 2012. Source: S&P/Case-Shiller 20-City Composite Home Price Index, Seasonally Adjusted

 

 

It took time for the Fed to recognize the crisis and gauge its severity. In responding, we had to avoid other potential risks, from higher inflation to increased moral hazard in financial markets. As we gained greater clarity, our knowledge of past financial panics guided our diagnosis of the new crisis and influenced the treatments we applied. The Federal Reserve’s response had four main elements: lower interest rates to support the economy; emergency liquidity lending aimed at stabilizing the financial system; rescues (coordinated when possible with the Treasury and the FDIC) to prevent the disorderly failure of major financial institutions; and the stress-test disclosures of banks’ condition (undertaken in conjunction with the Treasury and other bank regulators).

 

In September 2007, once it seemed clear that Wall Street’s financial turmoil could threaten Main Street, we started cutting the target for the federal funds rate. We continued until we reduced the target to near zero and could go no further. From there, we would venture into uncharted waters by finding ways to push down longer-term interest rates, beginning with the announcement of large-scale purchases of mortgage-backed securities. The journey was nerve-racking, but most of my colleagues and I were determined not to repeat the blunder the Federal Reserve had committed in the 1930s when it refused to deploy its monetary tools to avoid the sharp deflation that substantially worsened the Great Depression.


Our emergency liquidity lending took many novel forms. When Congress created the Fed in 1913, it envisioned us lending to banks in a panic, thereby serving as lender of last resort. Changes in the financial system over the subsequent hundred years required us to counter a run by wholesale lenders and other short-term creditors, not depositors, and so to lend to a broad array of financial institutions, not just banks. Our efforts, often drawn from our blue-sky thinking, were widely seen as creative, even daring. But, in essence, we did what Congress had intended when it created the Federal Reserve, what Walter Bagehot had advised a century and a half earlier, and what central banks had always done in the midst of panics. When financial institutions lose their funding, central banks replace it by lending against collateral, thereby reducing the pressure to dump assets at fire sale prices. Bagehot never heard of an asset-backed security or a repurchase agreement, but I think he would have understood the principles we applied to damp contagion.

 

Bagehot probably had not considered the possibility that a central bank would serve as lender of last resort beyond the borders of its own country. But the global role of the dollar meant that turmoil abroad could spill over into U.S. markets. So, through swap lines with fourteen other central banks, we supported dollar-denominated funding markets in Europe, Asia, and Latin America. The swap lines were our largest single program, with nearly $600 billion outstanding at their peak. They would prove crucial in containing global contagion.

 

In a few instances, we went beyond Bagehot by using our lending authority to rescue large institutions on the brink of collapse, including Bear Stearns and AIG. As we emphasized at the time, we took those actions not out of any consideration for their shareholders, executives, or employees but because their failure would surely have led to greater financial contagion and fanned the fear and uncertainty already raging through the markets.

Finally, working with the Treasury and other banking agencies, we helped restore confidence in the banking system through the stress tests in spring of 2009. By providing credible information about banks’ prospective revenues and losses, we helped pave the way for private investment in the banking system. For much of the panic, the Fed alone, with its chewing gum and baling wire, bore the burden of

 

battling the crisis. This included preventing the failure of systemically important institutions. Starting in July 2008, action by Congress facilitated a more comprehensive response. The Treasury was empowered to bail out Fannie and Freddie and later, through the TARP, to begin the recapitalization of the U.S. banking system. Measures such as the Treasury’s guarantee of the money market funds and the FDIC’s guarantee of bank liabilities also helped to calm markets.

 

Even as the financial panic subsided in 2009, the damage done by the crisis became increasingly apparent. The recession would deepen into the worst economic downturn since the Great Depression. Unemployment would peak at 10 percent in October 2009. A quarter of homeowners would owe more on their mortgages than their homes were worth. Lenders had begun 1.7 million foreclosures in 2008 and would initiate 2.1 million more in 2009 and 1.8 million in 2010. Worst of all, the crisis and its economic


consequences dealt such a body blow to Americans’ confidence that it threatened to become a self-fulfilling prophecy. The markets were calmer, but we still had our work cut out for us.


 

PART III

 

AFTERMATH


 

CHAPTER 19

 

Quantitative Easing:

 

The End of Orthodoxy

 

It was March 7, 2009, and I was again back in my hometown of Dillon, South Carolina. Two and a half years had passed since Dillon had welcomed me, early in my chairmanship, for Ben Bernanke Day. This time, as I walked by rundown brick storefronts on Main Street, Scott Pelley of CBS’s 60 Minutes walked alongside. During the day, trailed by TV cameras, I met with students at Dillon’s high school, visited my childhood home on Jefferson Street—it had been through several owners and a foreclosure since my family lived there—and attended the dedication of a highway interchange named in my honor. Appropriately, the exit at the Ben Bernanke interchange took the driver off Interstate 95 toward South of the Border, where I had once waited tables, then on to Dillon. I hope someday to hear a radio report that “traffic is light near the Ben Bernanke interchange.”

 

As Pelley and I strolled along the sidewalk to a wooden bench near what was once my family’s pharmacy, I tried to explain what the Federal Reserve does, how we were responding to the financial crisis, and what I expected for the economy. But, as I learned from many people after the program aired, the images of Main Street—as I had hoped—left the more lasting impression. “You know I come from Main Street. That’s my background,” I told Pelley. “And I’ve never been on Wall Street. I care about Wall Street for one reason and one reason only—because what happens on Wall Street matters to Main Street.” I explained that if we failed to stabilize financial markets and restart the flow of credit, someone like my father, who once borrowed to build a new and larger store a block away from the original one, would be out of luck. When Pelley asked why I was doing a TV interview, a rare occurrence for a sitting Fed chairman, I replied: “It’s an extraordinary time. This is a chance for me to talk to America directly.”


I talked about how the Fed was helping to bring down mortgage rates, strengthen banks so that they could make loans again, and stabilize money market funds. “And I think as those green shoots begin to appear in different markets—and as some confidence begins to come back—that will begin the positive dynamic that brings our economy back,” I said. Some have suggested that the phrase “green shoots” meant that in March 2009 I saw a strong economic recovery right around the corner. Of course neither I nor my colleagues at the Federal Reserve expected anything of the sort. I was referring to recent improvements in mortgage and other financial markets, which I believed would ultimately help the economy begin to recover. That forecast wasn’t so bad. On March 9, just two days after the interview, the Dow Jones industrial average hit bottom, closing at 6,547, a near twelve-year low, and then began its long climb back. Financial conditions continued to improve over the spring, reflecting, among other factors, our monetary policy actions and the bank stress tests. The economic contraction would end in June of that year, although unemployment would continue to rise through October.

 

60 Minutes brought the Fed’s story to a broad audience, something we desperately needed. I hadcome to the Fed as an advocate of transparency, mostly because I thought it would make monetary policy more effective if the markets and the public understood our thinking. But transparency about the Fed and our policies also was proving essential for the greater battle of winning the public’s trust. Michelle Smith, our communications director, believed that the Fed’s sphinxlike image had ceased to serve. “The public and the media deserve the opportunity to learn more about the individual, the policy choices, and the institution,” she wrote during our discussions over the 60 Minutes invitation. “Let’s do it.”

 

It was only the beginning. That year I would take students’ questions at universities, write op-eds explaining the Fed’s actions, and appear on a nationally televised town hall hosted by Jim Lehrer of PBS. Television appearances, in particular, were not my métier. I have crossed hosting The Tonight Show off the list of my post-Fed job possibilities. But I am glad that we reached out, and not only to explain the Fed’s side of the story amid the barrage of negative coverage. Economic conditions in early 2009 were scary, and if I could explain what was happening and reassure people about the future, it could only help.

 

WITH MORTGAGE-BACKED SECURITIES purchases just getting under way, the FOMC did not take additional action at its first meeting of 2009. Only four governors attended. Randy Kroszner had recently left the Board and Dan Tarullo was not yet sworn in. As Tim’s successor as president of the Federal Reserve Bank of New York, Bill Dudley also became vice chairman of the FOMC.

 

We were now treating every meeting as a joint meeting of the Board and the FOMC to stress cooperation between the overlapping bodies. A few Committee members remained uncomfortable about our alphabet soup of lending facilities. Jeff Lacker of the Richmond Fed frequently expressed the concern that our programs, including our plan to purchase mortgage-backed securities, were unnecessarily distorting markets. Since Adam Smith, economists have generally believed in the capacity of free markets to allocate resources efficiently. But most of my colleagues and I recognized that, in a financial panic, fear


and risk aversion prevent financial markets from serving their critical functions. For now our interventions remained essential, I argued. With the support of most of the Reserve Bank presidents, the Board extended the emergency lending facilities for six months, to October.

 

At the FOMC meeting, our discussion of the economy was dour and most around the table expected we would need to take new steps soon. The deepening U.S. recession was spreading globally. Inflation, an important concern when the Committee had met six months earlier, was rapidly declining as spending plummeted and commodity prices fell. The prospect of improvement in the economy was nowhere in sight. “I think we ought to recognize that we could be at zero [interest rates] for quite a long time,” I said.

 

BEFORE BECOMING CHAIRMAN, I had spoken about monetary policy after short-term interest rates reached zero. I was responding to a fairly widely held view that, once rates hit zero, it marked the exhaustion of monetary policy options. I had argued then to the contrary. Now the time had come to put my ideas into practice. We had reached the end of orthodoxy.

Our purchases of hundreds of billions of dollars of securities were probably the most important and definitely the most controversial tool we would employ. We usually referred to them as large-scale asset purchases, or LSAPs, but the financial world persisted in calling the tool quantitative easing, or QE.* The purchases of Fannie and Freddie debt in December 2008 and of mortgage-backed securities in January 2009 marked our first use of it. Purchases of Treasury securities would come next.

 

Our goal was to bring down longer-term interest rates, such as the rates on thirty-year mortgages and corporate bonds. If we could do that, we might stimulate spending—on housing and business capital investment, for example. In particular, our planned purchases of $600 billion of mortgage-related securities were intended to increase demand for the securities at a time when many investors were shying away from them. By adding to the demand for MBS in particular we hoped to push down their yields, which would in turn cause the interest rates paid by individual mortgage borrowers to decline. Indeed, since financial markets are forward-looking, mortgage rates had started to fall in late November 2008— after our announcement but before any actual purchases were made.

 

Similarly, when we bought longer-term Treasury securities, such as a note maturing in ten years, the yields on those securities tended to decline. Of course, nobody in the private sector borrows at the same interest rate as the U.S. Treasury, the safest of all borrowers. But lower yields on Treasury securities generally spill over to other longer-term interest rates. For example, when considering a corporate bond, investors typically evaluate the yield on that bond relative to what they could earn on a Treasury of similar maturity. If the yield offered by the Treasury security falls, investors will usually accept a lower yield on the corporate bond as well. Moreover, when the Fed’s purchases reduce the available supply of Treasuries, investors are forced to shift to other assets, such as stocks, leading the prices of those assets to rise. In buying Treasury securities, our ultimate goal was to precipitate a broad reduction in the cost of credit.†


Date: 2016-04-22; view: 635


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