The Sub-Prime Market, Financial Crisis and Federal Reserve Policy Actions

Subprime crisis that began in mid - 2007. Financial Crisis Most financial crises involve asset-price crashes, failures (insolvency) of financial institutions, or both. Great Depression 1929-1933 Subprime crisis that began in mid - 2007. The response of the central bank is the key to controlling the economic damage from a crisis The IMF intervenes in emerging market crises, but this intervention is controversial. 2

House Prices

Stock Market Prices Dow Jones Industrial Average

Insolvency of Financial Institution A financial institution is insolvent when the value of its assets is less than its liabilities, making net worth negative Regulators force closure of insolvent banks Insolvency can spread between institutions because they are connected; for example, banks have deposits in and make loans to other banks Hedge funds buy risky assets with borrowed funds and can become insolvent if the asset prices decline. 5

Liquidity Crises Bank run: Commercial banks may lack enough liquid assets to meet depositors’ demands forcing sales of assets at fire-sale prices and resulting in losses that can cause insolvency Investment banks, such as Lehman Brothers, that raise funds by borrowing, experience liquidity crises when creditors lose confidence and stop lending, forcing asset sales The 2008 crisis at the investment bank Bear Stearns was a liquidity crisis. 6

Financial Crises and the Economy – Direct Cost The direct costs of a crisis are: Asset holders suffer losses when asset prices fall Homeowners, owners of common stock Owners of financial institutions lose their equity Creditors of financial institutions lose the funds they have lent When banks fail, uninsured depositors and the FDIC incur losses Losses on assets reduce aggregate expenditure The direct effects of a financial crisis primarily involve losses on various assets. 7

The recession may further reduce asset prices A Vicious Cycle The recession may further reduce asset prices The recession can worsen banking problems Both of these feedbacks can trigger a vicious cycle of falling output and worsening financial problems A crisis may sustain itself for a long time The feedback loops shown in figure 18.1 worsen the crisis. 8

Policy Responses to Financial Crises Monetary policy, liquidity provision, and bailouts used by regulators to fight crises Some economists believe that central banks should raise interest rates to dampen asset-price bubbles that lead to crashes, but this idea is controversial Central bankers don’t generally try to dampen bubbles. 9

Expansionary Monetary Policy Lower interest rates to stimulate aggregate expenditure to offset the effects of asset-price crashes and reduced bank lending. This has not been working. Fed’s focus in 2008-2009 was saving the system. Stimulate the economy once banking system is stabilized. The Fed lends to banks through traditional discount loans and new credit facilities created in 2008 and 2009. Most of the new credit facilities have expired. Hitler’s rise to power also stimulated capital flight from Europe to the United States. 10

The Sub-prime Market and Fed Policy Actions

Types of Mortgages Prime Sub-Prime Mortgage (the no-problem mortgage) borrower has a good credit score - 680 or higher borrower fully documents their income and assets low debt to income ratio - does not exceed 35% borrower injects at least 20% equity (down payment) Conforming loan - Fannie Mae Sub-Prime Mortgage (the no-problem mortgage) Can’t make a down payment – No problem. Don’t earn enough to meet the monthly tab – No problem. No doc loans (we don’t care if you have no income!) option ARMs. (don’t have enough to make monthly payment, send what you can!) Referred to as NINJA Loans

Financial Institution Financial Institution Functions Financial Institution Commercial Banks and Thrifts Risk stays with originator

Shift risk:

The Fed’s Monetary Policy Toolbox Prior to the sub-prime crisis the Federal Reserve used three monetary policy tools (the old tool box!) Open Market Operations and the target federal funds rate. Purchase and sale of government securities. Discount rate: the interest rate the Fed charges on loans it makes to commercial banks. From January 2002 up to August 2007 Fed policy was to set the discount rate for primary credit 100 basis points (1 percentage point) above the target federal funds rate. this policy has changed since August 2007. Reserve Requirement: the level reserves banks are required to hold either as vault cash on deposit or at a Federal Reserve Bank (10% of demand deposits) http://www.federalreserve.gov/

Fed Policy Actions – Federal Funds Rate The Fed lowered the Federal Funds Rate from 5.25% in 2007 to a range of 0 – 0.25%

Fed Policy Actions: August 2007 Aug. 7: The FOMC votes to maintain its target for the federal funds rate at 5.25 percent. Aug. 9: BNP Paribas, France’s largest bank, halts redemptions on three investment funds. Aug 16: Fitch Ratings downgrades Countrywide Financial Corporation to BBB. Aug. 17: The Federal Reserve Board votes to set the Discount Rate for primary credit 50 basis points above the FOMC’s federal funds rate target The Fed also increases the maximum primary credit borrowing term to 30 days, renewable by the borrower.

Fed Policy Actions: September and October 2007 Sept 18: The FOMC votes to reduce its target for the federal funds rate 50 basis points to 4.75 percent. Oct. 31: The FOMC votes to reduce its target for the federal funds rate 25 basis points to 4.50 percent.

Jan. 2008: federal funds rate reduced 2 times (75bp and 50bp) to 3.25% December 2007 and Jan. 2008 Dec 12: Finding banks reluctant to borrow, the Fed creates the Term Auction Facility (TAF) in which reserves are auctioned to depository institutions against a wide variety of collateral. “By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress” Jan. 2008: federal funds rate reduced 2 times (75bp and 50bp) to 3.25%

March 2008 Mar 11: The Federal Reserve Board announces the creation of the Term Securities Lending Facility (TSLF), Lend up to $200 billion of Treasury securities to Primary dealers for 28-day terms against federal agency debt, federal agency residential mortgage-backed securities (MBS), non-agency AAA/Aaa private label residential MBS.

March 2008 Mar 14: Fed lends JPM $30B to buy Bear Stearns. The Fed could not lend to directly to Bear Stearns. The loan blurred the distinction between the lender of last resort and a bailout, since the loan was collateralized by risky assets “without recourse”. Meaning if the collateral declined in value, the Fed was entitled to only the collateral Mar 16: The Federal Reserve Board establishes the Primary Dealer Credit Facility (PDCF), extending credit to primary dealers at the primary credit rate. Mar 16: The Federal Reserve Board lowers the spread between the primary credit rate (discount rate) and FOMC target for the federal funds rate to 25 basis points. The Board also votes to increase the maximum maturity of primary credit loans to 90 days. Mar 18: FOMC lowers the FFR rate 75 bp to 2.25%.

September 2008 Sep 7: Federal government takes over Fannie Mae and Freddie Mac. Sep 15: Lehman Brothers Holdings files for Chapter 11 bankruptcy protection. Sep 15: The Federal Reserve Board authorizes the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG). Sep 16: The net asset value of shares in the “Reserve Primary Money Fund” falls below $1, primarily due to losses on Lehman Brothers commercial paper and medium-term notes.

September 2008 Sep 19: The Federal Reserve Board announces the creation of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) to buy high-quality asset-backed commercial paper from money market mutual funds. Sep 21: The Federal Reserve Board approves applications of investment banking companies Goldman Sachs and Morgan Stanley to become bank holding companies.

September 2008 Sep 29: The U.S. House of Representatives rejects legislation submitted by the Treasury Department requesting authority to purchase troubled assets from financial institutions

Oct 2008 Oct 7: The Federal Reserve Board announces the creation of the Commercial Paper Funding Facility (CPFF), which will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. Oct 7:The FDIC announces an increase in deposit insurance coverage to $250,000 per depositor.

Nov 2008 Nov 25: The Federal Reserve Board announces a new program to purchase direct obligations Fannie Mae, Freddie Mac and Federal Home Loan Banks and MBS backed by the GSEs. Purchases of up to $100 billion in GSE direct obligations will be conducted (QE1 starts)

Dec 2008 – Jan 2009 *Dec 16 - The FOMC votes to establish a target range for the effective federal funds rate of 0 to 0.25 percent.

Mar 2009 Mar 18– QE1 expanded. “To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.”

Assets: Lending to nonbanks: TALF, CPFF, AMLF, and MMIFF; Short-term lending to financials: discount window, TAF, currency swaps, PDCF, and repos; Misc: Maiden Lanes I, II, and III, credit to AIG, and other Fed assets.

Liabilities: Other: Reverse repos, Treasury cash holdings, and deposits with Federal Reserve Banks other than reserve balances and excluding the Supplemental Financing Program.