Dealing With Financial Turmoil: The Fed’s Response David C. Wheelock* Federal Reserve Bank of St. Louis November 6, 2008 *Views expressed are not necessarily official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

The Housing Slump: Root of the Crisis Declining sales and rising vacancy rates Less construction Falling house prices Rising foreclosure rates –Cause mortgage-backed securities to decline in value, resulting in large financial losses and uncertainty about viability of counterparties.

Sales of Existing Homes Annual Rate Last Observation: Sept 2008

Home Vacancy Rate Percent Last Observation: Q3:2008

Months Supply of New and Existing Single Family Homes Last Observation: Sept 2008 Months

U.S. Building Permits and Housing Starts Last Observation: Sept 2008 Thousands

Median Sales Price of Existing Single Family Homes Last Observation: Sept 2008 Year over Year % Change

The Growth In House Prices: United States Average Last Observation: 2008:Q2 Year over Year % Change

The Housing Boom (Bubble?) Many economists discounted the “bubble” notion: –Income growth was high –Interest rates were low But, house prices rose much faster than GDP, rents, or median household income

House Price and GDP Growth S&P/Case Shiller Home Price Index and U.S. GDP Growth, 2001 = 1 Last Observation: 2Q 2008 House Price IndexGDP

House Prices Compared to Rent Last Observation: 2008:Q2 Note: OFHEO Purchase only index begins in Q1:1991. Value set equal to C-S index for Q1:1991. Rent Price is from CPI index.

House Prices Compared to Median Income Note: Income is Nominal U.S. Median Income. US Ratio is C-S HPI. Regional Ratios are OFHEO HPI.

What Caused the Boom? House prices had been rising since the mid- 1990s, but accelerated in , coinciding with: –Low interest rates –Rising household incomes –Mortgage market innovations (“originate to distribute” – subprime loans and securitization)

House Price and Personal Income Growth Last Observation: 2008:Q2 Percent

House Price Growth and Mortgage Rate Last Observation: 2008:Q2 HPI growth rateMortgage rate

Large Increase in Non-Prime Mortgages,

What Ended the Boom? House price appreciation began to fall in the second half of 2005, coinciding with: –Slowing of U.S. personal income growth –Rise in mortgage rates –Hurricane’s Katrina and Rita

Consequence of the housing slump…

Financial Distress

Falling House Prices and Financial Distress Rise in mortgage defaults and foreclosures –Mainly on subprime, adjustable rate loans Significant losses on mortgage-backed securities and derivatives (especially private- label MBS’s, even highly-rated securities) Uncertainty about the viability of counterparties caused risk spreads to increase and trading in financial markets to fall sharply.

House Prices and Foreclosure Rate Last Observation: 2008:Q2 Rate of New Foreclosures% Change in House Prices Case-Shiller Index

U.S. Foreclosure Rates by Loan Type Rate of New Foreclosures Last Observation: 2008:Q2

How this Became a Crisis “Originate to Distribute” lending model –Principal/agent problems – originators often didn’t have skin in the game –Investors relied on ratings agencies that used backward-looking valuations and had their own principal/agent issues Fannie Mae and Freddie Mac had conflicting objectives, were highly leveraged but lightly regulated. Credit default swaps and other over-the- counter derivatives ($50+ trillion!)

Interest Rate Spreads and Illiquid Markets Percent Last Observation: October 31, 2008

Commercial Paper Outstanding Seasonally Adjusted, Billions of Dollars Last Observation: October 22, 2008

The Fed’s Response

The TAF, TSLF, and PDCF Term Auction Facility (TAF): Fed auctions fixed amount of reserves to DIs; provides liquidity while avoiding the stigma of borrowing at the discount window. Term Securities Lending Facility (TSLF): Fed lends Treasury securities to DIs in exchange for other marketable assets. Primary Dealer Credit Facility (PDCF): Lending facility for all primary dealers, including non-DIs.

Bailouts and Non-Bailouts Bear Stearns (March ’08): Fed lent $30 billion to facilitate JPMorgan’s acquisition of Bear. Concern about systemic risk. Fannie/Freddie (Sept. ’08): Treasury places in conservatorship, replaces CEOs. Lehman (Sept. ’08): Allowed to fail. AIG (Sept. ’08): Fed lends up to $85 billion (increased later to $120); CEO replaced. Systemic risk – huge amount of credit default swaps outstanding.

The $700 Billion TARP Troubled Asset Relief Program Capital Purchase Program – Treasury will purchase preferred stock in a qualifying financial firm. $125 billion in nine largest banks $125 billion in other banks that apply and qualify Other program(s) may include purchases of MBSs and loans, insurance of troubled assets, and assistance to borrowers.

Commercial Paper, Money Market Funds Commercial Paper Funding Facility (CPFF): Fed will purchase highly-rated unsecured and asset-backed commercial paper. Money Market Mutual Fund Liquidity Facility (AMLF): Fed loans to banks to purchase asset- backed paper from MMMFs. Money Market Investor Funding Facility (MMIFF): Sets up special vehicles to buy money market instruments. Fed committed up to $540 billion.

Old Fashioned Monetary Policy The FOMC has sharply cut the fed funds rate target – negative real rate throughout Monetary base growth – up sharply since September (“quantitative easing”).

Target Fed Funds Rate minus Yr/Yr CPI Inflation Last Observation: Sept 2008 Expected Fed Funds Futures, CPI MA Forecast Forecast Percent

St. Louis Adjusted Monetary Base, Yr/Yr Growth, SA Last Observation: 10/20/08 Percent

Summary (1) The financial crisis was triggered when house prices began to decline and subprime mortgage defaults increased. Subprime accounts for about 10 percent of mortgage market. Subprime ARMs represent about 7 percent of loans, but 43 percent of foreclosures. Some $85 billion of losses on non-prime mortgage loans has mushroomed into some $1.4 trillion of losses world wide (IMF estimate).

Summary (2) Systemic failure centered in MBSs and other derivatives that have lost substantial market value. The Fed (and other agencies) have attempted to contain the crisis and re-start financial markets by providing liquidity and acting as lender of last resort.

Questions?