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

2. 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 will close insolvent banks Insolvency can spread between institutions because they are connected; for example, banks have deposits in and make loans to other banks

3. Liquidity Crises Commercial banks may lack enough liquid assets to meet depositors’ demands (Bank run) –Banks forced to sell 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 (lenders) lose confidence and stop lending, forcing asset sales (Bank run) Crises can spread to other financial institutions as depositors and creditors lose confidence, spreading a crisis throughout the economy

4. Financial Crises and the Economy – Direct Cost The direct costs: –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, reduce the real level of economic activity

5. Financial Crises and the Economy - Lending and Spending –A crisis causes a credit crunch – decline in borrowers’ collateral and net worth worsen adverse selection and moral hazard, reducing lending –Bank failures reduce lending because failed banks don’t lend remaining banks become fearful and reduce lending to increase liquid assets (repair balance sheets) –Lower lending reduces aggregate expenditure by firms and individuals who rely on bank loans for funds The direct and indirect effects cause a fall in aggregate expenditures that reduce real output, causing a recession

6. A Vicious Cycle The recession may further reduce asset prices and can worsen banking problems These feedbacks can trigger a vicious cycle of falling output and worsening financial problems A crisis may sustain itself for a long time

8. CBO Measure of the Output Gap

9. Policy Responses to Financial Crises Monetary policy –interest rate and/or money supply Provide liquidity (lender of last resort) Bailouts All used by regulators to fight crises NOTE: Some economists believe that central banks should raise interest rates to dampen asset-price bubbles that lead to crashes, but this idea is controversial

10. Policy Responses to Financial Crises Monetary policy: Lower interest rates to stimulate aggregate expenditure to offset the effects of asset-price crashes and reduced bank lending. –This has not worked - interest rate zero bound. Provide liquidity: The Fed’s focus in 2008-2009 was saving the system. –The Fed provided liquidity to banks through traditional discount loans. –New credit facilities created in 2008 and 2009. –Most of the new credit facilities have expired. –Stimulate the economy once banking system is stabilized, which is where we are now.

11. The Sub-prime Market and Fed Policy Actions

12. Types of Mortgages Prime –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

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

14. Traditional Mortgage Model - Example $1Million Mortgage: 10% per year for 10 years plus $1million at the end of 10 th year Commercial BankBorrowerDepositors Assets Liabilities DepositsLoans Commercial Bank Balance Sheet $ $ $ $ $$

15. Shift risk:

16. Modern Mortgage Model (I) 1000 borrowers at $1million each = $1 billion in mortgage loans Mortgage: 10% per year for 10 years ($100million) plus $1 Billion at the end of 10 th year Commercial Banks/Mortgage Originator 1000 Borrowers Investment Banks: (Merrill, Lehman, etc. $1Billion Plus fee Originator sell 1000 loans to Investment Bank For $1 billion (plus a fee), the investment bank gets the right to the interest payments ($100 million per year) and principal payments.......

17. Modern Mortgage Model (II) 1000 BorrowersInvestment Banks: (Merrill, Lehman, etc. CB services the 1000 loans...... Story Doesn’t Stop Here! The investment bank gets the right to the interest payments ($100 million per year) and principal payments ($1 Billion). Commercial Banks/Mortgage Originator

18. Modern Mortgage Model (III) 10% per year for 10 years ($100million) plus $1 Billion at the end of 10 th year 1000 Borrowers Investment Banks: (Merrill, Lehman, etc. CB services the loans MBS Investment bank creates Mortgage Back Securities which are sold to investors. They collect a fee....... Commercial Banks/Mortgage Originator

19. Special Purpose Vehicle 18-19 Loans All Other Assets Deposits Other Liabilities Capital Bank AssetsLiab. Assets Liab. SPV Cash Loans ABS Investors Cash ABS Converting on-balance sheet assets to a securitized asset: SPV is set up solely for this purpose. Acts as a conduit passing cash flows to investors for a fee. It has no rights to the cash flows and it ceases to exist when the ABS matures.

20. Structured Investment Vehicle 18-20 Loans All Other Assets Deposits Other Liabilities Capital Bank AssetsLiab. Assets Liab. SPV Cash Loans Commercial Paper Investors Cash ABCP and Repo Converting on-balance sheet assets to a securitized asset: SIV is a structured operating company set up to earn higher returns then its cost of funds. Borrows very short-term and invest long-term. How does this differ from a bank? Huge liquidity risk!

21. 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 (Discount Loan): the interest rate the Fed charges on loans it makes to commercial banks. –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)

22. 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%

23. Fed Policy Actions: August 2007 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 50 basis points above the FOMC’s federal funds rate target. Traditionally set at 100 basis points above FFR. –The Fed also increased the maximum primary credit borrowing term to 30 days, renewable by the borrower. Question: Does discount lending add reserves to the banking system?

24. 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% Question: Does a TAF loan add reserves to the banking system?

25. March 2008 *Mar 11: The Federal Reserve Board announces the creation of the Term Securities Lending Facility (TSLF), which will 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. Question: Does the TSLF add reserves to the banking system? http://www.federalreserve.gov/newsevents/reform_tslf.ht mhttp://www.federalreserve.gov/newsevents/reform_tslf.ht m

26. March 2008 *Mar 14: Fed “lends” JPMorgan $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. Question: Does the PDCF add reserves to the banking system? *Mar 16: The Federal Reserve Board lowers the spread between the discount rate and the federal funds rate to 25 basis points. –The Board also votes to increase the maximum maturity of primary credit loans to 90 days.

27. September 2008 *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. *Sep 17: US Treasury announces temporary Supplemental Financing Program (SFP). Question: How does this affect reserves in the banking system?

28. 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.

29. 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 Passed in October. Troubled Asset Relief Program - TARP

30. Oct 2008 *Oct 7: The Federal Reserve Board announces the creation of the Commercial Paper Funding Facility (CPFF). –Provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle that will purchase three-month commercial paper directly from eligible issuers. –Fed becomes a “market maker of last resort” *Oct 7: The FDIC announces an increase in deposit insurance coverage to $250,000 per depositor. *Oct: FED begins paying interest on reserves.

31. January 2009* The Federal Reserve Bank of New York begins purchasing $100 billion of fixed-rate mortgage- backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae under a program first announced on November 25, 2008 (*QE1, LSAP, starts). Question: Does a LSAP add reserves to the banking system?

32. 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.”

33. November 2010 *QE 2: From Nov. 12, 2010 through June 30, 2011, the Fed purchased $600 billion of long-term US treasury securities. The Fed also made $167 billion in principal reinvestment.

34. September 2011 Operation Twist Twist the Yield Curve. Buy long and sell short

35. September and December 2012 *QE 3: (Sept 2012) Fed announced a new $40 billion a month, open-ended, bond purchasing program of agency mortgage- backed securities. *QE 4: (Dec 2012) Increased to $85 billion a month.

36. Trends in Fed’s Balance Sheet http://clevelandfed.org/research/data/credit _easing/index.cfm