bernanke lecture three 20120327

7/31/2019 Bernanke Lecture Three 20120327

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TH E FEDERAL RESERVE

AND THE FINANCIAL CRISIS


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Lecture 3:

The Federal Reserve's Responseto t he Financial Crisis


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Lender of last resort pow ers

- For fin ancial stabilit y: Cent ral banks provideliquidity (short -term loans) to f inancial inst itut ionsor m arkets to help calm financial panics.

M oneta ry po licy

- For m acroeconom ic stability: In norm al t im es,cent ral banks adjust the level of short -terminterest rates to influence spend ing, product ion,employment, and inflation.

The Tw o M ain Tools of Cent ral Banking


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Today's lect ure w i ll fo cus on lender -of- last -resor t

po l icy du rin g t he f in ancial cr isis. M on et ary po l icyw i ll be covered in t he next lect ure.


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Financial System

Vulnerab ilit ies Before t he Crisis

Pr ivat e-sect or vulner abi l it ies- excessive leverage (debt )

- banks' failure to adequately m onito r and m anagerisks

- excessive reliance on short -term fund ing

- increased use of exot ic financial inst rum ents thatconcentrated risk


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Pub l ic-sect or vulner abi l it ies- gaps in regulatory st ructure

- failures of regulat ion and supervision

- insufficient at tention paid to the stability of thefinancial system as a whole


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An Import ant Pub lic-Sect or Vulnerabil i t y:

Fannie Mae and Freddie Mac

Fannie M ae and Freddie M ac are pr ivat ecorp orat ions t hat w ere est ab l ished by t heCon gress and are referr ed to as gover nm ent -sponsored enterprises, or GSEs.

They are t he largest " packagers" of in div idualm or t gages into m or t gage-backed secur i t ies(M BS), w hich t he y guarant ee against loss.


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Fannie and Freddie w ere perm i t t ed to o perat ew i th inadequate capi ta l t o back t he i r guarantees- a point recognized by t he Fed and ot her s priort o t h e crisis.

Their balance sheet s grew rapidly, includin gt hr ou gh p ur chases of sub pr im e M BS, expo singthem to addi t ional r isks.


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A Key Trigger:

Bad M or t gage Product s and Pract ices

Exot ic m or t gages (such as " explodin g ARM S" ) andsloppy lending practices (such as no-doc loans)prol i ferated before the cris is.

Repaym ent o f t hese loans depend ed on cont inuallyrising house prices.


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Rising ho use pr ices created h om e equ i ty forborrowers, a l lowing them to re f inance in to more-st andard m or t gages af t er a few years.

W hen ho use pr ices st op ped r ising, how ever,borro w ers could ne i ther re f inance nor m eet t he(typical ly increasing) payments on their exoticmortgages.


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Examples of Bad M ort gage Pract ices

- interest -only (IO) adjustable-rate m ort gages (ARM s)- opt ion ARM s (perm it borrow ers to vary the size of

m onth ly paym ents)

- long amor t ization (payment period greater than 30

years)- negat ive am or t ization ARM s (init ial payments do not

even cover interest costs)

- no-documentation loans


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The Deterio rat ion of Lend ing Pract ices[images of home loan ads. stating things like "Home Loans Made Easy!", "You CouldSave $$$ With The Combo Loan.", "low monthly payments, 4 out of 5 approved, noup-front cost or obligation, loans for homeowners with less than perfect credit", "lowstart rate, stated income, no documentation loans, 100% finance available, interest onlyloans, debt consolidation."]


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The Financing of Exotic

and Subprime Mortgages

M any t ypes of f inanc ia l inst i tu t ions " packaged"exot ic and sub pr im e m ort gages into secur i t ies.

- Som e secur it ies w ere relat ively sim ple inst ructure for exam ple, m ost GSE-backed M BS.

- Other secur ities w ere very com plex and opaquederivativesfor example, collateralized debtob ligat ions, or CDOs.

Rating agencies gave AAA ratings t o m any oft he se securi t ies.


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M any of t hese secur i t ies w ere sold t o invest ors.

Financial inst i tu t ions also r etained som e of t hese

securi t ies - of t en in of f-b alance-she et vehicles,f inanced by cheap short- term funding l ikecommercia l paper.


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Com panies like AIG sold " insur ance" t o p rot ectinvest ors or f inancia l f i rm s t hat held t hesesecurit ies.

These f in ancia l syst em pract ices am pl i f ied t herisks of low-qual i ty lending.


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Subprime M ortgage Securit izat ion

[Diagram. Low quality mortgages goes to Financial firms created securities made up of mortgages and other assets (Credit rating agencies also go to this). Then from thereit goes either to investors or financial firms. Credit issuers also go to either investors or financial firms.]


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The Crisis: A Classic Financial Panic

A f in ancia l panic occurs w hen pro viders of sho rt -

te rm cred it (th ink depositors in a bank) suddenlylose con f idence in t he abi li ty o f the borr ow er( th ink the bank) to repay; providers of short- termcred it t hen qu ick ly w i thdr aw t he ir f und s.


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As hou se pr ices fe l l, it b ecam e clear t hat t he

values of m any m or t gage-relat ed secur i t ies w ou ldfall sharply, imposing losses on financial f irms,investment vehicles, and credit insurers (l ike AIG).

Because of com plexi ty of m any secur i t ies andpoor r isk monitoring, however, investors andeven t he f i rm s t hem selves w ere u nsure abou tw her e losses w ou ld fa l l.


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Runs began, as f in ancial f i r m s and invest or s

pu l led fun d ing f rom any f i rm t hou ght to bevuln erable t o losses.

Th ese run s generat ed huge pressur es on keyf inancial f i rm s and d isrup t ed m any im por t antf inancial markets.


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Large Financial Firms Came Under IntensePressure in 2008

Bear St earns: Forced sale, M arch 16

Fannie and Fredd ie: Placed in conservatorship,l iabil i t ies guarant eed by t he U.S. Treasury, Sep t . 7

Lehm an Brot hers: Filed for bankruptcy, Sept. 15 M errill Lynch: Acqu isition by Bank of Am erica

announced, Sept . 15


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AIG: Received emergency l iquidity assistance fromthe Fed, Sept. 16

W ashingt on M ut ual Bank: Closed by regulators,

acqu isit ion by JP M organ Chase ann ounced, Sep t . 25 W achov ia: Acquisi t ion by Wells Fargo announced,

Oct . 3


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Policy Response: Overview

Lesson s fr om t he Great Depression

- In a financial panic, the cent ral bank needs to lendfreely to halt runs and restore m arket f unct ioning.

- Highly accom m odat ive m onetary policy helpssupport econom ic recovery and em ploym ent.


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Heeding t hose lesson s, t he Federal Reserve and

t he federal governm ent t ook v igoro us act ions tost em t he f inancial panic, sup po rt key f inancialm arkets and inst i tu t ions, and l im i t t hecont rac t ion in ou tput and employment .

Sim i lar act ions w ere t aken by fo reign centr albanks and governments.


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Global Response

On Oct ob er 10, 2008, G-7 cou nt r ies agreed to

w ork t oget her t o st abi lize th e glob al f inancialsyst em . The y agreed t o

- prevent the failure of system ically im por tantfinancial institutions

- ensure financial inst itut ions' access to fund ing andcapital

- restore deposito r confidence

- w ork to norm alize credit m arkets


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The in t ernat ional po l icy respon se aver t ed t he

col lapse o f th e glob al f in ancial syst em .- After the announcem ent, the interest rates banks

paid to borrow short -term funds droppeddramatically.


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Int erbank Rates Fall af t er Oct . 10, 2008Cost o f In te rbank Lend ing

[For the accessible version of this figure, please see the accompanying HTML.]


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Federal Reserve Act ions:

The Discount Window

The Fed lends t o b anks t hr ou gh a facil i ty calledt he d iscount w indow .

As t he cr isis bui l t , t he m atur i ty of d iscou ntw indo w loans w as ext ended and th e in terest rate

reduced. Regular auct ions of d iscoun t w indow fun ds w ere

cond ucted t o encour age broad par t icipat ion byf inan cial f i rm s.


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Federal Reserve Actions:

Special Liquidity and Credit Facilities

New pr ogram s allow ed t he Federal Reserve t opro vide l iqu id i ty t o a var iet y of f inancialinst i tu t ions and m arkets facing runs or o t heri l l iquid i ty problems.

A l l loans w ere requi red to be " secured " byadequat e col lat eral.


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The purpose w as to- enhance the stability of the financial system

- prom ote the availability of credit to U.S.households and businesses and t hereby supportthe recovery

This is t he t radi t ion al lender -of- last -resor tfu nct ion of cent ra l banks.


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Inst i t ut ions and M arkets Covered by t he

Fed's Lender-of-Last Resort Actions

Banks (t h rough t he d iscount w indow ) Bro ker -dealers (f inancia l f i rm s t hat deal in

securit ies and derivatives)

Com m ercial paper bor row ers M oney m arket f unds

Asset -backed secur i t ies m arket


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Case St udy: M oney M arket Funds

and the Com m ercial Paper M arket

M oney market funds (M M Fs) are invest m entcom pan ies t hat sel l shares and invest t h eproceeds in short-term assets.

M M Fs hist or ically have alm ost alw ays m aint ainedst able $1 share pr ices.


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Money Market Funds

[diagram showing multiple investors who purchaseMMF Shares going inot Money Market Fund (MMF).]


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Case St udy: M oney M arket Funds

and the Commercial Paper Market

A l th ou gh M M F shares are not insured, investo rsuse M M Fs l ike checking accou nt s and expect t obe able t o earn interest and r edeem shares ondemand for $1.

M M Fs invest heavily in commercial paper (CP)and other short- term assets.


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Commercial Paper

Commercial paper (CP) is a sho rt -t erm (t yp ically

90 days or less) debt inst ru m ent issued bycorporat ions.

CP is used by no nf inancial cor po rat ion s t o pay fo rim m ediat e expenses such as payrol l and

inventories.

CP is used by f in ancial corp or at ion s t o r aise fun dst hat t hey th en lend to o rd inary b usinesses and

households.


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M oney M arket Funds and

the Commercial Paper Market[diagram showing multiple investors who purchase MMF shares going to a Money Market Fund (MMF) who purchase CP: providesshort-term funds to businesses. Multiple businesses exchange with Money Market Fund through Commercial Paper (CP) Market.]


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Lehm an Bros., M oney M arket Funds,

and Com m ercial Paper

Lehm an Bro t hers w as a glob al f in ancial servicesf i rm .

Like ot her securi t ies f i r m s, Lehm an rel ied heavilyon sho rt - ter m bo rro w ing (for exam ple, CP) t o

fund the i r investments . During t he 2000s, Lehm an invest ed exten sively in

m or t gage-related secur i t ies and com m ercia l realestate (CRE).


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As ho use prices fel l and del inq uen cies andfo reclosur es rose, t he value of Lehm an'sm or t gage-relat ed asset s fel l .

Lehm an's CRE ho ldin gs also w ere show ing largelosses.


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As Lehm an's cred it or s lost con fid ence, t heyw i th drew fu nd ing (for exam ple, ceasedpurchasing Lehman's CP) and curtai led otherbusiness with Lehman.

W i th losses m oun t ing, Lehm an could not f indnew capi ta l or anot her f i rm to acqui re i t .

On Sept em ber 15, 2008, Lehm an f i led forbankruptcy.


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The Run on M M Fs

Af t er t he co l lapse of Lehm an Brot hers, one M M F

t hat held CP issued by Lehm an fai led t o m aint aina $1 shar e pr ice.

This led t o a rapid loss of con fid ence by invest or sin ot her M M Fs and a sud den f loo d ofredempt ionsanother example o f a run or panic.


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In respo nse, t he Treasury prov ided a t em po rary

guarantee o f th e va lue of M M F shares. Actin g as lender of last resor t , t he Fed creat ed a

pro gram to pro vide backst op l iquid i ty . Under t h isprogram , the Fed lent to banks w ho in t urn

pr ovided cash to M M Fs by pur chasing som e oftheir assets.

These act ions ended th e run w i th in a few days.


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The Run on M M FsNet F lows to Pr ime M oney Market Funds



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Dislocat ions in t he CP M arket

M M Fs respond ed to th e run by cur t ai ling t he i r

pu rchases of sho r t -t erm asset s, includ ing CP. Con sequen t ly, t he dem and for n ew ly issued CP

dr ied up and int erest rates on CP soared .

This episod e is an exam ple of ho w a f in ancia lcr isis can spr ead in u nexpected dir ect io ns(Lehm an ^ M M Fs ^ CP).


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St ra ins in t he CP m arket con t r ibu t ed to an overal l

con t ract ion in credi t available to f inan cia linst i tut ions and to nonfinancial businesses.

The Federal Reserve est ablished special pr ogram st o repair fu nct ion ing in t he CP m arket and rest artt he f low o f cred it .


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CP Rates Soared dur ing the CrisisCost o f Shor t - te rm Bor row ing"



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Support of Crit ical Institutions:Bear Stearns and AIG

In M arch 2008, a Fed loan faci li tat ed t he t akeoverof t he fai ling b ro ker -dealer , Bear St earn s, by t hebank JP M or gan Chase.

In Oct ober 2008, t he Fed in t ervened t o preventt he fai lur e of t he nat ion's largest insur ancecompany, AIG.


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Case Study: AIG

In Sept em ber 2008, AIG a m ul t inat ionalinsur ance and f in ancial services f i r m facedser ious liqu id i ty prob lem s t hat t hreat ened itssur vival. M any losses cam e fr om t he insur ance itsold on bad mortgage-related securi t ies.

Because AIG w as in terconnect ed w i th m any ot herpart s of t he glob al f in ancial syst em , i ts fai lurew ou ld have had a m assive ef fect on ot herf inan cial f i rm s and m arket s.


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Over t im e, AIG st abi l ized. It has repaid t he Fedw ith interest and has m ade pro gress in redu cingTreasury's stake in the company.

The pr oblem s at Lehm an, AIG, and ot her

com panies h igh l ight ed t he n eed for new t oo ls t odeal w i th syst em ically cr i t ical f inancia l inst i tu t ionson t he verge of f a ilure.


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Consequences of t he Cr isis for Spending,Output, and Employment

Spend ing and out put cont ract ed sharp ly inrespo nse to redu ced credi t f low s, skyrocket ingbo rro w ing cost s, and plum m et ing asset values.

- GDP fell a tot al of m ore than 5 percent from itspeak to its trough.

- M anufactu ring out put declined nearly 20 percent,

and new home construction plum m eted 80percent.

- M ore than 8-1/ 2 m illion people lost th eir jobs.

- Unemploym ent rose to 10 percent.


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M any of our t rad ing par tners w ere also h i t byrecessions it w as a glob al slow do w n.

Threat o f a second Great Depression was very real.


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Com par ison t o the Great Depression

In t erm s of econ om ic con sequ ences, t he Great

Depression w as con sider ably m ore severe t hanthe recent recession.

The fo rceful pol icy respo nse t o t he recentfinancial crisis and recession l ikely averted muchw orse ou t com es.


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Com par ison t o the Great DepressionS& P 500 Com po s i te Ind ex



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Com par ison t o the Great DepressionIndus t r ia l Produc t ion



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Lect ure 4

Lect ure 4 w i ll d iscuss t he af t erm ath of th e

financial crisis:- t he recession and m on et ary po l icy respo nse

- t he sluggish recovery

- changes in f in ancia l regulat io n fo l low ing t he cr isis

- im pl icat ion s of t he cr isis fo r cent ra l bank pract ice


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TH E FEDERAL RESERVE

AND THE FINANCIAL CRISIS

bernanke lecture three 20120327

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