Federal Reserve and Financial Crisis

- Based on Lecture (3) by Ben Bernanke in George Washington University 

This lecture describes the financial crisis, its implications and the policy responses by the federal reserve. 

As a reminder, the central banks have two main tools, that is, the lender of last resort and the interest rates. Also, the last lecture has discussed several vulnerabilities in the economy. A key trigger, to reiterate was,
1. Exotic mortgages (such as adjustable-rate mortgages or ARMS) and sloppy lending practices (such as no-doc loans)
2. Another feature of these mortgages was that, for them to be paid back it was necessary for house prices to increase. This was because for the earlier times under ARMS the mortgage rates were low, which subsequently increase with time. In order to pay back, it was required to refinance these loans with more standard ones. So, ones the prices stopped rising, the borrowers found it difficult to refinance and were stuck with high rates

Examples of bad mortgage practices,
1. Interest-only (no need to pay principle) adjustable-rate mortgage
2. Option ARMs (permit borrowers to vary the size of monthly payments)
3. Long amortization (payment period greater than 30 years)
4. Negative amortization ARMs
5. Debt consolidation (individual will not only borrow for the house, but add the debts of credit cards etc, and pay for that)
6. no-doc loans

Such mortgages were financed by,
1. Financial institutions (like Fannie and Freddies and others) which "packaged" exotic and subprime mortgages into securities and sold them off to the market. But the financial institutions also retained some of these securities - often in off-balance-sheet vehicles, financed by cheap short-term funding like the commercial papers
2. Rating agencies gave AAA ratings to many of these securities
3. Companies like AIG sold insurances to protect investors and financial firms that held such securities. These practices amplified the risks of low-quality lending

The mortgage originators (like the thrift firms) did not care much about the quality of loans because they could sell most of them. So, these loans were sold off to financial firms, who would then pack different types of debts, in discussion with the credit rating agencies, to create AAA-rated securities. These were then sold to investors (like pension funds), but the financial institutions also kept these securities in off-balance-sheet vehicles for themselves. There were also credit insurers who would insure such securities, against a premium, in case they go bad.

The Crisis: A financial panic occurs when providers of short-term credit suddenly lose confidence in the ability of the borrower to repay; providers of short-term credit then quickly withdraw their funds. So, as the house prices fell, it became clear that the values of many mortgage-related securities would fall sharply, imposing losses on financial firms, investment vehicles, and credit insurers (like AIG). Because of the complexity of financial instruments and poor-risk monitoring, no one was sure where the losses would fall. Therefore, the financing firms and investors pulled funding from any firms they thought would be exposed to losses. This created huge pressures on the financial system and disrupted financial markets. 

Unlike in 1930s which saw failure of several small banks, the 2008 crisis witnessed even the failure of largest financial firms like Bear Stearns (forced sale), Fannie and Freddie, Lehman Brothers (filed for bankruptcy), Merill Lynch (acquisition by Bank of America), AIG (received Feds assistance), Washington Mutuals Bank (acquisition by JP Morgan), Wachovia (acquisition by Wells Fargo).

Lessons from the Great Depression,
1. Under stress, the central bank needs to lend freely to halt runs and restore market functioning
2. Highly accommodative monetary policy helps support economic recovery and development

Heeding to these lessons, the Federal Reserve did take quick steps. On October 10, 2008, G-7 countries agreed to work together to stabilize the global financial system. They agreed to,
1. Prevent the failure of systematically important financial institutions
2. Ensure financial institutions access to funding and capital
3. Restore depositor confidence
4. Work to normalize credit markets

The Federal Reserve played an important role in providing liquidity. The Fed has a facility called a discount window, to provide short term funding to banks. As the crisis built, the maturity of discount window loans was extended (from usual overnight loans to longer-term loans). They also had auctions of discount window funds where funds bid on how much they would pay for the specific amount the Fed wanted to pump into the system. The 2008 crisis was unlike the older crisis Fed had faced and this called for the creation of new programs. So, fed had to go beyond the discount window and they created special liquidity and credit facilities to provide liquidity to other institutions which were facing liquidity issues. All the loans were secured with collateral, according to the Bagehot's principle. The purpose of these other facilities was to,
1. Enhance the stability of the financial system
2. Promote the availability of credit to US households and businesses and thereby support the recovery

Institutions and markets which were covered by the Feds lender of last resort actions are as follows,
1. Banks (through the discount windows)
2. Broker-dealers (financial firms that deal in securities and derivatives were provided short term lending through collateral)
3. Commercial paper borrowers
4. Money market funds
5. Asset-backed securities market. Not only the home mortgages but auto loans, credit card loans etc are financed by bundling them all together and selling them to the market. During the crisis, the market for these securities was dried up, which the Fed helped start again

Other than the first action, the following (2-5) required the Fed to invoke emergency to create and take such actions under the clause of the Federal Reserve Act 13(3).

The fed provided support to the MMMFs and CP market. It also supported critical institutions like Bear Stearns and AIG. In March 2008, a Fed loan facilitated the takeover of the failing broker-dealer, Bear Stearns, by the bank JP Morgan Chase. In October 2008, the Fed intervened to prevent the failure of the nation's largest insurance company AIG.

In terms of economic consequences, the Great Depression was more severe than the recent crisis. The forceful policy response to the recent financial crisis and recession likely averted much worse outcomes.