The Sub-Prime Market, Financial Crisis
and Federal Reserve Policy Actions
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
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
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
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
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
CBO Measure of the Output Gap
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
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.
The Sub-prime Market and
Fed Policy Actions
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
Financial
Institution Functions
Financial Institution
Commercial Banks and Thrifts
Risk
stays with
originator
Traditional Mortgage Model - Example
Borrower
Commercial Bank
Mortgage: 10% per year for 10
years plus $1million at the end
of 10th year
$
$1Million
$
$
Commercial Bank Balance Sheet
Liabilities
Assets
Loans
$
Depositors
$
Deposits
$
Shift risk:
Modern Mortgage Model (I)
Commercial
Banks/Mortgage
Originator
1000 Borrowers
Mortgage: 10% per
year for 10 years
($100million) plus
$1 Billion at the
end of 10th year
Investment Banks:
(Merrill, Lehman, etc.
Originator sell 1000
loans to Investment
Bank
$1Billion
Plus fee
.
.
.
1000 borrowers at
$1million each =
$1 billion in
mortgage loans
For $1 billion (plus a fee),
the investment bank gets
the right to the interest
payments ($100 million per
year) and principal
payments.
Modern Mortgage Model (II)
1000 Borrowers
Commercial
Banks/Mortgage
Originator
Investment Banks:
(Merrill, Lehman, etc.
CB services the
1000 loans
.
.
.
The investment bank gets
the right to the interest
payments ($100 million per
year) and principal
payments ($1 Billion).
Story
Doesn’t Stop
Here!
Modern Mortgage Model (III)
1000 Borrowers
.
Commercial
Banks/Mortgage
Originator
Investment Banks:
(Merrill, Lehman, etc.
CB
services
the loans
.
.
10% per year for 10 years
($100million) plus $1 Billion at
the end of 10th year
MBS
Investment bank
creates
Mortgage Back
Securities which
are sold to
investors. They
collect a fee.
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)
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. 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?
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?
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 28day 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
m
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.
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?
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
• Passed in October. Troubled Asset Relief
Program - TARP
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.
January 2009*
• The Federal Reserve Bank of New York begins
purchasing $100 billion of fixed-rate mortgagebacked 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?
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.”
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.
September 2011 Operation Twist
Twist the Yield Curve. Buy long and sell short
September and December 2012
• *QE 3: (Sept 2012) Fed announced a new
$40 billion a month, open-ended, bond
purchasing program of agency mortgagebacked securities.
• *QE 4: (Dec 2012) Increased to $85
billion a month.
Trends in Fed’s Balance Sheet
http://clevelandfed.org/research/data/credit
_easing/index.cfm