Running Head: THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
Track 11 Undergraduate Student
Interactive Session
The Federal Reserve and the Global Financial Crisis:
How the Federal Reserve Created and Cured the Crisis, 2001-2011
1
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
2
Abstract
Easy credit monetary policies of the United States Federal Reserve, implemented to fight the
recession in 2001, led to artificially low interest rates, which led to the creation of bad assets.
When trust in those assets was lost, the world was plunged into a financial crisis that only the
Federal Reserve and other central banks around the world had the ability to fix. The Federal
Reserve was forced to inject billions of dollars into the global economy during the crisis and
trillions more after the crisis to keep the global economy stable, all to combat its bad policies
from a decade earlier. The Federal Reserve, while it may not need to be more regulated, needs to
be more aware of its effects on the global economy in the future.
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
3
The Federal Reserve and the Global Financial Crisis
Introduction
In a lecture at George Washington University in March 2012, then Federal Reserve
Chairman Ben Bernanke said, “Central banks, as they have for a number of centuries, can help
calm a financial panic” (Bernanke, 2013a, p. 64). The period of 2007-2009 experienced less of a
financial panic and more of an all out global financial crisis. Central banks around the world
needed to do more than simply calm the crisis, they needed to take actions to fight it. This
action, necessitated by a crisis caused by failures of U.S. mortgage backed securities, was to
create a retaining wall of money to keep the global economy from failing.
A combination of Federal Reserve and other central banks’ policies before 2007 led to
the mass creation and selling of risky U.S. mortgage backed securities around the world. The
crisis began in Europe in 2007 when the actual security of mortgage backed securities was called
into question. Trust was lost across Europe, simply because it bore the most risk by buying the
bulk of the questionable securities. Central banks assured banks that there would be a free flow
of cash to ensure they were “awash in liquidity” (Irwin, 2013, p. 128).
The U.S. entered a recession at the end of 2007. Eventually, mortgage backed securities
failed investment banks in the U.S. in 2008. To fight this, the Fed cut interest rates and lent
money to ensure that funds still flowed around the economy. Then in late 2008, the global
economy was on the brink of collapse. The Federal Reserve, the lender of last resort to the U.S.,
became the lender of last resort to the world. Over $580 billion were loaned to foreign banks by
December 2008.
To ensure liquidity of banks and other institutions after the crisis, the Federal Reserve
began a program of buying large-scale assets in March 2009. A second purchase of large-scale
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
4
assets began in November 2010 (Bernanke, 2013a, p. 102). These have been referred to as
Quantitative Easing 1 (QE1) and Quantitative Easing 2 (QE2), respectively. QE1 and QE2 have
effectively kept both short term and long term interest rates low, creating “greater confidence in
the financial markets” and “promoted growth and recovery.”
These actions of the Federal Reserve, and other central banks, essentially saved the
global economy from destruction. While the Fed cured the crisis, its causes can be traced back
to the policies of the Fed of the early 2000s. In essence, the Federal Reserve had to fix a global
crisis which it had inadvertently caused.
The Boom
The Federal Reserve, led by Chairman Alan Greenspan, began to lower the interest rates
and expand the supply of money in 2001, both to combat the recession of that year. The amount
of money in circulation rose at a rate “above 10 percent, and remained above 8 percent entering
the second half of 2003” (White, 2009, p. 116). Simultaneously, the Federal Reserve lowered
the Federal Funds Rate from 6.25 percent at the beginning of 2001 to 1.75 percent at the end of
2001 (White, 2009, p. 116). The rate was lowered even further, reaching a low of 0.98 percent
by 2003 (Table 1).
This supply of loanable funds began a decrease in real interest rates in the United States.
Because of this, 30 year mortgage rates began to fall. Also, because the Federal Reserve lowered
short-term rates, adjustable-rate mortgages “became increasingly cheap relative to 30-year-fixedrate mortgages” (White, 2009, p.118). The amount of new mortgages with adjustable rates
doubled by 2005 (White, 2009, p. 118). Low rates led to a demand for houses, which increased
the prices of existing houses (White, 2009, p. 119). By 2006, the average cost of a house was
five times as much as the average income in the U.S., having “increased by about 130 percent”
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
5
since the late 1990’s (Irwin, 2013, p. 99; Bernanke, 2013a, p. 41). Housing prices around the
world were also rising. It has been estimated that “the value of all housing in the developed
world” rose “to $70 trillion in 2005, from $30 trillion just five years earlier” (Irwin, 2013, p.
100).
By 2005, there was what Bernanke called, a “global savings glut,” meaning that there
was an excess of money in the global economy (Bernanke, Bertaut, DeMarco, Kamin, 2011b, p.
1). This abundance in global liquidity was a result of the increases in global supplies of money.
The glut not only contributed to keeping rates low, but created a demand for safe investments
(Bernanke et al., 2011b, p. 1). To meet demand, financial institutions began to bundle several
mortgages and sell them to investors at increasing amounts. These mortgage backed securities
had very low risk because the bundles were seen as diverse, with the odds of many simultaneous
mortgage defaults being very low. At least it seemed so at the time (Irwin, 2013, p. 102). The
amount of mortgaged backed securities that were issued skyrocketed. In 2005, $901 billion
worth of securities were issued, “up from $36 billion a decade earlier” (Irwin, 2013, p. 102). 55
percent of these United States securities were sold to foreign investors, with the “most prominent
source being Europe” (Bernanke, 2011b, p. 8-9).
The Crisis in Europe, 2007
On August 9, 2007, the financial crisis was triggered when “the large French bank BNP
Paribas temporarily halted redemptions from three of its funds because it could not reliably value
the assets” backed by mortgages (Cecchetti, 2008, p. 6). This caused financial institutions
around the world to doubt the value and credit rating of similar assets. In Europe, a loss of trust
transpired, leading to “a sudden hoarding of cash and cessation of inter-bank lending” (Cecchetti,
2008, p. 6). This “contraction in the supply of short-term funds caused overnight interest rates in
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
6
Europe to shoot up,” prompting a “liquidity injection” of €94.8 billion by the European Central
Bank (Cecchetti, 2008, p. 6). The Federal Reserve also injected funds and lowered the Federal
Funds Rate (Cecchetti, 2008, p. 12-13).
Even with these injections and adjustments, the trust problems and credit issues
“worsened through the late fall 2007 and early winter 2008” (Cecchetti, 2008, p. 12). A
contributing factor to the problems was that many “European banks needed dollar funding as
opposed to euro funding” (Bernanke, 2013a, p. 92). Those European banks held “dollar assets
and they [made] loans to support trade, which is often done in dollars, so they needed dollars”
(Bernanke, 2013a, p. 92). Because of this, on December 12, 2007, the Federal Reserve did a
swap “with the European Central Bank and the Swiss National Bank of $20 billion and $4
billion, respectively” (Cecchetti, 2008, p. 13). Those central banks then lent those dollars out to
the European banks that needed them, thereby “easing dollar funding pressures around the
world” (Bernanke, 2013a, p. 93).
On the same day as the currency swaps, the Federal Reserve announced the creation of
the Term Auction Facility (TAF), a “way to get reserves to banks that needed them” (Cecchetti,
2008, p. 14). TAFs made sure that dollars made it to “U.S. affiliates of European banks” (Irwin,
2013, p. 131). The first TAF was on December 20, 2007, with the Federal Reserve lending $20
billion, the bulk of which went to banks from Europe (Table 2). Both the currency swaps and the
TAF were to ensure that there was a free flow of funds in Europe.
Crisis Hits the United States, 2007-2008
Although the United States’ economy had survived the early months of the crisis, “by
December 2007, the nation was officially in recession,” and by March 2008, the problems that
hit Europe, hit the United States (Irwin, 2013, p. 132). Bear Stearns, an investment bank, relied
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
7
“on lenders being willing to extend them credit against solid collateral” (Irwin, 2013, p. 132).
However, its “business of packaging mortgages into securities” began to fall apart when
investors doubted whether “the assets Bear had on its books were worth what it claimed they
were” (Irwin, 2013, p. 132).
By March 13, 2008, Bear Stearns was on the brink of collapse. It had “$14.2 trillion of
notional value in derivative contracts—futures, options and swaps—outstanding with thousands
of counterparties” (Cecchetti, 2008, p. 17). If Bear Stearns failed, the prices of those securities
would collapse, affecting the entire financial system (Cecchetti, 2008, p. 17). To prevent this,
the Federal Reserve invoked Article 13(3) of the Federal Reserve Act, allowing it “to make loans
to any individual, partnership, or corporation” (Cecchetti, 2008, p. 17).
On March 14, the Federal Reserve made a loan to Bear Stearns worth $12.9 billion. The
loan was repaid on March 17. By the next weekend, a deal was brokered for Bear Stearns. The
Federal Reserve would take on “$30 billion worth of mortgage-backed securities” and J.P.
Morgan would buy the rest (Cecchetti, 2008, p. 17-18). The Federal Reserve also allowed other
investment banks to borrow directly.
By September 2008, the problems that hurt Bear Stearns hit the investment bank Lehman
Brothers. However, this was different, in that Lehman Brothers was insolvent and no one was
willing to take it over (Irwin, 2013, p. 143). Lehman Brothers, who filed for bankruptcy
protection, was failed by mortgage backed securities.
American International Group (AIG), “an insurance company with a $1 trillion balance
sheet,” was also failing because of mortgage backed securities. As mortgage backed securities
lost value, global holders wanted AIG to assure it could cover the losses. It had neither the assets
nor the ability to secure a loan. As a result, along with Lehman Brothers’ bankruptcy, the Dow
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
8
Jones Industrial Average fell 504 points (Irwin, 2013, p. 145). To Bernanke and other officials at
the Federal Reserve, because AIG had been “so interconnected with both the U.S. and the
European financial systems and global banks,” its failure “would have been basically the end” of
the global economy (Bernanke, 2013a, p. 85).
To keep the financial system going, the Federal Reserve began to loan out trillions of
dollars to firms in the United States, as well as firms around the world (Irwin, 2013, p. 151). By
December 10, 2008, the Federal Reserve loaned $580 billion to foreign banks (Irwin, 2013, p.
154). To ensure that the funds circulated, interest rates were lowered to historic lows of nearly
zero percent (Irwin, 2013, p. 163-164). Central banks around the world did the same (Irwin,
2013, p. 161-162). To keep the global financial system from completely failing, central banks
created a retaining wall of money through inflation. It held.
Government Recovery Programs and More Actions from the Federal Reserve, 2008-2012
The United States Congress passed legislation called the Troubled Assets Relief Program,
or TARP, on October 3, 2008. TARP was established to help bring “more democratic
legitimacy” to the financial responses to the crisis (Irwin, 2013, p. 157). The Federal Reserve
could not keep bailing out insolvent institutions. Rather, it was a task that Congress and
President Bush’s administration needed to undertake. TARP served to loan money by buying
toxic assets from banks that had become insolvent as a result of losses from mortgage-backed
securities. In all, TARP would be worth about $700 billion. By loaning this amount of money,
banks and other financial institutions could remain solvent and maintain proper liquidity,
therefore keeping markets secure (Blinder, 2014, p. 179).
Only about $430 billion of the $700 billion that TARP allocated was actually loaned.
Although originally passed to loan money to banks to cover mortgage-backed securities losses,
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
9
TARP money was also used for other asset guarantees, the auto-industry bailout, and to cover
foreclosures (Blinder, 2014, p. 205). Alan S. Binder, in his book “After the Music Stopped,”
wrote that TARP is exemplified as potentially one of the most successful economic policy
innovations (Blinder, 2014, p. 177), and characterized it as a “smashing success” on justification
of having a net cost to taxpayers of only $32 billion (Blinder, 2014, p. 205).
In December 2008, the Federal Reserve created the Term Asset-Backed Securities Loan
Facility, or TALF, which fulfilled TARP’s initial purpose of buying troubled assets (Blinder,
2014, p. 206). TALF served to loan money to institutions that would be willing to buy troubled
assets up to $200 billion. The U.S. Treasury also promised $20 billion in TARP money. By
February 2009, the Fed increased the loan amount to $1 trillion (Blinder, 2014, p. 207). TALF
loans started in March 2009, but would only total $70 billion. However, that same month, the
Federal Open Market Committee promised it would buy $1.75 trillion worth of Treasury
securities, GSEs, and mortgage-backed securities (Blinder, 2014, p. 207). These purchases
would come to be known as Quantitative Easing 1.
The first Quantitative Easing was done in part because regular monetary policies were no
longer applicable. Interest rates could not be cut further but the economy still needed credit. QE
started as, what the Fed called, large-scale assets purchases, or LSAPs (Bernanke, 2013a, p.
102). The LSAPs included the Treasury securities, GSEs, and mortgage-backed securities, all of
which were guaranteed by the Federal government (Bernanke, 2013a, p. 102).
The second Quantitative Easing was initiated in November 2010. This QE was another
LSAP. In total, QE1 and QE2 “increased the Fed’s balance sheet by more than two trillion
dollars” (Bernanke, 2013a, p. 102). By buying the assets, the Federal Reserve reduced “the
available supply of those securities” which forced investors “to settle for a lower yield”
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
10
(Bernanke, 2013a, p. 104). To pay for these purchases, the Federal Reserve credited “the bank
accounts of the people” who sold the assets, with those accounts being counted as “reserves that
the banks would hold with the Fed” (Bernanke, 2013a, p. 105).
Increases in credit at the end of 2011 were more currency swaps between the Federal
Reserve and the European Central Bank “in an attempt to try to reduce strains in Europe”
(Bernanke, 2013a, p. 104). To provide dollar funding in Europe, the Federal Reserve lowered
“the pricing on the existing temporary U.S. dollar liquidity swap arrangements” that were
established during the crisis (Board of Governors of the Federal Reserve System, 2011).
Conclusion
In response to the crisis, the U.S. Congress passed a reform bill known as The DoddFrank Wall Street Reform and Consumer Protection Act in an attempt to reduce the severity of
any future financial crisis. Dodd-Frank, as it is more commonly referred to, overhauled the
regulation of financial institutions in the United States, implementing more rules and more
oversight. However, the legislation did not have any major affect on the Federal Reserve, even
though the blame for the crisis rests on the Federal Reserve. Easy credit monetary policies,
which were implemented to fight the recession in 2001, led to artificially low interest rates,
which led to the creation of bad assets. When trust in those assets was lost, the global economy
was plunged into a crisis that only the Federal Reserve and other central banks around the world
had the ability to fight. The Federal Reserve was forced to inject billions of dollars into the
global economy during the crisis and trillions more after the crisis to keep the global economy
stable, all to combat its bad policies from a decade earlier. The Federal Reserve, while it may
not need to be more regulated, needs to be more aware of its effects on the global economy in the
long run.
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
11
References
Bernanke, Ben S. (2013a). The Federal Reserve and the Financial Crisis: Lectures by Ben S.
Bernanke. Princeton, NJ: Princeton University Press.
Bernanke, B. S., Bertaut, C., DeMarco, L. P., Kamin, S. (2011b). International Capital Flows and
the Returns to Safe Assets in the United States, 2003-2007. Board of Governors of the
Federal Reserve System International Finance Discussion Papers, (1014). Retrieved
from http://www.federalreserve.gov/pubs/ifdp/2011/1014/ifdp1014.htm.
Blinder, Alan S. (2014). After the Music Stopped: The Financial Crisis, the Response, and the
Work Ahead. New York, NY: Penguin Books.
Board of Governors of the Federal Reserve System. (2011). Press Release, November 30, 2011.
Retrieved from
http://www.federalreserve.gov/newsevents/press/monetary/20111130a.htm.
Board of Governors of the Federal Reserve System. (2013). Term Auction Facility (TAF) [data
file]. Retrieved from http://www.federalreserve.gov/newsevents/reform_taf.htm.
Caravalho, C., Eusepi, S., and Grisse, C. (2012). Policy Initiatives in the Global Recession: What
Did Forecasters Expect?. Current Issues in Economics and Finance, 18(2), 1-10.
Cecchetti, S. G. (2008). Crisis and Responses: the Federal Reserve and the Financial Crisis of
2007-2008. National Bureau of Economic Research Working Paper Series, (14134).
Retrieved from http://www.nber.org/papers/w14134.
Federal Reserve Bank of St. Louis. (2014). Effective Federal Funds Rate [data file]. Retrieved
from http://research.stlouisfed.org/fred2/series/FEDFUNDS.
Federal Reserve Bank in the St. Louis. (2014). M2 Money Stock [data file]. Retrieved from
http://research.stlouisfed.org/fred2/series/M2
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
12
Gokhale, J. (2009). Financial Crisis and Public Policy. Policy Analysis, (634), 1-24.
Irwin, Neil. (2013). The Alchemists: Three Central Bankers and a World on Fire. New York,
NY: Penguin Press.
White, L. (2008). Federal Reserve Policy and the Housing Bubble. Cato Journal, 29(1), 115-125.
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
Table 1
Effective Federal Funds Rate
Date
FFR
2001-07-01
3.77
2001-08-01
3.65
2001-09-01
3.07
2001-10-01
2.49
2001-11-01
2.09
2001-12-01
1.82
2002-01-01
1.73
2002-02-01
1.74
2002-03-01
1.73
2002-04-01
1.75
2002-05-01
1.75
2002-06-01
1.75
2002-07-01
1.73
2002-08-01
1.74
2002-09-01
1.75
2002-10-01
1.75
2002-11-01
1.34
2002-12-01
1.24
2003-01-01
1.24
2003-02-01
1.26
2003-03-01
1.25
2003-04-01
1.26
2003-05-01
1.26
2003-06-01
1.22
2003-07-01
1.01
2003-08-01
1.03
2003-09-01
1.01
2003-10-01
1.01
2003-11-01
1.00
2003-12-01
0.98
2004-01-01
1.00
2004-02-01
1.01
2004-03-01
1.00
2004-04-01
1.00
Federal Reserve Bank of St. Louis. (2014). Effective Federal Funds Rate [data file]. Retrieved
from http://research.stlouisfed.org/fred2/series/FEDFUNDS
13
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
Table 2
Term Auction Facility Data
Loan Data
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Dec 20 2007
Borrower
14
Borrower City
Loan Amount Interest Rate
in Millions
CITIBANK NA
NEW YORK
10.0
4.650
NORINCHUKIN BK NY BR
NEW YORK
10.0
4.650
BANK OF NOVA SCOTIA NY AGY
NEW YORK
14.7
4.650
LANDESBANK HESSEN-THURIN NY BR
NEW YORK
1,900.0
4.650
LLOYDS TSB BK PLC NY BR
NEW YORK
205.9
4.650
WESTLB AG NY BR
NEW YORK
2,000.0
4.650
TORONTO-DOMINION BK NY BR
NEW YORK
250.0
4.650
BAYERISCHE LANDESBANK NY BR
NEW YORK
1,000.0
4.650
WESTPAC BKG CORP NY BR
NEW YORK
90.0
4.650
ARAB BKG CORP NY BR
NEW YORK
200.0
4.650
SOCIETE GENERALE NY BR
NEW YORK
39.2
4.650
MIZUHO CORPORATE NY BR
NEW YORK
700.0
4.650
INTESA SANPAOLO SPA NY BR
NEW YORK
5.9
4.650
BANCO SANTANDER SA NY BR
NEW YORK
191.4
4.650
DRESDNER BK AG NY BR
NEW YORK
2,000.0
4.650
DZ BK AG DEUTSCHE ZENTRA NY BR
NEW YORK
2,000.0
4.650
MITSUBISHI UFJ TR & BKG NY BR
NEW YORK
25.0
4.650
BAYERISCHE HYPO VEREINS NY BR
NEW YORK
100.0
4.650
BANK TOK-MIT UFJ NY BR
NEW YORK
200.0
4.650
SUMITOMO MITSUI BKG NY BR
NEW YORK
800.0
4.650
NATIXIS NY BR
NEW YORK
500.0
4.650
NORDEA BK FINLAND PLC NY BR
NEW YORK
50.0
4.650
DEXIA CREDIT LOCAL NY BR
NEW YORK
2,000.0
4.650
LANDESBK BADEN WUERTTEMB NY BR NEW YORK
2,000.0
4.650
DEPFA BK PLC NY BR
NEW YORK
198.0
4.650
WACHOVIA BK NA
CHARLOTTE
25.0
4.650
BANK OF MONTREAL CHICAGO BR
CHICAGO
475.0
4.650
FIRST TN BK NA
MEMPHIS
1,000.0
4.650
BNP PARIBAS HOUSTON AGY
HOUSTON
1,400.0
4.650
BNP PARIBAS SF BR
SAN FRANCISCO
600.0
4.650
FIRST NB OF NV
RENO
10.0
4.650
Board of Governors of the Federal Reserve System. (2013). Term Auction Facility (TAF) [Data
file]. Retrieved from http://www.federalreserve.gov/newsevents/reform_taf.htm
THE FEDERAL RESERVE AND THE GLOBAL FINANCIAL CRISIS
Table 3
M2 Money Stock
Date
2007-01-01
2007-07-01
2008-01-01
2008-07-01
2009-01-01
2009-07-01
2010-01-01
2010-07-01
2011-01-01
2011-07-01
2012-01-01
Value
in Billions
7157.5
7373.9
7625.1
7903.8
8341.7
8435.6
8508.3
8679.1
8937.2
9493.7
9821.5
Federal Reserve Bank in the St. Louis. (2014). M2 Money Stock [data file]. Retrieved from
http://research.stlouisfed.org/fred2/series/M2
15