Understanding the
Policy Response to
the Financial Crisis
Macroeconomic Theory Honors
EC 204
Key Problems in the Crisis

Bank Solvency



Declining home prices and rising mortgage defaults put
banks in danger of insolvency.
Policy Response: TARP and Regulatory Reform.
Credit Market Illiquidity


Failure of major financial institutions (Bear Stearns,
Lehman, AIG, GSEs) precipitates freezing-up of credit
markets.
Policy Response: Fed gets creative: TAF, TSLF, CPFF,
AMLF, TALF, etc…
Bank Solvency

It’s all about balance sheets…
Firstbank's Balance Sheet
Assets
Liabilities
________________________________________________
|
Reserves
$200
|Deposits
$1,000
|
Loans
$800
|
|
Secondbank's Balance Sheet
Assets
Liabilities
________________________________________________
|
Reserves
$160
|Deposits
$800
|
Loans
$640
|
|
Bank Solvency

More accurate representation of a typical bank…Owners
have to put up some equity!
Assets
Liabilities and OwnersΥEquity
________________________________________________
|
Reserves
$200
|Deposits
$750
|
Loans
$500
|Debt
$200
|
Securities
$300
| Capital (OwnerΥs Equity)
$50
Bank Solvency





Banks make money through leverage.
Leverage ratio = Assets/Bank Capital.
Example has leverage ratio of 1000/50 = 20.
For every dollar of capital, the bank has 20 dollars
of assets and 19 dollars of deposits and debt.
Implication: Bank can lose much of its capital
quickly.
Bank Solvency




Consider a drop of 5% in value of its assets.
This represents $50.
But this is the total value of the bank’s capital.
A leverage ratio of 20 leads mean a 5% fall in asset
value will wipe out the bank’s capital!
Bank Solvency: Transmission
of the Crisis

Securities held by banks included mortgage-backed
securities and other risky assets. As defaults on these
securities rose, bank capital came under pressure:
Assets
Liabilities and OwnersΥEquity
________________________________________________
|
Reserves
$200
|Deposits
$750
|
Loans
$500
|Debt
$200
|
Securities
$300
| Capital (OwnerΥs Equity)
$50
Bank Solvency: Transmission
of the Crisis

Insurance contracts on these securities bring additional
parties into the crisis. Debt of the troubled financial
institutions in turn becomes a problem for other investors and
institutions…
Assets
Liabilities and OwnersΥEquity
________________________________________________
|
Reserves
$200
|Deposits
$750
|
Loans
$500
|Debt
$200
|
Securities
$300
| Capital (OwnerΥs Equity)
$50
Bank Solvency - The Policy
Response


As Treasury Secretary Geithner has said: “Its all
about capital, capital, capital…”
(1) TARP - Troubled Asset Relief Program ($700B)




Phase I: Putting capital directly into the banks
Phase II: Entice investors to buy the bad assets
(2) Regulatory reform
(3) Support housing market - expand GSE lending,
loan modification programs, tax incentives
Bank Solvency - The Policy
Response: TARP


TARP I: Add to capital
TARP II: Remove bad securities/add some capital
Assets
Liabilities and OwnersΥEquity
________________________________________________
|
Reserves
$200
|Deposits
$750
|
Loans
$500
|Debt
$200
|
Securities
$300
| Capital (OwnerΥs Equity)
$50
Bank Solvency - The Policy
Response: TARP II

TARP II: Deals with two sorts of troubled assets





Risky home loans:
FDIC will lend 85% of cost to investor, additional 7.5% in Treasury
equity, investor comes up with just 7.5% equity. Government and
investor split any capital gain on asset. Government gets interest on
loan. Loan is “Non-recourse.”
Risky mortgage-backed securities:
Asset managers provide 25% equity stake, Treasury matches this with
equal amount of equity, and provides loan for remaining 50%. Loan is
non-recourse.
Some TARP funds also to be used as credit protection to expanded
Federal Reserve lending facility for ABS.
Bank Solvency - The Policy
Response: Regulatory Reform






Create a Systemic Regulator
Transparency for derivatives and other exotic securities
Oversight of hedge funds, insurance companies, money market
funds
Capital ratios
Ability to takeover financial companies that present dangers to the
system
Intended to provide better understanding of overall risk to financial
system and to ensure adequate capital to cover potential risks.
Bank Solvency - The Policy
Response: Regulatory Reform

Again, can use the simple balance sheet to understand how such
reforms would work…
Assets
Liabilities and OwnersΥEquity
________________________________________________
|
Reserves
$200
|Deposits
$750
|
Loans
$500
|Debt
$200
|
Securities
$300
| Capital (OwnerΥs Equity)
$50
Bank Solvency - The Policy
Response: Housing Market

Attempts to support housing market and stem rise in default rate
on mortgages:





Expand GSE lending
Loan modification programs
Tax Incentives
Fed purchases of long-term securities -- bring down mortgage rates
Evidence that mortgage market has responded, as rates continue
at low levels. But high unemployment represents a strong
headwind.
Credit Market Illiquidity

Federal Reserve has responded in three key
ways to the breakdown in the credit system.



Traditional role as lender of last resort - both
using OMO and new approaches.
Provision of liquidity directly to borrowers and
investors in key credit markets.
Support for specific institutions (AIG, Citi, BoA).
Credit Market Illiquidity

Lender of last resort:




Cut federal funds rate from 5.25 to near zero
Extended repayment period for discount window
borrowing
Term Auction Facility - all 7000+ commercial
banks eligible -- broader types collateral
Facilities for lending to primary dealers - lengthen
term and allow broader types of collateral
Credit Market Illiquidity

Provision of credit to markets:



Commercial paper market
Money market mutual funds
Asset-backed loan markets -- consumer, credit
card, auto, student, business loans (nonrecourse) -- Expanded to include GSE debt, other
MBS and L.T. Treasuries
Credit Market Illiquidity

Loans for Specific Institutions:




Begun with Bear Stearns workout
AIG
Citi
BoA
Credit Market Illiquidity

Implications of Fed policy response:




Balance sheet of Federal Reserve has changed
drastically
Both composition and size
Banks holding large amounts of excess reserves
Huge decline in money supply multiplier
The Fed’s Balance Sheet:
July 2007


Assets
Treasury Securities
Liabilities
Currency
$790.6
781.4


Repurchase Agreements
16.8

Loans
42.4
30.3
Commercial Bank Reserves
0.2
U.S. Treasury Deposits
and Official Foreign Liabilities


Foreign Exchange
20.8
Other
5.7

Gold
11.0
Capital
34.1

Other

Total Assets
27.5
880.4
Total Liabilities Plus Capital
880.4
The Fed’s Balance Sheet:
March 2009


Assets
Treasury Securities
898.0
$422.7
Liabilities
Currency


Mortgage-Bkd Securities
795.7
237.0
Commercial Bank Reserves

Loans
278.0
Liabilities
913.0
U.S. Treasury Deposits
and Official Foreign


CB Liquidity Swaps

Gold
328.0
11.0
Other factors Absorbing Reserves
1307.3
Capital and other liabilities
55.0
Total Assets of the Federal Reserve
Since the beginning of the financial market turmoil in August 2007,
the Federal Reserve's balance sheet has grown in size and has
changed in composition. Total assets of the Federal Reserve have
increased significantly from $869 billion on August 8, 2007.
Selected Assets of the Federal Reserve
The increase in the size of the Federal Reserve's balance sheet has
been accompanied by a change in the composition of the assets held.
The level of securities held outright has declined, on net, while the
various liquidity facilities have added a host of other assets.
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Credit Extended through Federal Reserve Liquidity
Facilities
Among the liquidity facilities, the largest changes in assets have resulted
from credit extended through the Term Auction Facility, the Commercial
Paper Funding Facility, and the central bank liquidity swap lines.
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Selected Liabilities of the Federal Reserve
On the liabilities side of the Federal Reserve's balance sheet, the amount of
currency increased somewhat, but reserve balances (deposits of depository
institutions) have increased dramatically, as have Treasury's deposits with
the Federal Reserve.
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