The Fed and the Liquidity Crisis
I got too busy this week (work + baseball) to write a newsletter. I am posting a rerun of a piece I wrote about the Fed's handling of the liquidity crisis. What follows is that which, in my view, deserves most of the credit for the Great Recession not being much worse than it was.
The Federal Reserve last week released the details of the various programs
which it instituted in response to the liquidity crisis which started in 2007.
Between February 2007 when HSBC was the first large bank to make a large write-off
($10.5 billion) and August 2008
banks world wide had written off $500 billion. Banks had a dual problem.
One was a capital problem but the persistent one was a liquidity problem. The
capital problem was partially fixed by raising more capital and diluting the
value of equity position of banks. The liquidity problem was more nefarious.
Banks became suspicious of one another and their normal flow of interbank lending
stopped.
Liquidity implies that an asset can be sold quickly without affecting the price.
The underlying reality was that if banks started to sell their stakes in home loans
the prices would be driven constantly down creating cascading losses as the
value of their stakes deteriorated and their new worth decreased.
The salient point was this: banks needed an extended period of time to get
rid of their lousy assets of pools of bad home loans. This required two things:
1) relaxation of accounting rules to not force banks to genuinely mark these
assets to market 2) a massive injection of liquidity on a scale never before
seen.
What follows are brief synopses of the various Fed created programs to provide
liquidity.
TAF
One solution was the Term
Auction Facility. The TAF was not merely a Federal Reserve thing. It was
the coordinated effort of the Federal Reserve, the European Central Bank, the
Bank of England, Bank of Canada, and the Swiss National Bank.
Under the Term Auction Facility program, the Federal Reserve auctioned term
funds to depository institutions by taking of a larger set of assets as collateral
that the Fed would normally take at its discount window. Cash was provided with
a broader set of assets as collateral.
I am going to sidetrack here with comments on some of what I have read about
this. The Fed was not giving money to anyone. It was lending money. All of these
loans were secured. The Fed lost zero. In fact it made money. It most certainly
took risks because it lowered the standard of the collateral it took.
The details of who got TAF money are
in this spreadsheet.
Primary Dealer Credit Facility (PDCF)
Some of the entities damages by the liquidity crisis were primary dealers.
There are currently 18
primary dealers. These are the entities which the Treasury department uses
to wholesale Treasury auctions. One of the most important elements of this is
what is called a "Tri-party Repurchase Agreement." A repurchase agreement
(repo) is the sale of securities and the agreement by the seller to repurchase
those securities for a given price on a given date. These are Wall Street versions
of a pawn shop. A Tri-party Repurchase Agreement is a repo where there is a third
part which acts as custodian for the securities. With these entities damaged
and lacking the trust of counterparties, the Fed established PDCF as an overnight
loan facility for primary dealers. It was to primary dealers what the Fed window
is to member banks. The dealers of immediate concern were Goldman Sachs, Morgan
Stanley, and Merrill Lynch. Details of all of the PDCF transactions
are in this spreadsheet.
The facility was announced on March 16, 2008, and was closed on February 1,
2010. All loan were repaid with interest.
It should also be noted that the big Wall Street investments banks were subsequently
either acquired by commercial banks or redefined themselves to become bank holding
companies and can now borrow from the Fed window.
Term Securities Lending Facility (TSLF)
This was another
type of support for primary dealers and loaned liquid Treasury securities
with less than totally liquid securities as collateral. These "less than
totally liquid securities" were agency MBS, CMO and bonds with
ratings from AAA to Baa/BBB. The TSLF was announced on March 11, 2008 and closed
on February 1, 2010. All securities loans made under the facility were repaid
in full, with interest.
Agency Home Loan-Backed Securities (MBS) Purchase Program
This was the facility for purchasing residential home loans. This helped Main
Street not Wall Street. These was FNMA, FHLMC and GNMA (FHA and VA) home loans.
The Fed purchased these home loans in bulk from primary dealers. Most of these
remain owned by the Fed and each transaction has its own CUSIP number. In addition
to the interest received there has been much principal repayment as homes are
sold and as those Fed owned home loans were refinanced at lower rates this year.
Understand that the Fed paid zero for the money. It created these fund out of
thin air. All of the interest received (less what is paid to the servicer) is
profit. The notion that this was a dramatic increase in money supply which could
create asset bubbles especially with low interest rates is valid. Asset bubbles
are a collateral effect.
Commercial Paper Funding Facility (CPFF)
Commercial paper is short-term (<270 days) borrowing usually by businesses
and governments to fund short-term operating expenses. Some commercial paper
is backed with assets and some is unsecuritized. This is a critical source of
funding for many businesses. While a business can issue commercial paper itself,
most commercial paper is sold to broker-dealers (investment banks and bank holding
companies) and those entities find retail buyers for this paper. To a large
extent is was money market mutual funds which provided the cash for commercial
paper. On September 16, 2008, consequent to the Lehman BK investors started
moving money out of money market mutual funds and these funds had to liquidate
assets at a bad time. On
that day the Reserve Primary Fund, the oldest money fund in existence, and
a holder of $785 million in Lehman Brothers commercial paper "broke the
buck" meaning that every dollar invested there was worth less than $1.00.
Before that day, in the entire 37 year history of money market funds this had
only happened twice. The notion that other than cash and bank deposits money
market funds were the safest investments had gotten a serious jolt.
When the liquidity crisis happened the money market funds were reluctant to
purchase commercial paper. We were facing a serious recession and the sources
of credit to many businesses disappeared almost overnight.
The Federal Reserve created the CPFF and the Federal Reserve Bank of New York
provided three-month loans to the CPFF LLC, a specially created limited liability
company (LLC) that used the funds to purchase commercial paper directly from
eligible issuers.
The facility was announced on October 7, 2008, began purchases of commercial
paper on October 27, 2008, and was closed on February 1, 2010. Net portfolio
holdings of the CPFF LLC peaked at $351.4 billion on 1/23/2009. The CPFF LLC
was dissolved on August 30, 2010. All loans that were made to the CPFF LLC were
repaid in full.
This is a
link to the CPFF page at the site of the Federal Reserve Bank of New York.
This is a spreadsheet
of all CPFF purchase transactions. This is a spreadsheet
loans that FRBNY made to the CPFF.
Term Asset-Backed Securities Loan Facility (TALF)
This addressed asset based securities (ABS). Asset based securities
are what banks, for example, use to finance auto loans, credit card debt and
student loans. When the liquidity crisis happened investors were reluctant to
purchase ABS. While TALF lending was done through intermediaries the people
who benefited were everyone who wanted an auto loan, a credit card, a student
loan or a small business loan. TALF loans were collateralized by assets. The
value of the assets always exceeded the value of the loan. This helped Main
Street not Wall Street.
The facility was announced on November 25, 2008, and began lending operations
in March 2009. TALF lending was authorized through June 30, 2010.
Central Bank Liquidity Swap Lines
These are foreign exchange swaps. Two types were enabled one for foreign banks
wanting to temporarily exchange their currency for U.S. dollars and one for
providing liquidity for foreign currency assets of U.S. banks. The later were
never activated. Since I am bad at explaining FOREX in my down-to-earth fashion
I will merely plagiarize the Fed.
"To address severe strains in global short-term dollar funding markets,
the Federal Reserve established temporary central bank liquidity swap lines
(also referred to as reciprocal currency arrangements) with a number of foreign
central banks. Foreign central banks then could draw on those lines to provide
dollar liquidity to institutions in their jurisdictions. In the swap transactions,
the Federal Reserve deals only with the foreign central bank. The transaction
is structured so that the Federal Reserve does not bear any foreign exchange
risk. In May 2010, dollar swap lines were reestablished with certain foreign
central banks because of the reemergence of strains in dollar funding markets.
The FOMC authorized temporary dollar liquidity swap arrangements with 14 foreign
central banks between December 12, 2007, and October 29, 2008. The arrangements
expired on February 1, 2010. All transactions were executed in full, in accordance
with the terms of the swap arrangements.
In May 2010, in response to the reemergence of strains in short-term dollar
funding markets abroad, the FOMC re-authorized dollar liquidity swap lines with
five foreign central banks through January 2011."
The Special Case
The Fed thought that there were some special cases which needed their own facilities.
(The Fed, Treasury and FDIC put together special liquidity facilities for BofA
and Citigroup but these were never used.) The notable special case was AIG.
AIG was (in theory) an insurance company with headquarters in New York City.
To oversimplify things the London unit of AIG became heavily invested in Credit
Default Swaps on collateralized debt obligations (CDOs) and the large decrease
in the value of these created a liquidity crisis for AIG. AIG was starting to
look like Lehman Brothers 2.0 (Lehman had declared bankruptcy and AIG had a
similar portfolio.) AIG had large positions in subprime and Alt-A home loans.
On September 16, 2008, AIG's stock dropped 60 percent. The Federal Reserve tried
to broker a massive non-government line of credit for AIG but there were no
takers. AIG's potential losses were diverse and the opinion of the Fed was that
it was easier to bail out AIG that to let it fail and bail out wherever counterparties
would be destroyed by an AIG bankruptcy. See this New
York Times post of that day.
That day the Fed decided to act on its own and provided AIG with a credit line
of up to $85 billion, AIG was aided both by the Fed's line and Treasury's TARP
program. The Fed created 2 LLCs to lend money to AIG. These were called Maiden
Lane II and Maiden Lane III. (The Federal Reserve bank in Manhattan is at the
corner of Liberty Street and Maiden Lane. For you movie trivia freaks, Maiden
Lane is also the street in San Francisco where the scene in the pet shop at
the opening of Hitchcock's "The Birds" was filmed.)
AIG went from being a Dow company to a company 79.9% owned by the US government.
(Note that the 79.9% ownership thing is designed to keep this off the books
of the Fed or Treasury. If the government owned 80% or more these would appear
on the government's balance sheet.) The ongoing plan has been to recapitalize
AIG and sell off pieces and repay Treasury and the Fed.
So What?
Since this was announced I have read countless criticisms of the Fed's
actions as detailed in this report. The fact is this: the Fed acted independently
in most of these cases. It acted under authority granted to it by of Section
13(3) of the Federal Reserve Act, which permitted the Board, in unusual and
exigent circumstances, to authorize Reserve Banks to extend credit to individuals,
partnerships, and corporations. If these were not unusual and exigent circumstances
then I am not sure what constitutes such.
The Fed did not give money away to any entity. It reacted in a most dramatic
way to a massive liquidity crisis which, if not immediately addressed, could
have created a worldwide depression. The Fed provided liquidity for funding
home loans, credit card debt, student loans and auto loans. As far as I can tell
the only long term loans are the home loans purchased by the Fed from FHLMC,
FNMA and GNMA. The Fed helped Main Street as well as Wall Street. All of the loans
made to increase liquidity to commercial banks and investment banks are repaid.
The Fed acted boldly and may someday be judged to have averted a worldwide
economic catastrophe and the end of 2009 transferred more than $45+ billion
in profit to Treasury. The discussion about whether the Fed should have the
dual mandate of controlling inflation and keeping unemployment low misses the
fact that real mandate of the Fed is preservation of the banking system.
The elements of the dual mandate are secondary and we do not normally think
about the Fed's first purpose because things such as this liquidity crisis do
not occur often.
The Fed gets criticized by folks of all political beliefs.
To me criticizing the Fed is like criticizing the fire department. Building
owners complain that they do water damage and the arson squad complains that
they destroy evidence. Like the fire department, as the Fed puts out economic
fires it does create collateral damage. That collateral damage takes the form
of asset bubbles created by low interest rates and large increases in money
supply. The Fed quite possibly averted a major worldwide depression and it so
doing made enough money that is gave Treasury $45 billion in 2009. So before
anyone bitches about the Fed they should perhaps think about that.
The liquidity crisis unfolded with such speed that there was no time for any
entity other than the Fed and other central banks to act. The Fed needed to
act without proximate input from politicians. Congress gave the Fed its agenda.
Listening to people in Congress and comedians on TV question Bernanke is, to
me, laughable. With these programs the Fed helped Main Street and Wall Street.
When it helped Main Street it also helped Wall Street. When it helped Wall Street
it also helped Main Street. The notion that Wall Street and Main Street have
opposing interests is one of the dumbest fallacies to come from all the discussion
about what the Fed did.
Dick Lepre
[email protected]
Web site: www.loanmine.com
Blog: economy.typepad.com
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