Understanding the Policy Response to the Financial Crisis

Macroeconomic Theory

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…

Quarterly Increase in Home Prices(S&P/Case-Shiller National Index)

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0

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25.0

2003 2004 2005 2006 2007

Annual Percentage Change

Annual Increase in Home Prices(S&P/Case-Shiller National Index)

-25%

-20%

-15%

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-5%

0%

5%

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2001 2002 2003 2004 2005 2006 2007 2008 2009

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 Owners’ Equity ________________________________________________ | Reserves $200 |Deposits $750 | Loans $500 |Debt $200 | Securities $300 | Capital (Owner’s 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 Owners’ Equity ________________________________________________ | Reserves $200 |Deposits $750 | Loans $500 |Debt $200 | Securities $300 | Capital (Owner’s 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 Owners’ Equity ________________________________________________ | Reserves $200 |Deposits $750 | Loans $500 |Debt $200 | Securities $300 | Capital (Owner’s 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 Owners’ Equity ________________________________________________ | Reserves $200 |Deposits $750 | Loans $500 |Debt $200 | Securities $300 | Capital (Owner’s 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 Owners’ Equity ________________________________________________ | Reserves $200 |Deposits $750 | Loans $500 |Debt $200 | Securities $300 | Capital (Owner’s 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

Some evidence that mortgage market is responding, as rates are now at low levels. But rising unemployment and declining economic activity represent strong headwinds.

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 (non-recourse) -- Recently 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 LiabilitiesTreasury Securities $790.6 Currency 781.4

Repurchase Agreements 30.3 Commercial Bank Reserves 16.8

Loans 0.2 U.S. Treasury Deposits 42.4 and Official Foreign Liabilities

Foreign Exchange 20.8 Other 5.7

Gold 11.0 Capital 34.1

Other 27.5

Total Assets 880.4 Total Liabilities Plus Capital 880.4

The Fed’s Balance Sheet: March 2010

Assets LiabilitiesTreasury Securities $422.7 Currency 898.0

Mortgage-Bkd Securities 237.0 Commercial Bank Reserves 795.7

Loans 913.0 U.S. Treasury Deposits 278.0and Official Foreign Liabilities

CB Liquidity Swaps 328.0 Other factors Absorbing Reserves 1307.3

Gold 11.0 Capital and other liabilities 55.0

Other 48.0

Total Assets 2103 Total Liabilities Plus Capital 2103

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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.

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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.

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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Money Supply (M1) and the Monetary Base

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Billions of Dollars

Money Supply

Monetary Base

Money Supply Multipliers

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