Thursday, April 14, 2011

A Brief History of the Fed and the Financial Crisis Part I: The Federal Funds Market and the Alphabet Soup of Programs.

Lets start out by establishing what it is the Fed actually does. It is a kind of short hand for commentators to say "The Fed is lowering/raising interest rates". More careful reporters and commentators will call the federal funds (fed funds) rate what it is or call it a policy rate.

Anyway, Figure 1 shows the relationship between the fed funds rate and a couple other rates.

Figure 1: Fed Funds and Selected Rates
Figure 1 should give you an idea of the kind of effect the federal funds rate has on "interest rates" over all. It is obvious that the rate on 3-month treasury bonds tracks the fed funds rates very closely. As well, the "prime rate"--the rate at which large banks lend to their best customers-- tracks the fed funds rate very closely but has a very clear risk/liquidity premium.

The effect of the fed funds rate is less obvious for the other rates. There seems to be a general pull downwards on 10-year yields, AAA bonds, and mortgages at least until the financial meltdown. You'll also notice that these three things move together pretty closely. That will be more important in part II.

Figure2: The Federal Funds Market

Here we have the federal funds market during the 21st century. The Federal funds rate being graphed here is the effective federal Funds rate not the target rate. You can get a pretty clear idea of what the target rate is from the effective rate. However we have also a little bit of added information. Notice the two big downward spikes. The first is at the very beginning of the graph (Jan 1, 2000) and the other is around the end of the year in 2001 (9/11/2001 to be exact).

Those two spikes represent huge injections of reserves into the fed funds market. The first was an intervention by the Fed to help prevent problems from the Y2K bug that never materialized. The other is of course in response to the massive disruption to the financial system when lower Manhattan was shut down for several days.

Figure 2 also tells the story of the Federal Reserve's role in the Financial crisis. We see a very, very sharp drop in the Federal Funds rate in 2001. In January of 2001 the Fed cut the fed funds rate from 6% to 5.50%. By the end of 2001 the rate was 1.25%. In Nov 2002 the Fed cut the rate all the way down to .75%. In 2003 the Fed raised rates to 2% and then keeps rates at that level until mid 2004 when it gradually starts (best illustrated by the step pattern in the discount rate) to increase interest rates to a peak of 6.25% in mid 2006.

Those low rates from 2001 to mid 2004 along with the quantity of reserves needed to keep rates that low many people say is a big part of the creation of the housing bubble. Initially, of course, the low rates were intended to juice the economy during the 2001 recession but critics say the Fed kept rates down too long.

I'm actually somewhat agnostic about the Fed's role. They must have had something to do with the housing bubble, but I'm not sure low rates were a sufficient condition. The giant increase in global savings during this period (it basically doubled)--as far as I'm concerned--is the central player in the housing bubble. Maybe we can think of the Fed as the yeast and the global savings glut as the flour. You can make bread without yeast, but it' won't rise. Of course, there are like a million other ways to blame the Fed beyond interest rate policy, such as thier role as a regulator and their refusal to use their ability to jawbone markets.

Also included this graph is the discount rate which, as we discussed in class is supposed to be a kind of "cap" on the federal funds rate. You'll notice several upward spikes. Lets zoom in a little bit:

Figure 3: Fed Funds Market Jan 2007 to March 2011

In late 2008 there are two significant spikes above the discount rate. This is indicative of the beginning of a financial panic. Banks are all scrambling to increase their excess reserves either "just in case" or because they legitimately need them. However some financial institutions may not have wanted to seem as though they needed discount loans and so borrowed at a rate above the discount rate from other banks, not the Fed. The expansion of discount loans through 2008 like the expansion of the fed balance sheet in general is really remarkable. The Fed had already increased its discount loans by about 1800% through 2007, from 27 million to $48.7 billion. From the 4th quarter of 2007 to its peak in 2009q1 the Fed increased the borrowed monetary base to $536.3 billion, an over 100% increase. All told, of course, the Fed increased its direct lending to the financial system by 20,000%!

This is a good place to talk about some of the unprecedented things the Fed did to try to stem the financial panic. It is important to point out that much of the lending the Fed did was not necessarily about maintain the target fed funds rate but was rather the fed fulfilling it's role as "lender of last resort". Credit markets in a financial panic seize up and banks and other financial institutions find it difficult or impossible to find funding. The Fed then steps in to make sure financial institutions can stay afloat. As well, the Fed greases the wheels of the financial system to get it running again.

A portion of the increase in discount loans I'm talking about were not loans to banks per se but were rather loans to money market mutual funds through banks. The Fed instituted a loan program (AMLF) in which they loaned money to banks so that they could buy commercial paper (corporate bills) from these mutual funds. This was intended to keep the commercial paper market operating in a time when no one wanted to loan money to anyone (especially financial companies) .

Not reflected in the loans above were a variety of programs such as the Term Auction Liquidity Facility or TALF. TALF loans were loans in which the collateral is an AAA rated asset backed securities (ABS). ABS of course tipped off the crisis through mortgage backed securities, but the ABS market is much bigger than just mortgages. ABSes finance credit cards, student loans, car loans and other things. Asset backed securities are fundamental to the "shadow banking system" the segment of the financial system that does many of the things banks do (make loans) but aren't actually banks. This market was also in a state of panic which was the justification for the TALF. Related (and a much bigger program) was the Commercial Paper Funding Facility (CPFF) which was similar to AMLF, but much much bigger.

Finally, there are the Maiden Lane programs (I, II and III). Essentially, these are "shell" companies the Fed created in order to buy assets from Bear Sterns and AIG. The Fed bought some of the uglier holdings of Bear Sterns to make the sale to JP Morgan Chase more attractive (Maiden Lane I) and the Fed bought a bunch of AIG's Mortgage Back Securities (MBS) in order to give AIG the cash needed to meet their obligations (Maiden Lane II). This was over and above the $85 billion line of credit the Fed set up for AIG. Finally, Maiden Lane III was another LLC set up by the Fed (partially owned by AIG). Maiden Lane III was created to buy up the Collateralized Debt Obligations (CDO) that several banks had take out insurance policies (Credit Default Swaps, or CDOs) on. As the value of the CDOs fell, AIG was obligated to pay these banks the difference between the market value of the CDOs and "par" (what the banks paid for them) value. AIG had already paid about $35 billion (mostly out of the $85 billion the Fed had lent them), the purchase of the CDOs from the banks by the Fed made up another $29 billion or so.

Now during 2008 the Fed isn't only making loans. The Fed is also rapidly slashing the federal funds rate. The Fed had begun cutting interest rates in September of 2007 (from it's peak of 5.25%), in response to what became the recession that started in December of 2007. Just real quick: I want to point out that the financial crisis was the result of the recession not it's cause, though it certainly made the recession worse. Anyway, in January of 2008 the Fed took the dramatic step of cutting the fed funds rate by .75%, there were several other cuts from January to March but on March 18th in the wake of the Bear Sterns collapse the Fed made another dramatic cut of 75 basis points off the fed funds rate. Long story short, from September 2007 to December 2008 the Fed cut the fed funds rate from 5.25% to a "target" of 0 to 25 basis points.

About this this target of 0 to 25 basis points: Importantly missing from Figure 2 is the interest rate the fed pays on deposits by banks at the Fed. When first instituted in October of 2008 the Fed made a distinction between what it would pay for required reserves and for excess reserves but later started paying 25 basis points on all reserves. Now, it may not be obvious from figure 3, but the fed funds rate has actually been below 25 basis points (roughly speaking around 15 basis points). Using the model of the market for reserves in class we came to the conclusion that no one would lend at less than 25 basis points. However, in the real fed funds market there are non-banks that buy and sell reserves (most notably Fannie Mae and Freddie Mac). These non-banks do not have deposits at the Fed though they make overnight loans and they are apparently willing to lend reserves at around 15 basis points.

I'm going to break this post up into two posts:

Part II: Quantitative easing.

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