Timothy F Geithner: Actions by the New York Fed in response to liquidity
pressures in financial markets
Testimony of Mr Timothy F Geithner, President and Chief Executive Officer of the Federal
Reserve Bank of New York, before the US Senate Committee on Banking, Housing and
Urban Affairs, Washington DC, 3 April 2008.
The original speech, which contains three Annexes, can be found on the Federal Reserve Bank of New York's
website.
* * *
Good morning, Chairman Dodd, Ranking Member Shelby, and other members of the
Committee. Thank you for giving me the opportunity to appear before you today. I am here to
outline the actions by the Federal Reserve Bank of New York in response to present
challenges in financial markets, including those in relation to the proposed merger of Bear
Stearns and JPMorgan Chase.
On the evening of Thursday, March 13, 2008, I took part in a conference call with
representatives from the Securities and Exchange Commission, the Board of Governors of
the Federal Reserve and the Treasury Department. On that call, the SEC staff informed us
that Bear Stearns' funding resources were inadequate to meet its obligations and that the
firm had concluded that it would have to file for bankruptcy protection the next morning. The
SEC said it concurred in that judgment, and it would spend the evening discussing with Bear
what kind of bankruptcy filing was appropriate.
The conference call that evening took place against the backdrop of an extraordinarily
challenging period in the U.S. financial system. This context was critical to the decisions we
made over the next several days. And I think it's important to start with an explanation of the
broad risks to the economy posed by the crisis now working through the financial system.
The intensity of the crisis we now face in U.S. and global financial markets is a function of the
size and character of the financial boom that preceded it. This was a period of rapid financial
innovation - particularly in credit risk transfer instruments such as credit derivatives and
securitized and structured products. There was considerable growth in leverage, greater
reliance on ratings on structured credit products and a marked deterioration in underwriting
standards.
The innovation in financial products was accompanied by a dramatic increase in the amount
of financial intermediation occurring outside the core banking system. The importance of
securities broker-dealers, hedge funds, and mutual funds in the financial system rose
steadily. Off-balance-sheet vehicles of various forms proliferated, and increased
concentrations of longer-dated assets were held in funding vehicles with substantial liquidity
risk.
The deterioration in the U.S. housing market late in the summer of 2007 precipitated a sharp
rise in uncertainty about the value of securitized or structured assets. Demand for these
assets contracted dramatically and the securitization market for mortgages and other credit
assets stopped working. This, in turn, increased funding pressures for a diverse mix of
financial institutions. Uncertainty about the magnitude and the level of losses for financial
institutions fueled concern about credit risk in exposure to those institutions.
Part of the dynamic at work was that banks were forced to provide financing for - or take
over - the assets in a range of structured investment vehicles and conduits financed by
asset-backed commercial paper. As some investors attempted to liquidate their holdings of
these assets, many of the traditional providers of unsecured funding to banks pulled back
from their counterparties in anticipation of the potential withdrawals of funds by their own
investors.
Market participants' willingness to provide term funding even against high-quality collateral
declined dramatically. As a consequence, the cost of unsecured term funding rose
precipitously and the volume shrunk. Banks were funding themselves at shorter and shorter
maturities. As unsecured term funding markets deteriorated, the premium on liquid,
marketable collateral - such as Treasury securities - rose considerably.
Even with the dramatic actions by the Federal Reserve and other central banks to address
these liquidity pressures, the strains in financial markets persisted. In many respects,
conditions worsened materially in February and March. Credit spreads on financial
institutions widened, equity prices declined and market functioning deteriorated sharply. By
the early part of March, the threat of a disorderly adjustment was growing.
What we were observing in U.S. and global financial markets was similar to the classic
pattern in financial crises. Asset price declines - triggered by concern about the outlook for
economic performance - led to a reduction in the willingness to bear risk and to margin calls.
Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable
to meet their obligations and their counterparties responded by liquidating the collateral they
held. This put downward pressure on asset prices and increased price volatility. Dealers
raised margins further to compensate for heightened volatility and reduced liquidity. This, in
turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of
higher haircuts forced sales, lower prices, higher volatility and still lower prices.
This dynamic poses a number of risks to the functioning of the financial system. It reduces
the effectiveness of monetary policy, as the widening in spreads and risk premia worked to
offset part of the reduction in the fed funds rate. Contagion spreads, transmitting waves of
distress to other markets, from subprime to prime mortgages and even to agency
mortgagebacked securities, to commercial mortgage-backed securities and to corporate bonds and
loans. In the current situation, effects were felt in the municipal and student loan markets.
The most important risk is systemic: if this dynamic continues unabated, the result would be
a greater probability of widespread insolvencies, severe and protracted damage to the
financial system and, ultimately, to the economy as a whole. This is not theoretical risk, and it
is not something that the market can solve on its own. It carries the risk of significant damage
to economic activity. Absent a forceful policy response, the consequences would be lower
incomes for working families, higher borrowing costs for housing, education, and the
expenses of everyday life, lower value of retirement savings and rising unemployment.
Federal Reserve response
The Federal Reserve has taken a series of policy actions to help contain the risks to the
economy posed by this financial crisis. The Federal Open Market Committee (FOMC) has
reduced the nominal federal funds rate target by 300 basis points since August of 2007.
Alongside these appropriately aggressive monetary actions, the Federal Reserve has taken
a series of initiatives aimed at improving market liquidity and overall market functioning. A
more detailed description of these liquidity initiatives is included as Annex I.
These actions are designed to allow financial intermediaries to finance with the central bank
assets they can no longer finance as easily in the market. And in this way these liquidity
facilities reduce the need for those institutions to take the types of actions, such as selling
other assets into distressed markets or withdrawing credit lines extended to other financial
institutions, that would serve to amplify the pressures in markets.
In addition to these monetary policy and liquidity actions, the Federal Reserve has been
working with community groups and housing advocates across the country to help
homeowners navigate the complex challenges of higher resets and falling home prices. The
Federal Reserve is actively working with homeowners and communities to identify solutions
to avoid foreclosures and their negative effects, support appropriate consumer protection and
responsible lending practices, and apply our expertise in research and evaluation to provide
community groups, counseling agencies, regulators, and others with detailed analysis to
support efforts to help troubled borrowers and communities.
I believe that the Federal Reserve System's response has helped reduce the risk of systemic
damage to the financial system, and thereby helped mitigate a potential source of downside
risk to growth. This in turn has helped mitigate the risks to the broader economy. It is
important to recognize that a substantial adjustment, recognition of losses, and reduction in
risk has already taken place. And a range of different prices of financial assets now reflect a
very cautious view of the future. The severity of the pressures in markets evident over the
last few months are in part a reflection of the speed and force with which markets and
institutions in our financial system adapt to fundamental changes in the outlook. This
capacity to adjust and adapt is one of the great strengths of our system. Nevertheless, we
still face a number of challenges ahead. The seeds of this crisis took a long time to build up,
and they will take some time to work through.
The role of banks and investment banks in our financial system
A driving force behind Congress' creation of the Federal Reserve System in 1914 was its
recognition of the need for a public institution to perform the role of lender of last resort. The
financial landscape in 1914 (and continuing until relatively recent times) was one dominated
by traditional banks. When the Federal Reserve was founded, there was no deposit
insurance, so the willingness of individuals and businesses to hold deposits at a particular
bank depended wholly on their degree of trust that the bank would be able to promptly
furnish them with the money they had deposited - whenever they might request it. But - as
Congress understood - the business of banking involves making loans as well as taking
deposits. Because banks, in order to make money, needed to extend long-term credit to
customers for things like the purchases of homes or investments in business equipment, not
all of the money taken in by banks could be readily available to be paid out if depositors were
to request it. In fact, only a small fraction of a typical bank's assets were kept in liquid enough
form to be immediately paid to depositors upon demand. This fundamental fact of bank
operation left banks - and the banking system - open to liquidity shocks that, nearly a
century later, have their echoes in recent market developments.
The financial crises around the turn of the century were the historic catalyst for the Federal
Reserve's creation by Congress. It is panic or fear that drives depositors en masse to the
door of the banking house to demand their money back. In such a case, even an institution
that is fundamentally solvent - i.e., whose assets (mostly longer-term loans) are worth more
than its liabilities - may find that it does not have enough cash on hand - that is, enough
liquidity - to satisfy its customers.
The function of a lender of last resort in such a case is to lend to the institution that is facing
heightened customer demand for repayment in an amount sufficient to satisfy customer
demands, while taking assets of the institution as security for the lending. If the lender of last
resort does not act to fulfill this role, the institution facing heightened customer demands for
repayment may be forced to begin a "fire sale" of its assets, the distressed and hurried
nature of which will cause them to be sold at less than their true long-run value, which may
quickly lead to the insolvency of the institution. The insolvency may precipitate further
downward pressure on the market value of such assets magnifying the risk to other financial
institutions.
Over the past 30 years, we have moved from a bank-dominated financial system to a system
in which credit is increasingly extended, securitized and actively traded in a combination of
centralized and decentralized markets. In many ways, the business models of banks and
non-bank financial institutions - especially large securities firms - have converged, with
banks playing a greater agency role in the credit process, and securities firms doing more of
the financing.
It is important to understand that investment banks now perform many of the economic
functions traditionally associated with commercial banks, and they are also vulnerable to a
sudden loss of liquidity. Unlike commercial banks, which rely significantly on deposits for
funding, investment banks operate according to a business model in which they fund large
portions of their balance sheets on a secured, short-term basis in what is known as the repo
market. Because the assurance of access to short-term secured funding on a daily basis is
such a critical component of business functioning for these entities, they are vulnerable to the
possibility of a sudden pullback in short-term lending, or a reduction in the willingness of
investors to lend against certain classes of securities.
As we have seen throughout the past nine months, these changes in the relative roles of
traditional commercial banks and investment banks have changed the nature of financial
stability. In the United States, the regulatory framework and most of the tools that were
created to prevent and manage financial crises were developed in a bank-dominated era,
and we have had to adapt those tools to deal with current market realities.
Bear Stearns
With this important context, let me return to the actions taken by the Federal Reserve in
response to the situation that arose at Bear Stearns. That response was shaped in roughly
four stages: (1) the decision on the morning of March 14 to extend a non-recourse loan
through the discount window to JPMorgan Chase so that JPMorgan Chase could in turn lend
that money to Bear Stearns; (2) the decision on March 16 by JPMorgan Chase and Bear
Stearns for JPMorgan Chase to acquire Bear and guarantee certain of its liabilities, along
with an agreement in principle that the Federal Reserve Bank of New York would provide
certain financing in the context of that acquisition; (3) the launching of the Primary Dealer
Credit Facility; and (4) the events of the following week, culminating in the March 24
announcement of revised merger agreement and guaranty terms between JPMorgan Chase
and Bear, and the finalizing of the terms and structure of the associated loan from the
Federal Reserve Bank of New York.
Let me begin with the market situation in which Bear was operating in the days leading up to
March 13. Fixed-income traders had begun hearing rumors that European financial
institutions had stopped doing fixed income trades with Bear. Fearing that their funds might
be frozen if Bear wound up in bankruptcy, a number of U.S.-based fixed-income and stock
traders that had been actively involved with Bear had reportedly decided to halt such
involvement. Many firms started pulling back from doing business with Bear. Some hedge
funds that had used Bear to borrow money and clear trades were withdrawing cash from
their accounts. Some large investment banks stopped accepting trades that would expose
them to Bear, and some money market funds reduced their holdings of short-term
Bearissued debt. The rumors of Bear's failing financial health caused its balance of
unencumbered liquidity on March 13 to decline sharply to levels that were not adequate to
cover maturing obligations and funds that could be withdrawn freely. This precipitated the
phone call that I described in the beginning of my testimony.
The news that Bear's liquidity position was so dire that a bankruptcy filing was imminent
presented us with a very difficult set of policy judgments. In our financial system, the market
sorts out which companies survive and which fail. However, under the circumstances
prevailing in the markets the issues raised in this specific instance extended well beyond the
fate of one company. It became clear that Bear's involvement in the complex and intricate
web of relationships that characterize our financial system, at a point in time when markets
were especially vulnerable, was such that a sudden failure would likely lead to a chaotic
unwinding of positions in already damaged markets. Moreover, a failure by Bear to meet its
obligations would have cast a cloud of doubt on the financial position of other institutions
whose business models bore some superficial similarity to Bear's, without due regard for the
fundamental soundness of those firms.
The sudden discovery by Bear's derivatives counterparties that important financial positions
they had put in place to protect themselves from financial risk were no longer operative
would have triggered substantial further dislocation in markets. This would have precipitated
a rush by Bear's counterparties to liquidate the collateral they held against those positions
and to attempt to replicate those positions in already very fragile markets.
In short, we judged that a sudden, disorderly failure of Bear would have brought with it
unpredictable but severe consequences for the functioning of the broader financial system
and the broader economy, with lower equity prices, further downward pressure on home
values, and less access to credit for companies and households.
Following that initial call with the SEC on March 13, my colleagues in New York and in
Washington spent the night focusing on the implications of a large-scale default by Bear and
how we might contain the consequential damage. Bear renewed conversations that began
earlier that day with JPMorgan Chase, which is Bear's clearing bank for its repo
arrangements, to explore a range of possible financing options. The New York Fed
dispatched a team of examiners to Bear Stearns to look at its books so that we could get a
better handle on what could be done. We gathered the best information we could, evaluated
the risks involved, and explored a range of possible actions.
At 5:00 a.m., we participated in a conference call with our colleagues at the Board of
Governors and the Treasury to review the options and decide on the way forward. After
careful deliberation, together we decided on a course of action that would at least buy some
time to explore options to mitigate the foreseeable damage to the financial system. With the
support of the Secretary of the Treasury, Chairman Bernanke and the Board of Governors
agreed that the New York Fed would extend an overnight non-recourse loan through the
discount window to JPMorgan Chase, so that JPMorgan Chase could then "on-lend" that
money to Bear Stearns.
This action was designed to allow us to get to the weekend, and to enable us to pursue work
along two tracks: first, for Bear to continue to explore options with other financial institutions
that might enable it to avoid bankruptcy; and second, for policymakers to continue the work
begun on Thursday night to try to contain the risk to financial markets in the event no
privatesector solution proved possible.
Over the course of that day, March 14, Bear was downgraded by the credit rating agencies,
and the flight of customer business from Bear accelerated. This set in motion a chain of
decisions across the financial system as market participants prepared for the possibility that
Bear would not be open for business once Asian markets opened on Sunday night. This
highlighted the urgency of working toward a solution over the weekend, ideally a solution that
would definitively address the prospect of default by Bear.
Bear approached several major financial institutions, beginning on March 13. Those
discussions intensified on Friday and Saturday. Bear's management provided us with
periodic progress reports about a possible merger. Although several different institutions
expressed interest in acquiring all or part of Bear, it was clear that the size of Bear, the
apparent risk in its balance sheet, and the limited amount of time available for a possible
acquirer to conduct due diligence compounded the difficulty. Ultimately, only JPMorgan
Chase was willing to consider an offer of a binding commitment to acquire the firm and to
stand behind Bear's substantial short-term obligations.
As JPMorgan Chase and other institutions conducted due diligence, my colleagues in New
York and Washington continued to examine ways to contain the effects of a default by Bear.
As part of these discussions, we began to design a new facility that would build on other
liquidity initiatives taken by the Federal Reserve System, and provide a more powerful form
of liquidity to major financial institutions.
Following the announcement on March 11 of the Term Securities Lending Facility, which
allowed primary dealers to pledge a wider range of collateral in order to borrow Treasury
securities, we had consulted with market participants on how to structure the auctions to
maximize their potential benefits to market functioning. Those discussions yielded a number
of helpful suggestions. In view of those suggestions, and after considering the greater risks
to the financial system posed by the Bear situation, we were able to work quickly on a
companion facility that would transmit liquidity to parts of the market where it could be most
powerful.
This is what led the Board of Governors of the Federal Reserve System to approve the
establishment of the Primary Dealer Credit Facility on March 16. Under Section 13(3) of the
Federal Reserve Act, the Board of Governors is empowered to authorize a Federal Reserve
Bank like the New York Fed to lend to a corporation, such as an investment bank, in
extraordinary circumstances under which there is evidence that the corporation cannot
"secure adequate credit accommodations from other banking institutions." The Board of
Governors needed to make the statutory finding that the circumstances were exigent and
extraordinary, and it did so, based on the situation prevailing in the financial markets and the
distinct possibility that absent an assurance of liquidity to major investment banks the
deterioration in financial conditions likely would have continued with substantial effects on the
economy.
We recognized, of course, that the use of this legal authority was, in itself, an extraordinary
step. At the same time, we were mindful that Congress included this lending power in the
Federal Reserve Act for a reason, and it seemed irresponsible for us not to use that authority
in this unique situation. Even with an agreement in place that might reduce the probability of
a default by Bear, we decided that independent of that outcome, it was important to get
assured liquidity to primary dealers by Monday morning, to address the accelerating process
of deleveraging and tightening liquidity seen in the financial system.
On Sunday morning, executives at JPMorgan Chase informed us that they had become
significantly more concerned about the scale of the risk that Bear and its many affiliates had
assumed. They were also concerned about the ability of JPMorgan Chase to absorb some of
Bear's trading portfolio, particularly given the uncertainty ahead about the ultimate scale of
losses facing the financial system. In this context, we began to explore ways in which we
could help facilitate a more orderly solution to the Bear situation. We did not have the
authority to acquire an equity interest in either Bear or JPMorgan Chase, nor were we
prepared to guarantee Bear's very substantial obligations. And the only feasible option for
buying time would have required open ended financing by the Fed to Bear into an
accelerating withdrawal by Bear's customers and counterparties.
We did, however, have the ability to lend against collateral, as in the back-to-back
nonrecourse arrangement that carried Bear into the weekend. After extensive discussion with my
colleagues at the New York Fed, Chairman Bernanke, and Secretary Paulson, and with their
full support, the New York Fed and JPMorgan Chase reached an agreement in principle that
the New York Fed would assist with non-recourse financing. Using Section 13(3) of the
Federal Reserve Act, the New York Fed agreed in principle to lend $30 billion to JPMorgan
Chase and to secure the lending with a pledge of Bear Stearns assets valued by Bear on
March 14 at approximately $30 billion. This step made it possible for JPMorgan to agree to
acquire Bear and to step in immediately to guarantee all of Bear's short-term obligations.
This guarantee was especially important to stave off the feared systemic effects that would
be triggered by the panic of a Bear bankruptcy filing and of the failure to honor its obligations.
And by agreeing to lend against a portfolio of securities, we reduced the risk that those
assets would be liquidated quickly, exacerbating already fragile conditions in markets. The
portfolio of securities is described in Annex II to this testimony.
On the evening of Sunday the 16th, I sent a letter to James Dimon, the CEO of JPMorgan
Chase, to memorialize the fact that we had reached a preliminary agreement that the New
York Fed would assist the acquisition with $30 billion in financing, with the understanding that
the parties would continue working during the week towards a formal contract. We also
provided regulatory approvals, including under Section 23A, to assist with the merger and a
transitional period for phasing in the assets under our capital rules.
The announcement of the agreement between Bear Stearns and JPMorgan Chase and the
announcement of the Primary Dealer Credit Facility were finalized just before Asian markets
opened on Sunday night, and the announcement of these actions helped avert the damage
that would have accompanied default.
On Monday morning, March 17, the $13 billion back-to-back non-recourse loan through
JPMorgan Chase to Bear was repaid to the Fed, with weekend interest of nearly $4 million.
The Primary Dealer Credit Facility was made available to the market. And at the request of
and with the full cooperation of the SEC, examiners from the New York Fed were sent into
the major investment banks to give the Federal Reserve the direct capacity to assess the
financial condition of these institutions.
Discussions were also continuing regarding the details of the Fed's financial arrangement
with JPMorgan Chase. Our legal teams engaged in the meticulous work of finalizing the legal
structure of the lending arrangement that had been agreed to in principle, including defining
the precise pool of collateral and related hedges that would secure the $30 billion loan.
At the same time, several infirmities became evident in the agreement between JPMorgan
and Bear during the week of March 17th that needed to be cured.
Negotiations between the two sets of counterparties proceeded almost immediately between
the New York Fed and JPMorgan Chase on the one hand, and between JPMorgan Chase
and Bear Stearns on the other. The New York Fed and JPMorgan discussed the details for
the secured financing. Bear Stearns and JPMorgan continued to negotiate changes to the
merger agreement that would tighten the guarantee and provide the necessary certainty that
the merger would be consummated. All the parties shared an overriding common interest: to
move toward a successful merger and avoid the situation in which they found themselves on
March 14.
The extended Easter weekend saw intense sets of bilateral negotiations among the three
parties. The deal, finally struck in the early morning hours on March 24, held benefits for all
parties. That deal included a new, more precise guaranty from JPMorgan, which lifted the
cloud of default risk that had been hanging over the transaction. Bear stockholders were to
receive a higher share price. In addition to fixing the guaranty, JPMorgan gained assurance
that its merger with Bear would take place. And the New York Fed obtained significant
downside protection on the loan and a tighter guaranty on its exposure. The new Fed
financing facility will be in place for a maximum of ten years, though it could be repaid earlier,
at the discretion of the Fed. This is an important feature: the assets that are being pledged as
collateral can be managed on a long-term basis so as to minimize the risks to the market and
the risk of loss. They can be held or disposed of at any time over the next decade. A
summary of Terms and Conditions is attached as Annex III.
In keeping with the traditional role of a lender of last resort, the extensions of credit to Bear
Stearns that the Fed made to facilitate the merger were secured by collateral. The $29 billion
loan will be extended only when and if JPMorgan Chase and Bear merge. We will be
protected from loss by three different risk mitigants: first, a substantial pool of
professionallymanaged collateral that, as of March 14, was valued at $30 billion; second, the agreement on
the part of JPMorgan Chase to absorb the first $1 billion of any loss that ultimately occurs in
connection with this arrangement; and third - and perhaps most importantly - a long-term
horizon during which our collateral will be safe-kept and, if sold, will be sold in an orderly
fashion that is not affected by the unnaturally strong downward market pressures that have
been associated with the recent liquidity crisis.
Are there risks here? Yes, but the risks are modest in comparison to the substantial damage
to the economy and economic well-being that potentially would have accompanied Bear's
insolvency. Congress created the Federal Reserve after the Panic of 1907 with broad
authority and a range of instruments to assume precisely this type of risk, in support of
overall financial stability and economic growth. Assisting the JPMorgan Chase merger with
Bear was the best option available in the unique circumstances that prevailed at the time.
There are those who have suggested that by intervening to forestall, and ultimately prevent,
a bankruptcy filing by Bear Stearns, the Federal Reserve risks magnifying the chance of
future financial crises, by insulating market participants from the consequences of excessive
risk taking. It is important to recognize that had we not acted we would in effect have
penalized those individuals, companies and financial institutions that had behaved more
prudently, but would have suffered significant damage from the effects of default by a major
institution.
The negative consequences to Bear's owners and employees from recent events have been
very real - so real that no owner or executive or director of a financial firm would want to be
in Bear Stearns' position. While we clearly knew that our actions, both in the context of the
JPMorgan Chase transaction and in the establishment of the Primary Dealer Credit Facility
would affect incentives for financial market participants, adding to the risk of "moral hazard,"
we believe that the lesson of the actual outcome for equity holders will serve to check and
even diminish incentives for undue risk-taking.
I believe that the actions taken by the Federal Reserve on a number of fronts in recent
months have reduced some of the risk to the economy that is inherent in this adjustment in
financial markets. By reducing the probability of a systemic financial crisis, the actions taken
by the Fed on and after March 14 have helped avert substantial damage to the economy,
and they have brought a measure of tentative calm to global financial markets. Relative to
the conditions that existed on March 14, risk premia have narrowed, foreign exchange
markets are somewhat more stable, energy and commodity prices are lower, perceptions of
risk in the financial system have diminished, and the flight to quality is less pronounced.
Nevertheless, liquidity conditions in markets are still substantially impaired and the process
of de-leveraging remains underway. And this will amplify the headwinds facing the U.S. and
global economy. In this context, policymakers and financial market participants need to
continue to act forcefully. And their actions need to be proportionate to the challenges.
Financial institutions need to continue to improve the quality of disclosure, and even the
strongest institutions face compelling incentives to raise new equity capital so that they can
take advantage of the opportunities ahead.
Actions to strengthen the capacity of the major government sponsored enterprises, the
Federal Housing Finance Board and the Federal Housing Administration to provide finance
to the mortgage market and help reduce the risk of avoidable foreclosures are a very
important complement to the broader policy actions already in place to contain the downside
risks to the economy.
The Federal Reserve, working closely with other maj