Joseph S Tracy: What the Fed did and why
Remarks by Mr Joseph S Tracy, Executive Vice President of the Federal Reserve Bank of
New York, at the Westchester County Bankers Association, Tarrytown, New York,
25 June 2010.
* * *
In my remarks this morning, I would like to look back over the events of the past several
years and offer my perspective on what were the essential drivers of the financial crisis and
the Federal Reserve's interventions.1 I will review the changes that have been taking place in
the U.S. financial system and how these changes created the conditions conducive to the
crisis. I will then discuss the developments in residential real estate financing that provided
the catalyst for the crisis.
With this background, I will outline the interventions that were carried out to mitigate the
crisis, focusing on those conducted by the Federal Reserve. I will direct my remarks to the
facilities that were created rather than to the actions taken for individual institutions since
these have been discussed extensively elsewhere. The lessons learned from the crisis are
important for the design of the policy response aimed at reducing the likelihood that the U.S.
economy ever again experiences this degree of trauma.
I begin with the simple exercise of what name we should assign to this past crisis. At first
blush, this may not seem like a useful exercise. But, as Shakespeare reminded us, names
are important as they convey a sense of our understanding of the event. One name that has
gained popularity is the "Great Recession", which is dated as beginning with the bankruptcy
of Lehman Brothers on September 15, 2008. This name conveys both the severity of what
occurred, as well as the calamity of what was avoided. The contraction in real output in the
six months following the demise of Lehman Brothers exceeded in size any other post World
War II recession - in that sense, it was a great recession. However, aggressive monetary
and fiscal policy actions both domestically and abroad were successful in preventing a
complete meltdown of the U.S. and the world economy. In that sense, the name also
emphasizes what the crisis was not. However, the name tends to focus one's attention too
much on the effect and not the cause of the crisis.
An alternative name is the "Panic of 2007", which is dated as beginning with the
announcement by BNP Paribus on August 9, 2007, of its suspension of redemptions for
three of its investment funds. This name stresses the financial crisis as the precipitating
event leading up to the severe decline in real economic activity slightly more than a year
later. The name conveys that at its very basic level, the crisis was a form of a banking panic.
The parallel to the name "Panic of 1907" is also a reminder to us that history has a way of
repeating itself unless we learn and apply its lessons well. For this reason, it is useful to take
a moment to recall the events of 1907.
At the turn of the 20th century there was no Federal Reserve System. Banks then as today
borrow short term in order to lend long term, making their profit on the difference in rates. At
the time, the banks' short-term liabilities took the form of demand deposits. If depositors
began to worry about the quality of a bank's loans and its ability to pay back its depositors, a
run on the bank could develop. Once started, no bank on its own can stop a run by its
depositors. To deal with these liquidity problems, the banks developed a clearinghouse
system whereby member banks could backstop each other. This system would work well as
long as banking problems were sufficiently localized so that unaffected member banks could
provide liquidity to those member banks facing a liquidity problem.
The problem in 1907 was that credit was also being supplied by trust companies that
operated outside of the clearinghouse system. Many of these trusts, including the
Knickerbocker Trust, lent money to speculators in the copper market, which was
experiencing a boom. So long as copper prices kept rising, these loans paid off. However,
when copper prices began to fall, there was a wave of loan defaults leading to a run on the
trusts that could not be stopped by the clearinghouse system. The resulting credit contraction
sent the economy into recession, transmitting the problems to the banking sector. In the end,
more than 240 banks failed even though the problem started outside of the banking sector.
The basic mechanics of a bank run have remained the same over time. Due to the maturity
mismatch involved in credit intermediation, banks in particular and financial institutions in
general must rely on trust by their "depositors" that the institution's assets will provide the
ability to pay back the depositors. The fundamental connection between liquidity and trust
was well described by Walter Bagehot in 1873:
"Every banker knows that if he has to prove that he is worthy of credit, however
good may be his arguments, in fact his credit is gone."2
There are two problems that depositors face. The first is that they typically know very little
about a particular bank's investments. This reflects both the lack of transparency in how
banks are investing their funds, and a lack of incentive by individual borrowers to expend
effort to try and learn this information - what economists call a public goods problem. The
second problem is that a depositor does not know what other depositors think about the
solvency of the bank. A bank may be solvent and a depositor may be convinced of that fact,
but if most other depositors think differently and decide to withdraw their funds, then the bank
will have to sell its assets and will likely become insolvent leaving the patient depositor
unable to reclaim his funds - what economists call a coordination failure problem. The
combination of these two problems implies that increases in uncertainty regarding values of
assets on a bank's balance sheet create an environment susceptible to deposit runs.
The failure of the clearinghouse system in 1907 was a catalyst for the formation of the
Federal Reserve System and its power as a lender of last resort. The problem of deposit
runs was effectively solved in 1934 with the institution of deposit insurance. Insurance solves
the public goods and coordination failure problems discussed above. A depositor need not
invest resources in determining which bank is a safe place to put his funds. Additionally, the
depositor is guaranteed to get his funds back regardless of whether other depositors decide
to withdraw their funds. The moral hazard problems created by deposit insurance
necessitated that the banks covered be subject to supervision and that a mechanism was
established so that problem banks could be resolved quickly in order to safeguard the
taxpayers' money.
There are many parallels between the Panic of 1907 and the events of 2007. In both cases,
credit intermediation had shifted outside of the core banking sector. An investment boom
preceded each panic - the earlier in copper and the later in housing - with much of the credit
being funded by sources outside of any existing liquidity protections. When the bubbles
began to deflate and prices began to fall, loan defaults quickly developed precipitating
funding runs on the institutions involved in extending this credit. What seemed like large
liquidity buffers by individual firms were quickly drawn down. Funding withdrawals
precipitated asset sales, which put further downward pressure on asset prices. The resulting
credit contractions adversely affected the real economy, setting up an adverse feedback loop
that exacerbated the initial losses.
Given the parallels between the events of 1907 and 2007 and, more importantly, the
similarities of the lessons learned from those episodes, I believe the most instructive name
for our latest financial crisis is the "Panic of 2007". In the rest of my remarks, I will explore in
greater detail the factors behind the panic, as well as the responses by the Federal Reserve.
The first question to explore is the extent to which the financial system had evolved over the
past several decades.3 Over this period, demand deposits lost their market share to money
market mutual funds, which, while considered safe, are not guaranteed like deposits. This
made it increasingly difficult and less profitable for banks to fund loans on their balance
sheets using deposits. Securitization markets developed where loans could be funded
through the market by investors. In addition, money market mutual funds, securities lenders,
institutional investors and businesses needed a safe way to deposit funds where they would
earn interest but retain ready access to their funds. Repurchase agreements or "repos"
developed to serve this need. A repo is a short-term collateralized loan that shares many
characteristics with a demand deposit except that repos are not guaranteed. At the same
time, large firms increasingly raised funds by issuing commercial paper in the market rather
than relying on bank loans - with the money market mutual funds being large investors in
this paper. Large banks, as well, came to rely at the margin on non-deposit funding through
the interbank funding market. The Fed acted as the lender of last resort for this market.
This system of market-based credit intermediation has been called the "shadow banking
system". The shadow banking system grew at a very fast rate over the past several decades.
Chart 1 shows that by 1990, mortgage originations in the shadow banking system equaled
originations in the banking system, and grew to more than double the level in the banking
system by 2008. Chart 2 highlights the growth in securitization across many different asset
categories besides residential mortgages, such as commercial real estate loans, auto loans,
credit card loans and student loans. A direct consequence of this growth was that the
short-term liabilities associated with the shadow banking system - repos and commercial
paper - exceeded the level of demand deposits as seen in Chart 3. Despite this rapid
transformation of the financial system, the liquidity protections put in place for demand
deposits (deposit insurance and access to the Fed's discount window) were not available to
these new funding sources.
This lack of liquidity protection was a source of systemic risk that was building in the financial
system - akin to underbrush that builds up in a forest over time increasing the risk of a major
fire. The Panic of 2007, however, required a trigger - a spark to ignite the fire. As I will
describe in more detail in a moment, subprime mortgages provided the spark. Once the fire
was started, the Fed was confronted with fighting the fire using a set of tools designed for a
20th century banking crisis - not a 21st century shadow banking crisis. As a result, the Fed
had to improvise and design new tools as it battled the financial blaze. Another choice would
have been to let the fire burn on the theory that this is the best way to clear away the
underbrush that has built up over time. The great risk with this strategy is that the fire burns
out of control creating considerable collateral damage in the process. If the choice is to fight
the fire, then once the fire is extinguished the job remains to aggressively act to remove the
underbrush - thus the urgent need for regulatory reform.
There were two necessary ingredients for a catalyst for a financial panic in the shadow
banking system. The first was the realization by investors of the possibility of incurring
significant losses on some securities. The second was uncertainty over which securities
would sustain these losses and consequently who held these securities. This uncertainty
enabled the financial crisis to also impact the banking system. Finding a way to reduce this
uncertainty would prove to be a key step to dealing with the crisis.
The housing boom had pushed house values significantly above fundamental values in some
markets, creating the possibility of substantial losses on mortgages written on houses in
these markets. The largest run-ups in house prices occurred in the "sand states" of Arizona,
California, Florida and Nevada. One approach to measuring the degree to which houses had
become overvalued is to compare the evolution of house prices to their replacement costs.
For housing markets such as Las Vegas, which are surrounded by open land, the price of
houses should not differ significantly from the cost of building a new house. These markets
are characterized by what economists call a horizontal long-run housing supply curve.
Chart 4 shows the ratio of house prices to estimated replacement costs over time for the four
sand cities of Las Vegas, Vallejo, Phoenix and Miami.4 In all four cities, prices relative to
estimated replacement costs largely stayed in a tight range between 0.8 and 1.2 over the
1980s and 1990s. However, by 2002 to 2003, house prices broke out of this range and
reached values well in excess of 200 percent of the replacement cost in Vallejo and Miami,
and 180 percent of replacement costs in Las Vegas and Phoenix. When the bubble burst in
these markets, house prices were likely to drop by a large magnitude.
Two factors were important in creating uncertainty over which assets were going to suffer
losses given a burst of the housing bubble. The first is that not all housing markets
experienced a boom. shows the ratio of house prices to replacement costs for Dallas
Chart 5
and Chicago. This ratio never broke above 1.2 for Dallas, and peaked at 1.4 for Chicago. An
implication is that the default risk on a mortgage (as well as the loss given default) depended
not just on the risk profile of the borrower, but also on the specific location of the property.
The second factor contributing to the uncertainty over the value of mortgage securities was
the lack of transparency in their design. Key information about the specific mortgages was
lost in the process of securitizing mortgages in the first place, and then later repackaging
these mortgage securities into collateralized debt obligations (CDOs) and CDOs-squared.5 In
addition, the complexity of the securities meant that it would be difficult to understand the
risks even if an investor had access to all of the relevant mortgage-level information.
Investors in AAA rated mortgage-backed securities were initially sanguine about these
information problems since these securities were thought to have a very low loss probability
as determined by the credit rating agencies. Once that assumption was no longer true, it was
very difficult to acquire and process that information.
How did house prices manage to depart so significantly from their fundamental value in some
housing markets? Asset booms and busts have been a feature of financial markets for
centuries as documented by Reinhart and Rogoff in their recent book This Time is Different.6
During a boom, a strong motivation for purchasing an asset is the expected price
appreciation on the asset. In the case of housing, rising prices however should ration
demand through two constraints. The first is the downpayment constraint. For a given
required downpayment percentage, as house prices increase a borrower must come up with
more cash for the downpayment. The second is the cash flow constraint. For a given interest
rate and downpayment percentage, as house prices increase, the mortgage payment relative
to the borrower's income increases making the mortgage less affordable.7 If lenders had
maintained minimum downpayment percentages and maximum debt-to-income ratios as the
housing boom began, then rising prices would have done a better job of rationing demand,
thereby limiting the duration of the bubble and the extent of overvaluation in the markets.
However, as Reinhart and Rogoff demonstrate repeatedly, "this time is different" so house
prices were expected to continue to increase, which "justified" lenders' decisions to lower the
downpayment percentages and raise the allowable debt-to-income ratios. In 2001, at least
half of new subprime mortgages had downpayments of 20 percent or less, and at least a
quarter had downpayments of 11 percent or less. By 2006, at least half of new subprime
mortgages had downpayments of 10 percent or less, and at least a quarter had no
downpayment at all. Similarly, in 2001, 42 percent of new subprime mortgages had
debt-toincome ratios that exceeded 34 percent (which is considered a high ratio meaning borrowers
may face some payment stress), while by 2006 this had increased to 62 percent.8 The
continued increase in house prices eventually came to a stop when lending standards could
not be eased any further to offset the effects of the higher prices.
The turndown in house prices quickly led to a significant increase in subprime mortgage
defaults. This happened for two reasons. First, most subprime mortgages were designed in a
way that created rollover risk. The typical subprime mortgage was a hybrid adjustable rate
mortgage with the initial "teaser" interest rate fixed for two or three years, and then adjusting
every six months thereafter. The first rate adjustment could be quite substantial and provided
a strong incentive for the borrower to refinance the mortgage at that point in time. So long as
house prices were rising, borrowers were able to refinance and roll over the loan. However,
when house prices began to decline, lenders were unwilling to refinance, and as a
consequence, borrowers were often unable to pay the higher interest rates, which prompted
defaults. Second, as the housing boom continued, an increasing share of new purchases
were by investors (declared or undeclared) rather than by borrowers who intended to live in
the house. The default decisions by investors are much more sensitive to declining house
prices than those by owner-occupied borrowers.
The vast majority of subprime loans were financed by investors through placing the loans
into securities that were sold onto the market. Most of the securities derived from these
subprime mortgages were deemed to be AAA rated by the rating agencies. The subprime
mortgage securities differed in an important way from those based on prime conforming
mortgages. For prime conforming mortgage-backed securities, the degree of credit protection
for the AAA investors is fixed in advance. In contrast, for subprime mortgage-backed
securities, the degree of credit protection for AAA investors started out "thin" and built up
over the initial couple of years so long as mortgages did not default early in their life.9 At the
peak of the housing boom, not only was leverage high for the individual subprime borrower,
but leverage was high for the investors in lower rated subprime mortgage securities.10 This
dynamic buildup of credit protection worked well so long as house prices kept increasing, but
proved to be disastrous for investors in AAA subprime securities when house prices began to
decline.
The AAA rated subprime securities were then used as collateral against repurchase
agreements. Given how safe the assets were thought to be, very small haircuts were
required for these loans. In addition, the composition of repo loan terms shifted toward
overnight, reaching 75 percent in 2008.11 These small haircuts implied that the broker
dealers could use considerable leverage themselves in purchasing these securities. So,
leverage was high at all levels of the financial chain from the individual subprime borrowers,
to the investors in the lower rated securities, and to the broker dealers who invested in the
highly rated securities. At their peak, subprime mortgage related securities amounted to only
around $1.2 trillion dollars - a relatively small size given the overall size of the repo market.
Leverage, however, amplified the losses as house prices began to decline.
Why did the point at which house prices peaked and started to fall in some housing markets
spark a run on the repo market? Additionally, why did the problems in subprime mortgage
assets spread quickly to other assets? Gary Gorton uses the analogy of an E. coli
breakout.12 Suppose that E. coli is thought to have infected a small quantity of the country's
meat supply. The difficulty is that no one knows which batches of meat have been infected. If
eating infected meat will cause the individual to become very sick, then the natural reaction is
for everyone to immediately stop eating meat altogether. This will continue until the entire
meat supply has been recalled and inspected. Subprime mortgage defaults were the E. coli
that infected the financial system. Some mortgage assets would lose significant value as a
result, but it was difficult to know which mortgage assets were "infected" and who was
holding these assets. The natural response was to pull back from these assets.
In a deposit run, when the quality of a bank's assets is brought into question, depositors
immediately withdraw their funds from the bank. In the case of the repo market, lenders
raised the haircuts required for the repo loans or refused to roll over the repo loans
collateralized by subprime mortgage assets. This is equivalent to a partial or a complete
withdrawal of funds from the market by the lenders.13 In addition, the higher haircuts forced
the owners of the assets to come up with additional cash which typically meant that they
were forced to sell assets. Given that there was little appetite to purchase mortgage-related
assets, high-quality assets had to be sold in order to raise this cash. This put downward
pressure on the prices of these assets and increased the uncertainty regarding their future
values leading to demands for higher haircuts on these assets, as well. The haircut spiral,
can be seen in Chart 6. A fire sale dynamic developed, which depressed asset prices further
leading to additional upward pressure on haircuts.
The rapid deleveraging of the shadow banking system as the run progressed led to a sharp
contraction in credit. We saw this earlier in Chart 2 with the near complete collapse in the
asset-backed security market. Banks were also adversely affected by this run on
securitization markets since they used these markets as well to fund many types of loans.
Several banks had to bring onto their balance sheets previously off-balance sheet entities
that they had used to securitize loans. This used up balance-sheet capacity making it more
difficult for banks to make up for the credit contraction going on outside of the banking
system. The problems in the financial system spread to the real economy. When Lehman
Brothers declared bankruptcy, a money market mutual fund - the Reserve Fund - "broke the
buck". The unanticipated losses incurred by the Reserve Fund expanded the bank run to the
money market mutual funds. Since these funds were significant investors in the commercial
paper market, this transmitted the strains to the commercial paper market. Dollar funding
pressures were also increasing for firms operating outside the United States as their ability to
access dollars through the foreign exchange markets began to become strained. The
subprime "E. coli scare" had effectively been transmitted far and wide across financial
markets.
Let me turn now to the interventions used to combat the financial crisis. The Fed knew much
less back in the autumn of 2007 than we know now about how far and wide the financial
crisis was to spread and the implications this would have for the real economy. The initial
response by the Fed was to use its traditional liquidity tools. On August 10, 2007, the Federal
Open Market Committee (FOMC) issued a statement indicating that the discount window
was available as a source of liquidity to those firms that had access to the window. A week
later, the FOMC cut the discount rate (the interest rate charged on discount window loans) by
50 basis points (a half of a percentage point) and extended the available term for these loans
from overnight to 30 days. Given that the liquidity strains were affecting many firms that did
not have direct access to the discount window, a key for this intervention to be helpful was
that depository institutions would pass the liquidity on to those firms that needed it the most.
Using the earlier forest fire analogy, it was as if the Fed could not drop water directly on the
burning section of the forest; rather, it had to drop the water on an adjacent section of forest
and hope that somehow the water got to where it was needed.
Several problems became apparent with this strategy. First, few discount loans were being
taken out. There is a history of "stigma" associated with borrowing from the Fed's discount
window. Given the high degree of uncertainty in the financial markets in the autunm of 2007,
this stigma effect likely became amplified. Second, given uncertainty about their own future
liquidity needs, banks developed a strong "precautionary demand" for liquidity. This implied
that they were less willing to lend out liquidity to other financial firms. Finally, it was becoming
increasingly difficult to assess the credit risk associated with lending to other firms even if
only for short terms. To use a medical analogy, the progression of a fever can be measured
by a person's temperature. The progression of problems in the interbank lending market can
be measured by the spread between LIBOR and the overnight index swap (OIS) rates for a
given term. Chart 7 shows the 3-month LIBOR/OIS spread. Prior to the onset of the financial
crisis, this spread had been very narrow. Very soon after the BNP Paribus announcement,
the "fever" shot up dramatically.
The first new liquidity facility that was introduced to deal with these problems was the Term
Auction Facility or TAF on December 12, 2007. The TAF program was designed to deal with
the stigma problem associated with the discount window and also to make it easier for the
New York Fed to sterilize the liquidity injections into the financial system. The TAF program
auctioned off a fixed quantity of term funding to depository institutions using the same
collateral to back up the loans as can be pledged at the discount window. Since the quantity
of funding was set in advance, it made it much easier than for discount window borrowing to
offset this liquidity injection. More important, however, was the design concept: term funding
priced and distributed in a competitive auction would hopefully avoid any stigma for the
winning participants of the auction. The TAF auctions were essentially a better way to dump
more water on the same section of the forest covered by the discount window. However, the
fire was still burning elsewhere.
The inadequacy of the Fed's traditional liquidity tools and their recent enhancement with the
TAF came to the forefront in the spring of 2008. Conditions were deteriorating for several
primary dealers, including Bear Sterns. The Board of Governors of the Federal Reserve
System (all of the governors are appointed by the U.S. president and confirmed by the
Senate) decided to activate a little known or used section of the Federal Reserve Act -
section 13(3) - which gives the Fed the ability lend to any "individual, partnership or
corporation" in "unusual and exigent circumstances".
On March 11, 2008, the Fed announced the establishment of the Term Securities Lending
Facility (TSLF). This program allowed primary dealers to swap a broad range of what had
become illiquid assets for Treasury securities that could be easily financed. This program
leveraged the Fed's large holdings of Treasury securities. The TSLF, however, came too late
for Bear Sterns. On March 14, the Fed again using its section 13(3) emergency powers
approved the takeover of Bear Sterns, the fifth largest investment bank, by JPMorgan Chase.
Without the acquisition by JPMorgan Chase, Bear Sterns would have had to file for
bankruptcy since they were essentially cut off from market funding. Two days later, on March
16, the Primary Dealer Credit Facility (PDCF) was introduced, essentially providing discount
window access to all primary dealers in an effort to provide a backstop to their liquidity
needs. Like discount window lending, PDCF loans had to be "secured to the satisfaction" of
the Fed. Chart 8 shows borrowing from the PDCF in comparison to borrowing from the
discount window. With the TSLF and PDCF, the Fed was now better able to direct water
directly to where the fires were burning the hottest.
At the same time that the Fed was using its traditional liquidity and new liquidity tools, it was
also aggressively cutting the federal funds rate, which is its primary instrument for stimulating
the real economy. In the summer of 2007, the fed funds rate was at 5.25 percent. By
March 18, 2008, the FOMC had reduced the federal funds rate by three percentage points to
2.25 percent - including two unusual 75 basis point reductions one on January 22, 2008, and
the other on March 18. The FOMC was well aware of the impact that the financial crisis could
have on the real economy and was actively trying to offset these adverse effects. The FOMC
made an additional 25 basis point reduction in the federal funds rate on April 30, and then
held the policy rate constant over the summer at 2 percent.
The Panic of 2007 turned into the Great Recession of 2008 following the bankruptcy of
Lehman Brothers on September 15 and the Fed's emergency assistance to American
International Group, Inc. In response, the Fed reduced the federal funds rate to essentially
zero by mid-December, instituted swap lines to provide dollar liquidity to foreign central
banks, added new liquidity facilities to target specific sectors of the shadow banking system
and began to expand its balance sheet through asset purchases. To deal with problems in
commercial paper market, the Fed introduced on October 27 the Commercial Paper Funding
Facility (CPFF) to backstop issues of commercial paper. In an effort to restart the
securitization market, on November 25, the Fed announced the Term Asset Backed
Securities Loan Facility (TALF).14
In December, the FOMC announced that it would begin to
significantly expand its balance sheet through purchases of long-term assets including
agency debt, agency mortgage-backed securities and long-term treasuries - the Large Scale
Asset Purchase or LSAP program. Other interventions were taking place directed by different
agencies and in conjunction with the Treasury. At the same time, fiscal policy was engaging
with Congress approving the $750 billion Troubled Asset Relief Program (TARP) program.
Policy had entered the "whatever it takes" phase in an effort to keep the Great Recession
from becoming something much worse.15
By the spring of 2009, the various guarantees and backstop liquidity facilities covering
different sectors of the shadow banking system were in place. The last element required to
deal with the Panic of 2007 was to address the uncertainty over the viability of the large
systemically important financial institutions. A horizontal review of the 19 largest financial
firms was conducted to assess their capital needs under a "worse-than-anticipated economic
scenario" - this was called the Supervisory Capital Assessment Program or SCAP (you can
tell that we are fond of acronyms).
There were two design features of the SCAP program that were essential for its ability to
reduce the uncertainty in financial markets. First, the process was designed to be transparent
with both the methodology published up front and the firm-by-firm results published at the
conclusion. Second, if a firm was deemed to need capital but was unable to raise it in the
market, Treasury pledged to provide the capital. The SCAP program was successful in
restoring a degree of confidence in financial markets and in enabling these financial firms to
raise capital on their own.
By the second half of 2009, the financial fever from the Panic of 2007 had finally broken with
the 3-month LIBOR/OIS spread narrowing back to pre-crisis levels.16 The economy began to
grow again. Having served their purpose, the Fed's special liquidity facilities have been
wound down. The policy focus has shifted to regulatory reforms and how to prevent a future
financial crisis. To be successful, these reforms must deal with the run dynamics in the
shadow banking system, as well as devise ways to limit the leverage cycle that is an integral
part of asset booms and busts that can trigger a panic. If the lessons from the panics of 1907
and 2007 are incorporated into the reforms, we may well avoid the Panic of 2107.