Elizabeth A Duke: Unusual and exigent - my first year at the Fed
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the Federal Reserve
System, at the Economics Club of Hampton Roads, Norfolk, Virginia, 18 February 2010.
* * *
Thank you so much for being here. It's great to be home with so many friends, former
colleagues, and former customers, and all of you who make Hampton Roads such a great
place to live and do business. I am truly honored to receive the Economic Impact award from
the Economics Club of Hampton Roads, joining such company as Paul Sarbanes, former
senator from Maryland and coauthor of the Sarbanes-Oxley Act, and Arthur Levitt, former
chairman of the Securities and Exchange Commission. By honoring me, you recognize the
extraordinary work of all the talented, knowledgeable, and dedicated men and women of the
Federal Reserve System. So I would like to take this opportunity to express my admiration
for the Fed staff and my colleagues on the Board of Governors, especially Chairman Ben
Bernanke. I witnessed firsthand the leadership, the concern for the U.S. economy, and the
political courage the chairman displayed as he led us through this tumultuous time. I
wholeheartedly believe that without the actions taken by the Federal Reserve to fight the
financial crisis, our financial system would have frozen and the outcome for the economy
would have been unthinkable. It is hard to believe that it has only been 18 months since I left
here. So I thought I would tell you a little about what I have been doing.
I was officially sworn in as a member of the Board of Governors of the Federal Reserve
System on August 4, 2008, at 8 o'clock in the morning. Just a half hour later, I attended my
first meeting of the Federal Open Market Committee (FOMC). (The FOMC, composed of the
Board of Governors and the 12 Federal Reserve Bank presidents, is the body that makes
decisions about interest rates and other aspects of monetary policy.) Six weeks later I
attended my second FOMC meeting. Normally, the Board of Governors convenes right after
the FOMC meeting for a quick vote on Reserve Bank requests to change the discount rate.
My second such meeting was anything but routine. We voted to lend $85 billion to prevent
the collapse of American International Group, Inc. (AIG), whose failure at such a fragile time
could have had disastrous results. In between those two meetings were some of the darkest
hours of the financial crisis. On September 7, the Treasury Department placed Fannie Mae
and Freddie Mac into conservatorship, essentially putting the government in charge of the
mortgage giants. On September 15, Lehman Brothers filed for bankruptcy protection. A day
later, a prominent money market mutual fund "broke the buck" - that is, its share price went
below $1 - sparking fears that no investments were safe as the financial crisis rapidly spread
around the globe. That was the same day we made the loan to AIG - not exactly a lot of time
to ease into a new job.
We realized that if we didn't act rapidly, the panic that we saw in financial markets - the
worst in 80 years - could quickly trigger a global depression. In fighting the crisis, the Fed
acted as a first responder of sorts using a wide range of tools, including lowering interest
rates; maintaining a steady flow of dollars to meet demand abroad; providing liquidity to
sound institutions to support faltering financial markets; and providing emergency loans to
specific, troubled institutions whose failures would have had disastrous consequences for the
financial system and the economy. Later, the Fed created additional programs to unlock
lending, the lifeblood of the U.S. economy.
While the economy today is by no means nearly as strong as we'd like it to be and some
parts of the financial system are still not functioning smoothly, the forceful actions by the
Federal Reserve in the fall of 2008 helped prevent the apocalyptic scenario that we all
feared. I'd like to explain how we acted swiftly, responsibly, and effectively in response to the
financial crisis.
Lowering interest rates
During more normal times, the Federal Reserve's policymaking is focused on short-term
interest rates, our main tool for steering the economy. The Fed influences the costs of
borrowing to buy everything from cars to condos to computers by controlling short-term
interest rates. Interest rates can be lowered to stimulate borrowing and spending when
demand is otherwise weak or raised to damp demand and curb inflation.
Before I arrived, the Fed had already responded to the weakening in the economy by
aggressively lowering its federal funds rate target from 5-1/4 percent in September 2007 to
2 percent. Two percent is extremely low for interest rates, but as the financial crisis
intensified and the economic outlook grew more dire in the fall of 2008, the Fed continued to
cut rates. For more than a year now, our policies have pushed down short-term interest rates
close to zero.
Once our main short-term interest rate lever was effectively at zero, we moved beyond
traditional monetary policy to push down longer-term interest rates. In November 2008, the
Fed began purchasing large volumes of longer-term, U.S. government debt and agency
mortgage-backed securities, eventually increasing the commitment to more than $1.7 trillion.
The added demand for these securities pushed up their prices, thus lowering their yields, and
put downward pressure on other long-term rates, including those for home mortgages and
corporate bonds.
Such actions by the Federal Reserve have led to lower borrowing costs for consumers and
businesses, including on business lines, credit cards, mortgages, and car loans. I have
spoken to many small business owners in Hampton Roads and across the country who say
that without such low interest rates, they might not have survived the severe economic
downturn. In addition, in response to the Fed's moves, the nationwide average rate for a
30-year fixed-rate mortgage dropped from 6-1/2 percent to below 5 percent, the lowest level
since the 1940s, and rates remain near historic lows. The low rates have helped some
people buy a home for the first time and others to refinance. In 2009, millions of households
refinanced their mortgages, thus reducing their monthly payments and giving them more
money to spend, reduce debt, or save. For example, on a $200,000 30-year mortgage,
refinancing from a 6.5 percent mortgage into one with a 5 percent rate saves the homeowner
$190 a month, or nearly $2,300 a year - a significant difference.
But, as we all know, lower interest rates only help if you can actually get a loan. And as the
financial crisis unfolded, credit began to shut down for even the best borrowers. So while
lowering interest rates helped, we knew we had to do more.
Providing liquidity
I don't want to give you a full laundry list of all the actions we have taken to help restore the
flow of credit - it's been tough keeping track of all the acronyms for the programs we have
set up in response to the crisis - but I'll mention a few of the most important.
For centuries, central banks have calmed financial crises by lending to financial institutions
against good collateral. Because central banks step in when other sources of funds retreat,
central banks acting in this capacity are known as lenders of last resort. Banks rely on
short-term funding such as overnight interbank loans or customer deposits to make the
longer-term loans their customers need. If funding becomes scarce, banks become less
willing to extend credit. To maintain the flow of credit, the Federal Reserve has made clear
that it will provide short-term credit to sound depository institutions as needed. The lending
program, known as discount window borrowing or primary credit, is provided at an
abovemarket rate so that banks use the facility only as a backup source of funds.
In theory, it is the higher rate that keeps banks from using the discount window as a regular
source of funds. In practice, bankers are quite suspicious that borrowing from the Federal
Reserve will bring additional regulatory scrutiny. In my banking days, I always described it as
being like borrowing from my father. I was always sure that at some point I would have to
answer uncomfortable questions. And since bank borrowing in normal times is rare, markets
would likely view any such borrowing as a sign of weakness. While the Fed doesn't release
individual borrower information, it does publish the total amount of outstanding loans weekly.
The sudden appearance of new discount window lending would likely send market
participants scurrying to identify the borrower, and it would at a minimum lead to rumors
about who was borrowing and why. The resulting negative view of the discount window is
known as stigma. When uncertainty about the health of individual institutions or the industry
as a whole increases, stigma intensifies as the market tries to identify the weaker players.
The dilemma facing the Fed is that when discount window borrowing is most needed to keep
credit flowing, it is most stigmatized.
The discount window is the Fed's main tool for distributing money to the banking system in
emergencies when bank-to-bank lending isn't functioning, which is precisely the situation that
prevailed in late 2007. But because banks were very reluctant to use the window, that key
tool was broken. To offset the stigma effect, the Fed took a number of steps. We reduced the
spread - the difference between the primary credit rate and the federal funds target rate -
ultimately from 100 basis points to 25 basis points. And we increased the maximum term
from overnight to 90 days. But banks' concerns about stigma still more than offset the
attractiveness of the lower rate.
In December 2007, the Fed went further, launching the Term Auction Facility, or TAF, which
provided term loans to banks through regular competitive auctions. The competitive nature of
the auction and the three-day deferred settlement of the TAF likely signaled that participants
did not face an immediate shortage of funds. Thus, TAF loans did not carry the same stigma
as primary credit. Finally, banks began to increase their usage of both primary credit and the
TAF, perhaps due to lower spreads, longer terms, and reduced stigma, but no doubt in large
part because market funding had become much less available.
Unlocking nonbank markets
As the crisis unfolded, it became clear that the normal tools of the Federal Reserve - lower
interest rates and loans to banks - were not going to be enough to maintain the flow of credit
to consumers and businesses. In today's world, much of the credit that acts as the lifeblood
of the economy is no longer funded on banks' balance sheets. To sustain credit markets in
the system outside the banks, the so-called shadow banking system, we employed the
seldom-used emergency lending authority in section 13(3) of the Federal Reserve Act.
Congress originally approved the 13(3) authority in response to business lending problems
during the Depression. It allows the Fed broad authority to lend to a wide range of borrowers
using good collateral in unusual and exigent circumstances as long as at least five
governors - all we currently have on the Board - approve. The circumstances were certainly
unusual and exigent, and for the most part, the authority was used to target critical markets
that performed the same function as bank lending but were outside the banking system.
Initially, 13(3) was used to establish lending facilities for securities dealers around the time of
the near failure of Bear Stearns. And when runs on money market mutual funds caused the
funds to stop buying commercial paper, it was used to support the commercial paper market,
a key source of funding for businesses.
Section 13(3) was also used to support the market for asset-backed securities (ABS), which
are made up of loans such as auto loans, credit cards, student loans, loans guaranteed by
the Small Business Administration (SBA), and loans to businesses for equipment purchases.
Many major lenders in these markets fund their lending by packaging the loans into
securities and selling them to investors. In the fall of 2008, ABS issuance came to a
standstill, which pushed up the cost of credit and greatly reduced its availability. As market
after market started to freeze, we were swamped with stories from a steady stream of trade
associations, businesses, individuals, lenders, and others about the consequences of
problems with ABS. Knowing that families and firms need access to loans to pay for college,
replace worn-out cars, or upgrade computer systems, staff at the Fed worked around the
clock to develop a credit facility that would help individuals and small businesses by
jump-starting new issuance of ABS.
In late November 2008, the Federal Reserve, working with the Treasury, created the Term
Asset-Backed Securities Loan Facility (TALF). Under the TALF, the Fed extends loans to
investors to help finance their purchases of highly rated ABS. Banks and other intermediaries
were then willing to renew their lending to consumers and small businesses because they
knew that investors would purchase securities backed by the new loans.
The TALF has helped encourage loans to households by facilitating a resumption of activity
in securities made up of auto loans, student loans, and credit card loans. The TALF also
helped enable mortgage modifications aimed at keeping people in their homes. Mortgage
servicers need funds to make the payments on delinquent mortgages while the loans are
being modified. Smaller servicers have been able to bundle the payment advances as
TALF-eligible securities, easing the pressure on the servicers to foreclose.
The TALF has also supported small business lending through equipment loans, fleet
financing, SBA loans, and floor-plan financing for everything from automobiles to
lawnmowers. In addition, thousands of small businesses were able to finance the purchase
of property and casualty insurance by taking out insurance premium loans that were, in turn,
securitized. In total, more than 3 million auto and student loans to households have been
facilitated through the TALF as well as nearly half a million loans to small businesses and
millions of credit card accounts to both consumers and businesses.
TALF loans also have been used to finance purchases of commercial mortgage-backed
securities (CMBS), a market that until late 2009 had been completely frozen for more than a
year. In fact, in November 2009, TALF funds were used to help bring to market the first new
issue CMBS since June 2008. And since that first deal, two others have funded without
assistance from the TALF, and several more are in various stages of development. We hope
that our work in the commercial mortgage sector will help alleviate some of the strains in
commercial real estate funding. As many of you know all too well, this sector is particularly
troubled as layoffs and business closures have led to vacant retail, office, and industrial
spaces across the United States and refinancing options for maturing loans remain quite
limited.
I have to admit, I was originally quite skeptical about the TALF. I was so skeptical, in fact,
that I was asked to take the lead working with staff on its development. Those of you who
have worked with me before know what a conservative lender I am. So you can imagine the
effort required by staff to overcome every concern and objection that I had. In the end, we
created a program that was really quite safe from the standpoint of the taxpayer, yet quite
successful from the standpoint of those who found loans that otherwise would have been
unavailable.
As pleased as I was to see that the TALF worked, I am even more pleased to see that it is
becoming unnecessary. In recent months, market conditions for auto and credit card ABS
have improved so much that new issues are increasingly being funded by non-TALF
sources. Moreover, even though TALF loans have three- and five-year terms, investors have
already repaid almost one-fourth of TALF loans.
Lending to AIG
Undoubtedly, the most difficult actions and the least popular from the public's view were our
assistance to individual firms, the so-called bailouts of investment bank Bear Stearns and
insurance company AIG. I wasn't there for Bear Stearns, but I did have to vote on the AIG
loan. And I can tell you it was the hardest decision I have ever made. Remember, as I
mentioned earlier, the vote had to be unanimous. So let me see if I can put you in that
moment.
The government had already put Fannie and Freddie into conservatorship to preserve the
mortgage market. Lehman had just failed, and we were getting the initial reports of the
fallout, like reports of battlefield casualties, that market after market was damaged or frozen.
Credit spreads, the difference between the rate in any given market and the risk-free rate,
were blowing up, bringing financial activity to a near standstill. Panic was so heavy in the
markets that it was almost a physical presence. I kept having this image in my head of the
panic being like the monster called "the Blob" that I saw years ago in an old movie. Like the
Blob, panic attacked one institution after another, and with each institution it ate, it grew
bigger and stronger. We had just watched it eat Lehman. We could not stop it there because
we are only authorized to lend against collateral, and Lehman did not have enough collateral.
Now it was focused on AIG. Unlike the situation with Lehman Brothers, we were presented
with an action we could take, a loan we could make to avoid the collapse of AIG. Our
knowledge of the company was limited because we had never supervised AIG, but the loan
could be secured with collateral. Based on our assessments of the collateral, we believed the
risk of the loans to be limited. And while the risk of making the loan was limited, the risk of
not making the loan - of letting AIG, which was significantly larger than Lehman, fail - was
certain to be huge. And no other entity - not a private company, not a consortium of private
companies acting together, not any other branch or agency of the government - was in a
position to do anything. The clock was ticking, and default was imminent. There was no time
to gather more information or find another solution. So I ask you, what would you have done?
It was in this context that the Federal Reserve, with the full support of the Treasury, made a
loan to AIG to prevent its failure. The loan imposed tough terms, senior management was
replaced, and shareholders lost almost all of their investments.
If I had to cast that vote again, even knowing all that followed, including the criticism that we
have received, I wouldn't change it. I still believe that the consequences would have been far
worse for all businesses and consumers if we had let AIG fail. Despite the claims by some
that healthier Wall Street firms or even the small businesses and consumers on Main Street
did not benefit from assistance to AIG, I would argue that no business or individual was
immune to the effects of a sequential collapse of key financial intermediaries. As it was, we
still had frozen credit markets that necessitated the facilities I discussed earlier. In the wake
of the Lehman failure and the near failure of AIG, it was as if someone turned off a switch on
business activity. Almost overnight, businesses went into full protection mode, halting all
capital expenditures, shedding inventory, and slashing expenses. In the face of massive
unemployment caused by layoffs and business failures, consumers stopped spending.
This first became clear to me during the October 2008 board of directors meeting at the
Federal Reserve Bank of San Francisco. The Federal Reserve System has 12 Reserve
Banks, each with a board of directors representing the economy of the district. We rely upon
these board members for real-time insight into conditions in the real economy. Usually, as
they go around the room reporting on conditions in their industry or part of the region, you
hear the full spectrum of emotion from gloom to caution to outright enthusiasm. But I will
never forget the chill that went down my spine as every single person at that meeting talked
about hunkering down and conserving cash. They were retailers, manufacturers, food and
energy producers, providers of private capital, bankers, and nonprofit leaders. And they were
spooked.
Do you remember all the predictions for Y2K, when the fear was that the economy would be
technologically unable to function? As the financial crisis unfolded, it seemed as if the
economy was psychologically unable to function. Everyone was frozen with fear. Then,
gradually, with the support of the liquidity facilities designed by the Fed, panic began to
recede. With the funds approved by the Congress for the Troubled Asset Relief Program,
also known as the TARP, and used by Treasury to inject temporary capital into viable banks
of all sizes, the U.S. government reassured the world that it would not allow its financial
system to collapse. To help markets better assess risk, the Federal Reserve led a horizontal
review, popularly known as the stress test, of the 19 largest financial institutions to estimate
the likely losses and capital requirements if economic conditions turned out to be even more
severe than anticipated. After publication of the stress test results, those banks raised
significant private capital, and confidence slowly returned to the markets. And, just as slowly,
the economy began to function again.
Putting the tools back on the shelf
It's a bit quieter at the Fed these days. All of our emergency credit facilities except for the
TALF and TAF were shut down by the beginning of this month in response to improving
financial market conditions. The TALF and TAF, meanwhile, are winding down. The final TAF
auction will take place in early March. The TALF will remain open until June for new CMBS,
but the March subscriptions will be the last for all other ABS and previously issued CMBS.
We are also tightening the term on primary credit as we return to normal discount operations.
Earlier today, the Board announced that we had approved an increase in the discount rate,
and that we are shortening the typical maturity for primary credit loans to overnight. With
these changes, we expect that banks will use private sources for normal funding and only
use primary credit as a backup source of funds. As I mentioned earlier, the discount rate is
the rate we charge banks that borrow at our discount window. It is not the rate we target for
monetary policy purposes. I'd emphasize that the changes are simply a reversal of the
spread reduction we made to combat stigma and like the closure of a number of
extraordinary credit programs earlier this month, represent further normalization of the
Federal Reserve's lending facilities; they do not signal any change in the outlook for
monetary policy and are not expected to lead to tighter financial conditions for households
and businesses.
If you look at all our liquidity facilities and add up the maximum levels reached by each, we
loaned approximately $2 trillion to combat the crisis. Using the experience, knowledge, and
ingenuity that were available throughout the Fed, we put together new facilities to meet new
challenges as the crisis unfolded. We responded with care and with speed. Most of the
funding was disbursed in a period of a few months, and now, roughly 18 months after the
start of the crisis, the nearly $2 trillion in credit provided through the liquidity facilities have
been paid down to slightly more than $100 billion. The funds were repaid without a single
penny of loss, and we still expect to collect every dollar of the loans that remain outstanding.
We also continue to expect that we will ultimately incur no losses on the credit we extended
to support Bear Stearns and AIG. Lending such enormous sums under such extreme
conditions and with such speed will always entail risk. But I believe the Federal Reserve was
able to do it as safely as it could possibly be done.
Since its inception, the Fed has been responding to crises. Indeed, the Federal Reserve was
created in 1913 in response to a series of banking panics that occurred in the early part of
the 20th century. In fighting the recent crisis, we made extensive use of the 13(3) authorities
that were assigned to us after the trauma of the Great Depression when such tools were not
initially available. Our ability to respond so quickly and so safely is due to the unique blend of
experience and expertise developed as part of our normal activities. We have research
economists who have spent a lifetime studying all the various markets that make up our
economy. And in New York, where open market operations are conducted, we have market
experts who interact with financial markets every day. We have the expertise to monitor
transactions and evaluate payment infrastructure through our check-clearing and wire
transfer operations in the Reserve Banks and our supervision of key clearinghouses.
Through our supervisory activities, we have banking industry experts and bank examiners
who continuously monitor the condition of financial institutions. We have personnel on site in
the largest banks. So we knew our borrowers and were able to evaluate the collateral that
secured the loans.
Unusual and exigent
The Federal Reserve has been entrusted with special authority to act in unusual and exigent
circumstances. Webster's dictionary defines unusual as "not usual, uncommon, rare." It
defines exigent as "requiring immediate aid or action." I sincerely hope that financial panics
such as the one we just experienced remain rare and uncommon. But I am proud of the
Federal Reserve's ability to take immediate and forceful action. As policymakers
appropriately debate reforms to ensure that this never happens again, I hope they also
ensure that if the unusual does happen, the Federal Reserve - or if not the Fed, some
government entity - has all the tools and capabilities necessary to meet it head on. And I
further hope that wherever the authority resides, there are men and women of the caliber of
those with whom I have been so fortunate to work at the Federal Reserve.
As for me, I am still hoping to find out what a normal time at the Fed feels like. Thank you for
honoring me and, by extension, all my colleagues with this distinguished award.