Source: http://www.frbsf.org/publications/federalreserve/annual/2008/financial_turmoil.html
Timestamp: 2013-05-19 20:57:59
Document Index: 758567427

Matched Legal Cases: ['art 1', 'art 2', 'art 3', 'art 4', 'art 4', 'art 5', 'art 1']

Economic Research, the other areas contributing to this report, and the Legal department are part of an interdepartmental committee the Federal Reserve Bank of San Francisco formed in 2008 to coordinate responses at the highest levels to the crisis. The initial focus on the fallout in the housing and mortgage markets now has expanded to
encompass the broader financial crisis. The committee coordinates individual department initiatives and interdepartmental initiatives to address challenges and analyze emerging developments and policy issues related to housing, financial markets, and financial institutions. Seated (Left to Right): Simon Kwan, John Krainer, Jose Lopez; Standing (Left to Right): Jens Christensen, Fred Furlong, Liz Laderman
The year 2008 marked a watershed for
the modern global financial system
and presented the Federal Reserve
with some of the greatest challenges
in its history. The financial market turmoil
that started in the previous year worsened
substantially during 2008, and its effect on
real economic activity was substantial. Facing
the mutually reinforcing combination of
the most serious impairment of our financial
system and the potentially worst economic
downturn since World War II, the Federal
Reserve took unprecedented actions as it
strived to restore economic growth, job creation,
and financial stability, as well as to preserve
price stability, an effort that continues
in 2009 (see Box 1: Financial Crisis Timeline).
The intensification of the turmoil in financial
markets in 2008 was due in part to the
marked deterioration in conditions in the
housing and residential mortgage markets.
As documented in last year’s annual report,
The Subprime Mortgage Market: National and
Twelfth District Developments, the end of the
credit and housing boom in the second half
of 2005 unveiled earlier excesses that eventually
led to the swelling of mortgage delinquencies
and the eruption of financial market
turmoil in August of 2007. In 2008, amid
the steepening of house-price depreciation,
the economy weakened substantially and the
number of mortgage delinquencies climbed
Box 1: Financial Crisis Timeline: Federal Funds Target Rate and Other Policy Actions (click to enlarge)
The buildup of financial stress in 2008
extended far beyond the housing and the
residential mortgage markets. In the earlier
boom years, asset values in general were inflated
in an environment of unusually low
risk spreads, heightened reliance on financial
leverage, and the proliferation of complex
and opaque financial instruments that
proved to be fragile under stress. As market
forces corrected these excesses, the simultaneous
re-pricing of risks, deleveraging, and massive write-downs by financial institutions
unleashed powerful forces across financial
markets in 2008.
Market Participants Lose Confidence
Resolution of the financial crisis is complicated
by a profound loss of investor and public
confidence in the strength of key financial
markets and institutions. The loss of confidence
stems in part from uncertainty about
the extent of potential financial losses in the
face of deteriorating economic conditions and
the difficulty of valuing complex financial
securities. Confidence is further undermined
by the limited disclosure by financial institutions
on their portfolio compositions and
asset holdings, which makes it difficult to assess
their exposure to losses. Many of these
institutions are especially vulnerable owing
to their very high leverage and heavy reliance
on very short-term funding.
During the year, the loss of confidence led
to serious impairment and, in some cases, a
freezing up of credit flows in key markets. One
notable example is the term interbank market—
that is, the market in which banks lend to
each other for periods longer than overnight.
Due to concerns about the ability of borrowers
in the interbank market to repay loans
and the desire of banks to protect their own
capital and liquidity positions, the spreads
on term interbank borrowing rates relative
to the Overnight Index Swap (OIS) rates—a
key measure of funding stress—spiked to uncharted
territory following several high profile
events during 2008, such as the forced sale
of Bear Stearns and the bankruptcy of Lehman
Brothers (see Chart 1).1 Other examples of
credit market impairment during the year
included the sharp slowdown of commercial paper issuance after a prominent money market
fund “broke the buck”—when its share value fell
below one dollar—and the elevated risk spreads
on mortgage-backed securities (MBS) that are
guaranteed by the two government-sponsored
enterprises (GSEs), Fannie Mae and Freddie
Mac, even after they were placed in conservatorship
Credit Stifled
The impairment of financial markets severely
stifled credit flows to households and businesses.
Issuance of private-label MBS, both for
residential and commercial mortgages, essentially
evaporated (see Chart 2), and the securitization
of consumer and business-related loans nose-dived. Commercial banks also severely
tightened credit terms and lending standards
during 2008. Although lending by commercial
banks expanded in 2008, the expansion did not
offset contractions in other sources of private
funding. On net, credit availability to households
and businesses was exceptionally tight.
Our economic system is critically dependent
on well-functioning financial markets and sound
financial institutions that mediate the flow of
credit. The impairment of financial markets and
credit flows took a heavy toll on the economy.
With the United States officially in a recession
during all of 2008, the economy lost about 2.6
million jobs, the worst 12-month period since
World War II. This created an adverse feedback loop—that is, economic deterioration intensified
stress in the financial sector, which in turn
further squeezed economic activity, creating a
mutually reinforcing cycle (see Chart 3).
An important lesson from both economic
theory and history is that policymakers must
confront circumstances like these with prompt
and aggressive action. Even so, in the first half
of 2008, the conduct of monetary policy was
complicated by rising commodity prices that
pushed up the headline inflation rate. The
nonetheless expected inflationary pressures to
subside, and longer-term inflation expectations
appeared to be stable. With the serious threat
to economic growth from the financial crisis,
the FOMC cut the federal funds rate target by
roughly five percentage points in the period
following the onset of the crisis. In December
2008, the FOMC took the historic step of lowering
the federal funds rate essentially to its
“zero bound,” establishing a target range of 0
to 1/4 percent. Expanded Policy Toolbox
Due to the extraordinary stress in financial
markets, in addition to lowering the federal
funds rate target, the Federal Reserve employed
a set of new tools to improve the functioning of
credit markets, ease financial conditions, and
support economic activity more generally. As
early as December 2007, the Federal Reserve
established the first of a number of new liquidity
and credit facilities, the Term Auction Facility
(TAF), to address the dislocation in the term
interbank market.2 This facility was set up as an
auction and served as another vehicle for extending
discount window loans to depository
institutions. Amid the global scope of the financial
crisis, the Federal Reserve also supported
the provision of U.S. dollar liquidity in foreign
markets by vastly expanding its network of
currency swap lines with other central banks
starting in December of 2007.
Box 2: Federal Reserve Bank Credit
These facilities for providing liquidity to
depositories are in keeping with the Federal
Reserve’s traditional role as lender of last resort.
However, since the financial crisis also
hit nonbank financial institutions and key
markets, providing liquidity to depository institutions
alone was not sufficient to meet the
liquidity and credit demands of the economy.
In response, the Federal Reserve employed a
number of other new tools, some of which involved
using the Fed’s authority to make direct
purchases of U.S. government agency securities.
For others, the Federal Reserve invoked
Section 13(3) of the Federal Reserve Act to lend
in “unusual and exigent circumstances” to “individuals,
partnerships, or corporations” that
are “unable to secure adequate credit accommodations
from other banking institutions.”
Under this authority, the Federal Reserve
initiated a number of special credit facilities
to extend credit to a broader range of counterparties,
against a broader set of collateral, and
for relatively longer terms (see Box 2: Federal
Reserve Bank Credit). The goals of these policy tools are to promote
the dissemination of liquidity, foster the
liquidity of key securities, increase the flow
of credit to seriously impaired sectors, and
lower interest rates in targeted nonbank credit markets. For primary dealers, these tools provide
access to collateralized loans from the
Federal Reserve and the option to borrow
Treasury securities.3 For others, these measures
provide liquidity for money market securities
held by money market mutual funds, support
the extension of credit to highly rated issuers
of commercial paper, and enable the Federal
Reserve to purchase both the direct obligations
of Fannie Mae, Freddie Mac, and the Federal
Home Loan Banks and agency MBS to
help lower mortgage interest rates. The Term
Asset-Backed Securities Loan Facility (TALF),
which was launched in early 2009, is directed
at supporting the particularly hard-hit
asset-backed securities market, which is instrumental
to the flow of credit for consumer loans,
student loans, business loans, and certain
mortgages that are not eligible for inclusion in
securities guaranteed by the housing GSEs.
Finally, a number of tools made possible
under the Federal Reserve’s emergency powers
involve targeted financial assistance to
preserve the stability of systemically critical financial
institutions. For example, these include
the credit facilities established by the Federal
Reserve Bank of New York in connection with
the acquisition of Bear Stearns by JPMorgan
Chase and the efforts to stabilize insurance
giant American International Group (AIG). The Fed’s Growing Balance Sheet Chart 4: Federal Reserve Bank Credit
The implementation of these policy tools
has substantially changed the composition
and, since mid-September 2008, the size of the
Federal Reserve System’s balance sheet (see
Chart 4).4 The Federal Reserve’s balance sheet
expanded rapidly toward the latter part of
2008 with the deterioration in financial market
conditions that led to the failure of Lehman
Brothers, followed by the near collapse of AIG,
the “run” on prime money market funds, the
severe dislocations in commercial paper markets,
and the general flight to quality by investors
seeking the safety of Treasury securities.5 At the beginning of 2009, Federal Reserve Bank
credit reached about $2.3 trillion, compared
with about $900 billion prior to the start of the
It is difficult to assess the effects of individual
facilities on particular markets, let alone
the impact on overall financial conditions.
Along with the Federal Reserve initiatives,
the federal government undertook a number
of efforts to support financial markets, including
the Treasury Department’s Troubled Asset
Relief Program, the Federal Deposit Insurance
Signs of improvement in commercial paper market
Corporation’s Temporary Liquidity Guarantee
Program, and the placement of Fannie Mae and
Freddie Mac in conservatorship. These programs
were designed to work with the Federal
Reserve initiatives to mitigate the effects of the
dislocation in financial markets. Indeed, there
are signs that stress in financial markets eased
from the crescendo reached in mid-September
2008. The improvement was evident in lower
risk spreads in commercial paper markets (see
Chart 5) and in a narrowing of the spreads on
the term Libor relative to the OIS rates (see
Chart 1), though the latter remained somewhat
elevated. In other markets targeted by the
Federal Reserve initiatives, risk premiums on
GSE-backed MBS moved lower in late 2008 and
early 2009, helping to bring down interest rates
on conforming mortgages.
Looking forward, the use of the Federal Reserve’s
balance sheet to restore financial stability
and economic growth has become even more
important, with the federal funds rate close to
zero at the beginning of 2009. In addition, the
Federal Reserve’s communications to the public
about its policy formulation will be vital in the
1. The OIS rate is the fixed leg underlying the derivative contract between two parties swapping overnight federal funds with term federal funds.
2. To further ease liquidity pressures at quarter- and year-end, the Federal Reserve announced the forward auctions of TAF loans on July 30, 2008.
3. The Federal Reserve Bank of New York trades U.S. government securities and other selected securities with designated primary dealers, which include banks and securities broker-dealers.
4. The Treasury’s Special Funding Program and the authorization of the Federal Reserve to pay interest on reserves allowed the Federal Reserve to expand its balance sheet while separately pursuing monetary policy actions directed at affecting the level of the federal funds rate.
5. The federal government also took extraordinary actions at the time by guaranteeing the shares of money market mutual funds, at the same time as the Federal Depository Insurance Corporation guaranteed senior unsecured debt of depository institutions and their holding companies and provided full deposit insurance coverage for non-interest-bearing transaction accounts. Letter From the President
of 2008 (PDF)