Fed’s Actions and the 2008 Financial Crisis
Posted: Wednesday, 08 October, 2014. | By: Vijay Kumar S
This document analyses Fed’s policies before, during and after the crisis. We have consciously avoided discussing any related fiscal actions. All the claims made here are supported by appropriate data. However, the intention has not been to provide an exhaustive analysis of each policy action. This article is only intended to provide the novice readers with an introductory reading on the financial crisis and point them in the right direction in case they are interested in doing an in depth study of the same.
A) Where did Fed go wrong?
- Discretionary Interest Rate Policy:
Taylor rule suggests that the nominal interest rates set by the monetary authority (federal funds rate in this case) should be based on the rate of inflation, the assumed equilibrium interest rate and changes in inflation, output and other economic conditions. This is generally indicated by the equation given below:
As can be seen from figure 1, Interest rates during the period of moderation (1984-2001) were close to that predicted by Taylor’s rule. However, there was a significant deviation from this rule after 2001. This led to a significant boom in housing which was the primary reason behind the financial crisis.
Figure 1 - Federal Funds Rate*
Figure 2 also compares the actual increases in housing units during this period and the estimate of the demand for housing units had the Taylor rule being followed. As can be clearly seen the low interest rates led to the creating of housing bubble which eventually collapsed in 2008.
- Sterilised Term Auction Facility (TAF)
TAF was instituted in Dec. 2007 when it was evident that the economy was under stress. However, this action failed to cool down the markets as reflected in the widening LIBOR-OIS spreads in figure 3.
However, what is important is to understand as to why the spreads kept increasing in spite of TAF. This was primarily because Fed sterilised its lending via TAF by selling bonds. Eventually, Fed had to stop sterilisation post-Lehmann as it didn’t have enough treasuries to sterilise any further. This action is shown in figure 4 by the steep fall in the amount of treasuries held by Fed.
Figure 5 shows the monetary base during the period of crisis. As can be seen the monetary base expanded very late. Such sterilised lending prevented the expansion of the monetary base when it was most needed. An expansion of monetary base at an earlier stage would have contained the crisis to a large extent. This was a clear deviation from Fed’s policies in the past when the monetary base was expanded well ahead of expected crisis situations. Two such major examples are the expansion of the monetary base before Y2K and immediately after 9/11. This is shown by the two spikes in figure 6.
- Poor Communication of Policy:
Fed launched the Treasury Asset Relief Program (TARP) during Sep 2008.However, Bernanke and Paulson failed to clarify the details and purpose of the policy. This induced more panic in the markets reflected by the sharp jump in the LIBOR-OIS spreads as shown in figure 7.More clarity about the plan was provided a month later which did bring down the spreads, but the damage had already been done.
Although it is not possible to establish causation, the reaction of the US market post TARP indicates that this action had a significant negative impact on the markets. Figure 8 shows the movement in the S&P 500 index during this time period. Similar fall was seen in all the major indices such as DAX, FTSE, CAC etc. This event points to the important role of managing expectations in an economy that a central bank needs to deliver upon. Any failure to manage the expectations of the people might lead to devastating consequences.
B) Where did Fed get it right?
- Quantitative & Credit Easing:
Fed adopted both quantitative and credit easing techniques to counter the slowdown. It’s important to understand the difference between QE and CE. QE focuses on the liability side of the Fed’s balance sheet and CE focuses on the asset side. However, both lead to the expansion of the Fed’s balance sheet.
The first LSAP (Large Scale Asset Purchase) was launched on Nov. 25, 2008 for purchase of $100 B of agency debt and $500 B in MBS. Figure 9 shows the size of assets on Fed’s balance sheet at important dates.
It is widely accepted that QE and CE measures did benefit the economy. This can also be determined by studying the behaviour of St. Louis Financial Stress Index (STLFSI). The STLFSI indicates the stress in the financial markets. It is constructed using 18 weekly data series. STLFSI uses seven interest rate series, six yield spreads and five other indicators. The fall in STLFSI post QE, as shown in figure 10, indicates that the additional liquidity significantly benefited the financial markets.
Unsterilized TAF operations (described in the previous section) also greatly eased the credit flow. QE further helped increase the monetary base significantly post-Lehmann collapse (as shown in figure 11). However, this increase in monetary based would have been ineffective had there been no expansion in bank lending. However, constant confidence building measures by Fed and the low interest rates ensured that the higher liquidity was passed on to the end users of credit. This increase in bank lending is shown in figure 12.
- Operation Twist
Operation Twist was launched by Fed (on Sep 21, 2011) to extend the maturities of assets on its balance sheet. This involves the purchase of long-term bonds and sale of the short-term bonds. The impact of this action on the composition of treasuries on Fed’s balance sheet is shown in figure 13.
The idea behind operation twist is to reduce the yield on the long-term bonds. This in turn would boost investments and increase inflow into equities. Although, isolating the impact of twisting is impossible it is widely believed that this helped keep long term interest rates low. Figure 14 shows the impact on the yield curve of treasury securities one day after the announcement by the Fed.
Figure 15 summarizes the impact of timeline and the impact of various fed actions.
- Broad Based Programs:
In addition to the above a number of broad based programs were also started by Fed to counter the impact of slowdown. The major ones are described below:
The following table summarizes few of the other broad based programs.
- Dollar Swap Lines:
The Fed exchanged dollars with foreign central banks for foreign currency to help address disruptions in dollar funding markets abroad. The FOMC authorized dollar liquidity swap arrangements with 14 foreign central banks between Dec 12, 2007, and Oct 29, 2008.
- Term Securities Lending Facilities (TSLF)
Fed also auctioned loans of U.S. Treasury securities to primary dealers based on a competitive single-price auction. The TSLF was announced on March 11, 2008, and closed on February 1, 2010. By the end of the program it loaned out U.S. Treasury securities worth $2.3 trillion to just 18 Wall Street banks
- Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility
Fed provided loans to depository institutions and their affiliates to finance purchases of eligible asset-backed commercial paper from money market mutual funds. The Facility began operations on September 22, 2008, and was closed on February 1, 2010.
Figures 16 and 17 show the size and impact of different lending programs.
|Primary Dealer Credit Facility||Term Asset-Backed Securities Loan Facility||Commercial Paper Funding Facility|
- Established in March 2008
- Provided overnight cash loans to primary dealers against collateral
- Primary dealers serve as counterparty for Fed’s OMOs
- Improved the ability of primary dealers to provide financing to participants in securities markets
- Helped promote orderly functioning of financial markets
- Closed on February 2010
- Federal Reserve Bank of New York to lend $200 billion to holders of certain ABS backed by consumer and small business loans
- Will help market participants meet the credit needs of households and small businesses
- US Treasury Department will provide $20 billion of credit protection to FRBNY under TARP
- Began operations in October 2008
- FRBNY financed the purchase of highly rated unsecured and asset-backed commercial paper
- Provided liquidity to U.S. issuers of commercial paper
- Intended to improve liquidity in short-term funding markets and contribute to greater credit availability for businesses and households
- Assistance to individual institutions:
In addition to broad based programs, assistance was also extended to individual institutions. Few such instances are briefly mentioned below.
Capital was also pumped into banks to provide liquidity. Figure 18 shows some of the largest borrowers of funds.
- Acquisition of Bearn Sterns by JP Morgan Chase
- Bridge loan to JPMC subsidiary
- Maiden Lane (I): SPV to buy $30 bn Bear Sterns MBS
- AIG Assistance
- Revolving Credit Facility
- Securities Borrowing Facility
- Maiden Lane (II)
- Maiden Lane (III)
- Life Insurance Securitization
- Citigroup Lending Commitment
- Non-recourse loan against ring-fenced assets
Although there is no complete consensus on the impact of Fed’s actions among economists, it can be safely said that a large number of them subscribe to the analysis performed in this article. We would encourage the interested readers to explore these policies further to get a deeper understanding of how each of these mechanisms work.
Thanks for reading! This article is written by Vijay Kumar, a PGP2 student at IIM Ahmedabad