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The U.S. Financial Crisis and Policymakers’ ResponsesMay 20, 2009

Following the failure of Lehman Brothers, a large investment bank, and American InternationalGroup AIG in September, the financial crisis intensified and the world economy sank into a severerecession. The Fed responded by reducing its target for the federal funds rate from two percent inearly September to near zero percent by December. The severity of the crisis, however, compelledhe Fed to take a series of aggressive and unprecedented actions beyond this conventionalt monetary policy response.In a speech in January, 2009, Ben Bernanke grouped the Fed’s actions into three categories:rovision of liquidity to financial institutions, provision of liquidity to nonfinancial borrowers andpinvestors, and the purchase of longer‐term securities.The provision of liquidity to financial institutions is central to a central bank’s traditional role as the“lender of last resort.” The Term Auction Facility TAF and Primary Dealer Credit Facility PDCFare two new lending facilities that the Fed has made available to financial institutions. In the springof 2008 the Fed also introduced the Term Securities Lending Facility TSLF, which lends Treasurysecurities to primary dealers. During the financial crisis the demand for Treasury securities hasrisen as investors try to hoard less risky assets. This program ensures that markets have an amplesupply of these securities. The Fed has also approved currency swap arrangements with foreigncentral banks. A currency swap works in the same way as a repurchase agreement. In a currencyswap, the Fed sells dollars to a foreign central bank in exchange for foreign currency, at the sametime agreeing to buy the dollars back at a pre‐specified exchange rate on some date in the future.urrency swaps have provided foreign central banks with the dollars they need to lend to banks inCtheir countries during the financial crisis.The breakdown of the financial system has disrupted markets that nonfinancial companies rely onfor short‐term borrowing needs. The Fed has stepped in to support these markets in order toensure that companies can get the loans they need to stay in business. The Money Market InvestorFunding Facility MMIFF, introduced in October 2008, makes loans to money market mutual funds.The existence of this facility essentially guarantees the money that the public invests in moneymarket mutual funds, supporting demand for commercial paper and other short‐term securitiesthat these funds purchase. The Commercial Paper Funding Facility CPFF was also created inOctober 2008. It purchases commercial paper from issuers through a newly created company calledthe CPFF LLC for “limited liability company”. In November 2008 the Fed introduced the TermAsset‐Backed Securities Loan Facility, which issues one to three‐year loans to holders of asset‐backed securities including securities backed by student loans, auto loans, credit card loans, loansguaranteed by the Small Business Administration, and others. This facility is intended to support lending in the types of markets listed above by supporting the securitization of these loans. InFebruary the Fed announced that it was going to expand TALF by as much as $1 trillion and toroaden the types of securities covered by the program to include securities backed by commercialbmortgages and other loans not previously included.Finally, the Fed has begun purchasing long‐term government securities, bonds issued bygovernment‐sponsored enterprises for the most part, Fannie Mae and Freddie Mac, and mortgagebacked securites issued by Fannie Mae and Freddie Mac. The purpose of these programs is toreduce long‐term interest rates in general and mortgage rates in particular. A reduction in yields onlong‐term government bonds should help bring down rates on corporate bonds of similarmaturities. This would make it easier for companies to borrow to finance investment projects.

Lower rates on home mortgages would stimulate demand for housing and also permit homeownersto refinance their mortgages, freeing up money to be used for consumption spending or to payown debt. Any new spending that results from a lowering of these long‐term rates will helpdstimulate the economy.Figure 1 below shows how the composition of the Fed’s asset holdings has changed as a result of itsnew lending facilities. Before 2008, total asset holdings were around $900 billion and rising at amodest rate. The bulk of the Fed’s assets were in the form of government securities that it hadaccumulated through open market operations. The Fed controls the money supply by setting thelevel of the monetary base. The monetary base is currency and bank reserves, which constitute thebulk of the liabilities of the Federal Reserve. Since by an accounting identity the Fed’s asset holdingsmust equal its liabilities, the size of the Fed’s asset holdings tell us essentially what the monetaryase must be. Thus Figure 1 tells us that before 2008 the monetary base was rising at a modest andbfairly stable rate.At the end of 2007 the Fed began making loans through TAF. These loans began making up a sizableportion of the Fed’s asset holdings by early 2008 as shown in Figure 1. The Fed soon began to makeloans through other liquidity facilities, offsetting offset these loans by conducting open market salesof Treasury securities so as to keep the monetary base on its intended path. By keeping themonetary base stable the Fed was able to maintain its federal funds rate target. By early September,2008, the Fed had $927 billion in assets, of which $480 billion were securities and $265 billionwere loans extended through its liquidity facilities other types of assets, including foreign currencyholdings, gold, and others, are also included in the total. The crisis that erupted in September 2008increased loans to a high of $1.6 trillion by December. The Fed did not offset this new lendingthrough open market sales of securities, so the total amount of assets the Fed held rose to a peak of $2.25 trillion. In effect, the Fed had almost tripled the monetary base in the space of a few months –an unprecedented act. Since December the total amount of lending has fallen as financial marketsave stabilized. The Fed’s purchases of long‐term Treasury and other securities, however, hashraised its holdings of securities and kept the total amount of assets near its December peak.Have the Fed’s actions been successful? One way to test this is to look at interest rate spreads invarious segments of the financial market. A good measure of the market’s perception of risk in thebanking sector is the difference between the interest rate at which banks lend to each other theLIBOR, or London interbank offered rate and the yield on three‐month Treasury bills – this isknown as the TED spread. Historically the TED spread is under 100 basis points, meaning that banks make short‐term loans to each other at less than a one percent premium over the Treasurybill rate. In October 2008, at the height of the financial crisis, the TED spread was over 400 basispoints. It has fallen since then, and is now at normal historical levels. The spread betweennonfinancial commercial paper rates and Treasury bill yields provides an indicator of the ability of nonfinancial companies to get short‐term loans. This spread, which is normally between zero and50 basis points, reached a high of over 200 basis points at the height of the financial crisis. Sincethen it has fallen to near zero. The “high‐yield spread” the difference between BBB and AAA‐ratedcorporate bond yields is a good measure of the market’s perception of default risk in the corporatebond market. In normal times this spread tends to be 50 to 150 basis points. In October 2008 thehigh‐yield spread rose to over 300 basis points. It has come down somewhat, but as of May thespread was still around 250 basis points. The movement of credit spreads suggests that the Fed’sinterventions have reduced perceptions of risk in the banking sector and freed up access to short‐erm credit for nonfinancial companies. But the Fed has been less successful in reducingerceptions of risk in the business sector as a whole.t p