The Credit Crisis and the Federal Reserve

FNCE 6300-OL1 Macroeconomics and Financial Markets Group A: Tarek Alshamali, Hector Hernandez, Mark Tipton and Marcus Werther 4/26/2010

Group A 2

In August 2007, the worst economic recession since the Great Depression was upon the American people. An unprecedented housing boom in the U.S. fueled a global financial crisis, which had been building for years, based on structural differences in world economies that created massive and destabilizing cross-border capital flows (Paulson 64). This crisis would soon bring about the failure of U.S. financial institutions thought too big to fail and a loss of public confidence in those that survived. Bad debt choked these firms balance sheets, resulting in an almost paralyzing credit crisis. Governments across the world had to react to protect and save their economies. In the U.S., the Federal Reserve (Fed) faced a daunting challenge, one in which the traditional tools of monetary policy alone were not adequate. The Fed had to get credit flowing through a financial system that was on the brink of collapse, and they did so by taking unprecedented actions. As the credit crisis eased, measures that were no longer needed were being discontinued; thus, the financial system was working toward an exit and return to normalcy. To fully understand the Feds strategies and actions in response to this monumental challenge, one must first understand the history and roles of the Fed in regulating the U.S. financial system. Before the Federal Reserve System was established, the U.S. suffered from a string of economic and financial emergencies. Prior to the Civil War, the states controlled the banking system. Since people preferred to carry hard cash rather than maintain bank deposits, banks were given the right to print their own money and use it for granting loans. With few controls in place, many banks defaulted as they created more money than they could cover with actual reserves. As the Civil War came to an end, the American economy began to rapidly expand and the banking system encountered a new set of problems. First, the service of creating money struggled to keep up with the demand of an industrializing nation. Second, the slow and expensive check clearing process was overwhelming and began to restrict business operations. Furthermore, liquidity crises recurred when demand from rural banks, who would deposit their reserves at larger metropolitan banks, exceed expectations. These shortages affected the securities market as financial assets would spiral downward; eventually market-wide panic would trigger selloffs. These problems led to the passage of the Federal Reserve Act of 1913. Federal Reserve Act established

Group A 3 the creation of 12 reserve banks across the country, each operating independently and responsible for its own district (Rose and Marquis, Money and Capital Markets 363-64). As new economic challenges presented themselves in the early twentieth century, the federal government adjusted the structure and role of the Fed. Eventually, U.S. securities trading became a more important function of the Fed as the country increasingly issued debt to finance wars, combat recessions and increase government programs. In response to the Great Depression, the biggest changes were implemented with the Banking Acts of 1933 and 1935. These pieces of legislation reorganized the Fed and gave it a vast amount of monetary power; this power would become instrumental in dealing with the credit crisis beginning in 2008 (Rose and Marquis, Money and Capital Markets 365). Today, the Federal Reserve System consists of the Board of Governors, the Federal Open Market Committee (FOMC) and the 12 reserve banks. Together, they are responsible for controlling the nations money supply, maintaining market stability, supervising the banking system, improving the flow of payments, and are the lenders of last resort for financial institutions (Rose and Marquis, Money and Capital Markets 365). As such, the Feds two main goals are to achieve maximum sustainable output and employment, and to promote stable prices (Rose and Marquis, Money and Capital Markets 357). To achieve its goals, the Fed has several tools at its disposalgeneral controls to affect the entire banking system and selective controls to affect only specific sections. The most important and widely used tool is the open market operations (Rose and Marquis, Money and Capital Markets 385), which consist of the buying and selling of U.S. government securities. These operations affect both interest rates and reserves through changing the supply of funds available for loans and investment (Rose and Marquis, Money and Capital Markets 385-86). The Fed can also change the discount rate, which is the rate charged on their loans to other institutions. The Fed is typically a secondary source of funds since credit is usually cheaper and easier to obtain in the money market (Rose and Marquis, Money and Capital Markets 394-95). Throughout the credit crisis beginning in 2008, the Fed reduced the discount rate multiple times in an effort to directly supply more funds to institutions in need, affect other rates, and indicate the direction of monetary policy. The Fed would also increase reserve requirements to help

Group A 4 ensure the stability of certain financial institutions, boosting public confidence in the financial systems ability to recover. The credit crisis beginning in 2008 was significantly different than previous crises, and the risk had been building for decades. Three recent mishaps by the Fed led to or at least helped incite the crisis. First, the Fed was far too willing to support the economy for far too long after the 2001 recession. From 2002 to 2003, the Fed reduced the federal funds rate to 1 percent and held it there for a prolonged period. This made money cheap to borrow and helped fuel the housing bubble. The second mistake took place between 2004 and 2006. During this time the Fed should have been aggressively trying to tighten the credit market instead of making slow and subtle changes. Finally, in early 2008 the Fed dropped the federal funds rate back down to 2 percent. This was done to minimize financial stress and spur economic growth but resulted in a commodity price spike (A Monetary Malaise par. 7). Spurring the crisis, a housing market collapse threatened a global network of financial institutions. 1 Lending institutions securitized, or packaged, mortgages to raise funds for other types of loans. Through special purpose vehicles, mortgage-backed securities (MBS) removed risky assets from banks balance sheets and brought banks additional funds through the sale of pooled mortgages. By 2007, MBSs accounted for $7.27 trillion in assets of commercial banks, out of $9.2 trillion in total assets. Freddie Mac, Fannie Mae, and Ginnie Mae issued most of these MBSs (Rose and Marquis, Great Credit Crisis 10-11). More complicated variants of the MBSs, such as collateralized mortgage obligations (CMO) led to derivatives such as collateralized debt obligations (CDO) and risk-spreading credit default swaps (CDS). Most of these derivatives were loosely regulated, if bounded by regulation at all (Rose and Marquis, Great Credit Crisis 13-17). The result was a financial system intertwined with derivatives for which there was no quantifiable real value or level of systemic risk. When housing prices fell, the value of these assets also fell, seriously jeopardizing the health of many global financial institutions. The
1

The housing market bubble began in the 1950s when the U.S. Congress laid the groundwork for a nationwide market for home mortgages. Government-sponsored entities (GSE) known as Freddie Mac, Fannie Mae, and Ginnie Mae were created to help make home ownership more affordable for more people, resulting in plentiful mortgages, many of them subprime (Rose and Marquis, Great Credit Crisis 10).

Group A 5 subprime mortgage market began to collapse in 2006, and the following year brought worsening funding challenges to major U.S. financial institutions. The Feds first response to the financial crisis was to ease terms of primary credit. In August 2007, the Fed reduced the spread of the primary credit rate over the FOMCs target for federal funds from 1 percentage point to percentage point. The Fed also lengthened the maximum maturity from overnight to 30 days. In December, the Fed created the Term Auction Facility, a new policy tool, to further improve access to term funding for depository institutions (WSJ Blog, Federal Reserve Statement par. 5). However, these actions would not be enough to prevent the crisis from worsening. In March 2008, Bear Stearns became the first major financial institution to begin failing. The firms stock price plummeted, and it was clear the fall of Bear Stearns (Bear) could threaten the global financial system. Trying to prevent a bank run on Bear, the Fed activated a provision not seen since the Great Depression, setting up a federal loan to Bear through JP Morgan Chase. However, the Feds attempt only delayed the fall of Bear. Soon, Lehman Brothers found itself in the same position as Bear, and the Fed was unable to find an intermediary to extend a loan. The systemic risk that had been introduced with complex derivatives of MBSs soon threatened all major U.S. financial institutions, including Freddie Mac and Fannie Mae (Rose and Marquis, Great Credit Crisis 23-25). Investment banks couldnt obtain enough critical short-term funding. On March 11, the Fed announced establishment of the Term Securities Lending Facility (TSLF), a weekly loan facility that promoted liquidity in Treasury and other collateral markets, generally fostering the functioning of financial markets. The TSLF offered Treasury securities held by the System Open Market Account (SOMA) for a one-month term against other eligible general types of collateral; loans were awarded to primary dealers based on a competitive single-price auction (Federal Reserve, TSLF). In May 2008, the Fed again lowered the spread of primary credit over the target federal funds rate, to percentage point, and the maximum maturity of primary credit was extended to 90 days (WSJ Blog, Federal Reserve Statement par. 5). Despite the Feds efforts, many banks failed (Rose and Marquis, Great Credit Crisis 26).2
2

Three banks failed in 2007, and 26 failed in 2008 (Rose and Marquis, Great Credit Crisis 26).

Group A 6 The summer of 2008 was nothing short of remarkable compared to what was experienced a few months prior with the forced sale of Bear Stearns to JP Morgan Chase. Confidence was coming back into the market. After the Dow Jones Industrial average broke 11,000 in July 2008, the market appeared to have bottomed out. The bond insurers MBIA and Ambac were up well over 400 percent from their May lows. Bernanke and Paulson were both cited as having expressed relief that the forced takeover of Bear Stearns was having the desired effect of restoring confidence to a still much shaken market (Cassidy). Now that regulatory agencies such as the Fed were clearly charged with rescuing the financial system, many regulatory concerns needed to be worked out. One of the most pressing was that the Primary Dealer Credit Facility (PDCF) allowed the Federal Reserve to conduct on-site examinations of institutions that are regulated by the SEC (Paulson, p. 135). Thankfully, Fed Chairman Ben Bernanke and Chairman of the Securities and Exchange Commission (SEC) Christopher Cox were uninterested in turf wars and understood the importance of protecting and maintaining economic and financial stability. They reached agreement on July 7, 2008. The initial recovery, however, was very superficial. Fannie Mae and Freddie Mac were starting to show strain. Treasury Secretary Henry Paulson and Bernanke convinced Congress to allow them to raise the credit lines for Freddie Mac and Fannie Mae. Losses were mounting, but the extent to which these institutions were hemorrhaging cash was severely underestimated. On July 30, 2008, the Fed established the TSLF Options Program, under which options to draw shorter-term TSLF loans at future dates are auctioned to primary dealers. All of these loans are collateralized by eligible collateral, including investment-grade corporate, municipal, mortgage backed and asset-backed securities (Polk 30). This essentially allowed qualified institutions to use various forms of illiquid securities to obtain Treasury securities which could be used as collateral in other transactions and would hopefully restore liquidity to the marketplace. Unfortunately, the TSLF was designed for the short term, and most of the counterparties were uninterested in having collateral provided by Treasury securities. Therefore, the potential benefit was significantly diminished. Talk on the street was focused on September 2008 when Lehman, Morgan Stanley and most of Wall Street would be releasing earnings. Speculation was rampant about Fannie Mae and Freddie Mac,

Group A 7 who had received access to the extra funds at the end of July. The Fed analyzed the potential impact of the negative earnings that were sure to come from Lehman, AIG, Fannie and Freddie. The route for Fannie and Freddie was a little more certain given that that they were GSEs and could be placed into conservatorship under certain circumstances. Lehman and AIG were more complicated. The Fed has the power under section 13(3) of its charter to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, that before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. (Federal Reserve) This action had already been taken with JP Morgan Chases purchase of Bear Stearns by providing a guarantee on certain assets. However, Lehman and AIG would require actual cash infusions which would be a hard sell to the American public. As a sign that Wall Street was preparing for the worst (a possible bankruptcy filing by Lehman Brothers after Barclays PLC walked away from a deal to purchase the troubled Wall Street investment bank )brokers on Sunday afternoon (September, 14 2008) were streaming into their offices and a special trading session for credit default swaps was called (Gasparino http://www.cnbc.com/id/26704405). That Sunday Timothy Geithner said that the Fed was not prepared to lend AIG the $50 billion to make up the shortfall and that it should instead pursue private funding (Paulson 218). He rescinded this statement two days later. The next day, Monday, Lehman Brothers filed for chapter 11 bankruptcy protection. Based on the amount of assets on Lehmans balance sheet, this bankruptcy was the largest ever in U.S history. The chapter 11 did not include its broker-dealer operations and other units, such as asset management firm Neuberger Berman which were liquidated to other investment firms (CNBC.com http://www.cnbc.com/ id/26708143). By Tuesday, September 16, AIGs shortfall had increased to $85 billion because its credit ratings had been slashed on Monday. The $85 billion needed to be committed by the end of the day. By

Group A 8 late morning it became apparent that AIG would be bankrupt if it didnt receive a $14 billion infusion by the days end (Paulson 228-229). The Fed felt that this loan was different than Lehman because this was a liquidity concern and not a capital concern. The idea was to extend the loan to AIG and sell its insurance subsidiaries when the market improved (Reuters; Walsh).3 Later that day, the deal was announced that AIG would receive an $85 billion loan from the federal government in exchange for a 79.9 percent stake in itself. The deal called for the Fed to lend up to $85 billion to AIG for two years in exchange for that 79.9 percent equity stake. AIG would pay interest at a steep 8.5 percentage points above the three-month London Interbank Offered Rate, making the current rate equal to about 11.4 percent at the time of issuance (CNBC.com http://www.cnbc.com/id/ 26747020) Much of this debt was later restructured in November 2008, when the Fed authorized the Federal Reserve Bank of New York, pursuant to its Section 13(3) authority, to restructure the revolving credit facility and to extend loans to two new special purpose vehiclesMaiden Lane II and Maiden Lane III (Polk 38). Complicating the matter, the Reserve Primary Fund, a $64 billion money market fund, and two smaller, related funds, revealed that they had broken the buck and would pay investors no more than 97 cents on the dollar. Breaking the buck was the Rubicon, said a federal official. This was the first time in the crisis that you could see stories talking about how it was affecting real people. One reason given by the Reserve Primary Fund for breaking the buck was that it had bought Lehman commercial paper with a face value of $785 million that was now worth little because of its bankruptcy. Hearing that Mr. Bernanke and Mr. Paulson wanted legislation passed in a matter of days, the Senate majority leader, Harry Reid, expressed astonishment. This is the United States Senate, he said. We cant do it in that time frame. His Republican counterpart, Senator Mitch McConnell, replied, This time we can. (Nocera) Later on Tuesday, September 16, there was a classic flight to quality as there was over $100 billion in orders for $31 of four week bills. The rate on the bills dropped 1.15 percentage points from the previous week to .10 percent (Paulson 232). By Wednesday, September 17, the demand for treasuries was so great that the yield turned negative; investors were paying for the safety of treasuries. Money market

In March 2010, two of these subsidiaries- AIA and Alico were sold for a combined $51 billion to repay the Fed sponsored bailout (Reuters; Walsh).

Group A 9 funds everywhere were breaking the buck or coming very close. Bank of New York, BlackRock and Northern Trust among others were reporting request for billions of dollars from their money market funds. To a certain extent there was the inherent risk of insolvency and it became worthwhile for investors to pay to have this risk removed. On Thursday Bernanke, Geithner and Paulson met with select members of Congress and the Senate including Barney Frank, Chris Dodd, Nancy Pelosi, John Boehner and Spencer Baucus among others to discuss what would eventually be called TARP. The meeting went as well as could be expected Paulson recounts. The primary purpose of the meeting had been to get reassurance that there was bipartisan support for not just a capital infusion into the markets but an entity that would be capable of taking these toxic assets off of the banks balance sheets. However, at this point toxic assets had little to do with the crisis. There was absolute hysteria in the market place. The market rallied 600 points to close up nearly four percent on the day on news of a possible bailout. On Friday, the SEC banned short selling 799 financial stocks for 10 days (with the option to extend). At 8:30 am the Fed unveiled AMLF which allowed the Fed to extend non-recourse loans to U.S depository institutions and bank holding companies to finance purchases of high quality commercial paper from money market funds. The Fed also said that it would purchase short term debt from Fannie Mae and Freddie Mac. On September 21, 2008, The Federal Reserve announced that it has granted a request by the country's surviving major investment banks Goldman Sachs and Morgan Stanley to change their status to bank holding companies. (CNBC.com http://www.cnbc.com/id/32862736) By September 26, Washington Mutual was forced to sell out by the FDIC and Wachovia was also looking for a suitor which it ultimately found in Wells Fargo & Co. Three days later, the Senate failed to pass the TARP bill and the market went in a freefall with the Dow ending the day down 777 points its largest ever. The bill was promptly passed on October 1 and was signed by the president on October 3. On October 6, the Fed announced that it would make $900 billion in short term cash loans available to banks (AP). The next day the Fed announced that it would make $1.3 trillion available to firms outside the financial sector through the purchase of commercial paper (Aversa); this facility was

Group A 10 called the Commercial Paper Funding Facility (CPFF) (Federal Reserve http://www.federalreserve.gov/ newsevents/press/monetary/20081007c.htm). It is interesting to note that this funding was made available under section 13(3) (New York Fed, 2008) which allows funding to any individual, partnership, or corporation. Section 13(3) was employed because the commercial paper had in essence totally dried up. When a company files for chapter 11 all its assets are frozen and as such holders of commercial paper have no way of getting back their original investment. This is why investors like Chanos and Angelo pulled their hedge fund money out of their prime brokerage accounts at Bear several days before its demise (Gasparino, The Sellout 368). The liquidity situation was so bad that the IRS relaxed rules on US corporations repatriating money held oversees in an attempt to inject liquidity into the US financial market (Glapa; Drucker). On October 8, the federal funds rate was dropped by half a percent and on October 14, $250 billion of the TARP was distributed to nine of the nations largest banks. At this point the banks were forced to take the money. Its also interesting to note that from the beginning, TARP never purchased any assets like it was intended to do. At most the debt that it issued may have been secured by some assets. On November 12, it was formally announced that TARP would not purchase assets but would be used to inject liquidity into the system. On October 21, the Fed said it would spend $540 billion to purchase short-term debt from money market mutual funds in the hopes of stirring the commercial paper market. Since the Primary Reserve broke the buck on September 16, investors had been liquidating their accounts and as such these funds which would purchase commercial paper ceased to function (Federal Reserve http:// www.federalreserve.gov/newsevents/press/monetary/20081021a.htm). In late November, the Fed pledged another $800 billion to help revive the financial system $600 billion of which was designated to buy mortgage bonds issued or guaranteed by the GSEs Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (Glapa). The other $200 billion was designated for the TALF (term asset-backed securities loan facility) which would buy student loans, small business loans, auto loans, etc. (Federal Reserve http://www.federalreserve.gov/monetarypolicy/20081125a.htm)

Group A 11 On December 16 the Fed lowered its benchmark interest rate virtually to zero; the federal funds target between 0 and .25% (Andrews). Essentially the only weapon that the Fed had left in its arsenal was to pump more liquidity into the market. This was a historic move for several reasons. One was that money would be lent out for free. Another is that the Fed demonstrated that it would stop at nothing to revive the frozen credit markets. In essence the Fed was doing its primary duty; it was the lender of last resort. In the spring of 2009, the financial markets slowly began to recover. Risk spread on corporate bonds narrowed, and liquidity and pricing in bank funding markets continued to normalize (Board of Governors, Monetary Policy Report 24). In testimony to Congress on July 21, 2009, Bernanke stated, Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system. Although credit conditions remained stressed, the Fed contributed to improvements in financial conditions through its policy actions encouraging the flow of credit, such as the temporary liquidity facilities. TALF had restarted the securitization of consumer and small business credit. The Supervisory Capital Assessment (SCAP) provided a stress test of the 19 largest financial institutions, and the results had boosted public confidence in these firms. Most issued equity, and all but one firm fully repaid Treasury funds (Board of Governors, Monetary Policy Report 1). Responding to improving conditions in the wholesale funding markets, on June 25, the Fed initiated a gradual reduction in the size of TAF auctions (WSJ Blog, Federal Reserve Statement par. 6). Looking ahead, Bernanke assured Congress that the Fed would be poised to help markets return to normalcy when appropriate, with such tools as increasing interest rates on reserve balances and conducting reverse repurchase agreements to drain liquidity from the banking system (Testimony, July 21, 2009). As the U.S. economy continued to contract in early 2009, coupled with growing unemployment, the Fed maintained the target federal funds rate at 0 to percent in order to promote economic recovery and price stability. In the second half of 2009, economic activity turned up, supported by continued improvements in financial conditions and stimulus from monetary (and fiscal) policies. GDP and consumer spending increased, business sector investment gained, and firms reduced their earlier pace of inventory liquidation (Board of Governors, Monetary Policy Report 1).

Group A 12 However, credit markets experienced continued stress throughout 2009. Delinquency and charge off rates at commercial banks increased, loan losses remained high, and small businesses experienced severely restricted access to credit. Along with restricted access, demand for business loans weakened. The same was true for households, even with declining interest rates for mortgages and consumer loans. This credit crunch was partly because of banks concerns with the ability to repay amid high unemployment and a still troubled housing market. In the final three months of 2009, banks tightened terms on credit card loans, reducing limits and raising interest rates. Asset backed securities backed by private student loans remained almost entirely supported by the TALF. Delinquency rates on commercial real estate (CRE) loans increased sharply in the second half of 2009. In response, the Fed joined other banking regulators4 to promote supervisory consistency, enhance the transparency of CRE renewal and restructuring, and ensure policies and actions did not inadvertently curtail availability of credit. In November, commercial mortgage backed securities (CMBS) new issuances resumed5, reestablishing an important source of financing for many lenders (Board of Governors, Monetary Policy Report 1-14). The Fed had designed TALF interest rates to become unattractive when market conditions improved. Strengthened issuance and declining yields on ABS issuance without TALF support increased by years end6, supporting consumer credit such as auto financing, with lower-trending interest rates. The year ended with improved functioning in short-term credit markets and declining usage of the Feds special liquidity facilities (Board of Governors, Monetary Policy Report 10). However, commercial paper issuances declined in late 2009, with $1.1 trillion outstanding, down from $1.3 trillion in September (WSJ Blog, Money has Tightened par. 2). The continued shift toward long-term debt resulted in strong net
4

Regulatory agencies joining the Fed in this effort included the Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency, Office of Thrift Supervision, and Federal Financial Institutions Examination Council State Liaison Committee (Monetary Policy Report, 12).
5

New issuances in the CMBS market had ceased in the third quarter of 2008 (Monetary Policy Report, 14).
6

In 2007, non-TALF consumer ABS peaked around $30 billion. From 2008-2009, most ABS were TALF consumer ABS, or ABS supported by TALF, and never exceeded $20 billion. In January 2010, all ABS were TALF supported, totaling under $5 billion.

Group A 13 issuance of corporate bonds as business took advantage of favorable market conditions (Board of Governors, Monetary Policy Report 12). In 2009, the Fed had pushed short-term rates to near 0 percent, flooded the financial system with loans, and committed to purchase more than $1.7 trillion of mortgage and Treasury securities. All of these actions were intended to restart a financial system devastated by debt crisis, and the Fed had reasonably succeeded, although deleveraging still continued (WSJ Blog, Money has Tightened par. 1). The Fed has provided highly accommodative monetary policy since the beginning of the financial crisis for the past two and half years. The Feds actions ultimately reduced the federal funds rate near zero and expanded the size of the Feds balance sheet (purchases of long-term securities and targeted lending programs). These rescue actions have been highly effective in improving the functioning of credit markets, specifically for interbank lending, commercial paper, consumer and small business borrowing and residential mortgages (Bernanke, The Feds Exit Strategy). While these accommodative polices are warranted for an extended period of time, they will cause inflationary problems when the economy takes hold. Thus, the Fed has developed an exit strategy for this eventuality. The exit strategy was developed by the FOMC and was presented before the Committee on Financial Services of the U.S. House of Representatives on February 10, 2010. The general concept of the exit strategy is tied to the management of the Feds balance sheet. For example, if the economy recovers, banks tend to lend out more of their reserves held at the Fed. This will increase M1 and M2 growth rate and increase inflationary pressures. In order to prevent this situation, the Fed must adopt counterbalancing measures to tighten money and credit growth. The two primary tools that will be used are the interest rate the Fed pays banks on reserve balances and significant draining of the Feds operations (selling of assets on the balance sheet). A portion of the exit strategy on accommodative monetary policy has already commenced. This does not include the tools that will be used for future monetary policy tightening, but include discontinued operations of liquidity programs that were created during the crisis. At the start of the crisis, private sources of liquidity started to dry up. In order to continue the flow of credit, the Fed made lending from the discount window attractive. However, banks didnt want to look financially weak by utilizing the

Group A 14 discount window for borrowed funds and incur further financial pressure. In order to address this stigma problem, the Fed created the Term Auction Facility (TAF), an alternative discount window program (Board of Governors, Federal Reserves Exit Strategy par. 5). TAF was discontinued on March 8, 2010, as was the TALF on March 30, 2010, ending this avenue of support for markets that utilize asset-backed securities such as those backed by auto, student, credit card and small business loans. As an element of the exit strategy is to reduce the quantity of its special liquidity programs; these temporary lending facilities have been effectively closed, and the Fed has incurred no losses exiting these programs (Bernanke testimony). The remaining portion of the exit strategy is the utilization of the two primary tools to tighten monetary policy, dependent upon future economic and financial developments. In fall of 2008, Congress authorized the Fed to pay interest on reserve balances (Board of Governors, Federal Reserves Exit Strategy par. 14). This tool may be used to tighten monetary policy by increasing the rate paid to banks on their reserve balances as the fed funds rate is increased. The banks response under normal conditions will be to engage in arbitrage to limit the spread between the fed funds rate and the rate the Fed pays on reserves. This will cause banks to not lend funds in the money market at rates lower than the risk-free rate earned at the reserve balances. The overall effect will increase short-term interest rates. This policy has shown to be effective in international markets. The European Central Bank, Bank of Japan, and Bank of Canada have used this tool in the past (Bernanke, Feds Exit Strategy par. 11). However, in the fall of 2008 the fed funds rate dipped below the rate paid by the Fed. This unusual circumstance was due to the massive lending Freddie Mac and Fannie Mae did with rates under what the Fed pays, since they do not hold reserve balances with the Fed. The second tool available to the Fed to tighten monetary policy is the options available to reduce reserves, thus decrease the money supply to the money markets. This tool will be utilized if the first tool is ineffective in reducing and draining excess liquidity from the market. The four options the Fed have available are arrangement of reverse repurchase agreements, selling of treasury securities by the Treasury Department with payments directed to the Fed, offer banks term deposits on their reserve balances, and sell a portion of the Feds long-term securities positions (Board of Governors, Federal Reserves Exit

Group A 15 Strategy par. 16-18). All these options will help increase short-term interest rates and limit the growth of the money and credit supply. The first option is to arrange huge reverse repurchase agreements with market participants. This process involves the sale of Fed held securities with an agreement to buy them back at a higher price at a later date. This option has been used historically when tightening monetary policy (Board of Governors, Federal Reserves Exit Strategy par. 16). The second option would have the Treasury Department sell Treasury Bills with proceeds deposited with the Fed. The Primary Dealers will reduce their reserve balances to purchase these securities, thus will lead to a decrease in M2 money supply. The Fed would try not to use this option, because they would not want to rely on the Treasury Department to achieve the Feds policy objectives. The third option would be to offer term deposits to banks (similar to negotiable CDs). The funds in the term deposits would not be available for use in the federal funds market. Currently, tests are being made of the effectiveness of this option (Board of Governors, Federal Reserves Exit Strategy par. 17). The fourth option would require the Fed to sell their long-term securities held in their balance sheet. These securities would include the $175 billion of agency debt and $1.25 trillion of mortgaged-backed securities both purchased from the market during the crisis. In addition, the balance sheet includes the $300 billion purchase of long-term treasury securities purchased in 2009. By selling these long-term securities into the open market the Fed will be able to reduce the banks reserves held at the Fed and reduce the Feds balance sheet simultaneously. Currently the Feds balance sheet is gradually reducing in size. The Fed is letting assets of agency debt and mortgaged-backed securities mature. The fourth option will be used in a time when economic recovery is sufficiently advanced and when the FOMC warrants financial tightening. Since the fourth option impacts the economy significantly, the Fed advised that all sales will be gradual and clearly communicated with market participants (Board of Governors, Federal Reserves Exit Strategy par. 20). As of February 20, 2010, the Fed no longer anticipates selling any long-term securities until after monetary policy tightening has started (Board of Governors, Federal Reserves Exit Strategy par. 21). Currently, the Fed intends to normalize the regular discount window loans. In 2010, they reduced the 90 day maximum maturity to pre-crisis levels and have increased the spread between the discount rate

Group A 16 and the upper limit of the Feds target for the fed funds rate from 25 basis points to 50 basis points (Board of Governors, Federal Reserves Exit Strategy par. 4), indicating an improving financial market. To ensure preparedness and give market participants familiarity with its actions, the Fed is currently testing their monetary tightening tools. When the time arrives when they need to implement their final portion of their exit strategy from the accommodative policies, the Fed should increase interest rates paid on reserves and commence significant draining operations. The credit crisis that began in 2008 was unlike any the Federal Reserve had faced before. History had taught the Fed some lessons to apply in its challenge to get and keep credit flowing, but traditional monetary policy tools had to be supplemented by policies and facilities uniquely suited to the complexities of the crisis. With improving but still fragile economic conditions, the Fed faces the formidable challenge of helping markets return to normalcy.

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