US Feds Response to the 2008 Financial Crisis and subsequent economic effects

Written by: Bilesh Ladva and ECO301 classmates. Presented by Bilesh Ladva 11 and Alice Su 13, Princeton University, USA, undergraduates

Structure of Presentation:
Background- Causes etc. Overview of programs used to combat recession Success of programs Reversing the programs Questions and discussion ( the most important part!)

US Financial Crisis- what do you think?

What caused it? How did it affect the US? How did it affect the world?

What caused the recession?

In one sentence:
An unduly complex financial system, with too much leverage, too little regulation, and too little regard for risk blew up, causing vast collateral damage.

By Alan Blinder, leading Macroeconomist, former Vice Chairman of the Fed and Princeton Professor! Quote from my first Macro course at Princeton

A Rude awakening: September 15-16, 2008

Lehman Brothers files for Ch 11 Bankruptcy
Largest in US history

Bank of America purchases Merrill Lynch

ML pressured into $50B deal after Lehman fall

AIG debt downgraded by all three major rating agencies Federal Reserve loans $85B
Caught off guard Deemed too interconnected, too huge, too global >$1 trillion

TARP
Troubled Asset Relief Program or Mortgage Bailout Bill Presented by Secretary of the Treasury Henry Paulson on 9/19/08 and passed on 10/3/08 Gave the US Treasury $700B in purchasing power

What was the purpose of TARP?

TARP takes illiquid mortgage assets out of the financial system. These toxic mortgage assets were blocking the system and preventing the credit needed to fuel the economy from being issued. TARP is a fiscal policy due to direct government involvement. Many experts believe that what we need afterwards is monetary policy.

The Fed Funds Rate-( Interbank Rate)

Ben Bernanke
BA Harvard University 1975, PhD MIT 1979. Chair of Princeton University Economics Department 1996-20 02 Chairman on Board of Governors of Federal Reserve System 2002-2005 Chair of Federal Reserve System- 2006-present Interested in Economic and political causes of the great depression

Fed Funds Rate - Timeline

Fed Funds Rate Timeline (2)

How do the Feds monetary policies work?

Feds Targets
Relieve the disruptions in credit markets Restore the flow of credit to households and businesses Restore overall economic growth Foster maximum sustainable employment and stable prices Effectively address the potential failure of systematically critical non-bank financial institutions

Response to Fed Funds Rate

Fed started to decrease short-term interest rates aggressively, from over 5% beginning in Sept 2007 At the height of the financial crisis, FOMC reduced Fed Funds Rate to unprecedented levels between 0 and per cent!

Federal Funds Rate Trend ( until early 2010)

Source- US federal reserve website

How does a lower Fed Funds Rate help the economy?

IS-LM relation ( LM SR shift outward, lowering interest rates and increasing Y) Central bank increase nominal money, M through O-M-O Change in M does not shift the IS curve Money however enters the LM relation

How does lower Fed Funds Rate help the economy? (cont.)
M/P = Y* L(i) LM Equation Increase in money lower interest rate increase in investment increase in demand and output Private consumption, C unambiguously increases Overall, monetary policy increases output and decreases interest rate

IS-LM Graph
IS LM Analysis of Feds Monetary Policy
Interest rate, i LM (for M/P) i* LM shifts down LM (for M/P > M/P) i decreases Y increases

IS Y* Y Output, Y

Fed Funds Rate

Fed maintained the same rate throughout 2009 and early 2010 Conventional monetary policy reaches limits Problem of liquidity trap exists since interest rates approach levels near zero. Liquidity trap: increase in money supply has little effect on the interest rate

Fed Funds Rate (cont.)

Investment unaffected Conventional monetary policy no longer affects output anymore Requires different set of tools unconventional methods

Liquidity Programs for Financial Firms

Established and expanded a number of liquidity programs Provide short-term liquidity to financial institutions Total almost $860 billion, represents nearly 45% of assets on balance sheet Loans are short term(<90 days) and made to reliable institutions

Liquidity Programs for Financial Firms (cont.)

Considered very safe Bank funding needs intensified sharply Fed, provides credit to meet liquidity needs, usually in the form of overnight loans, repaid at the start of each business day.

Liquidity Programs for Financial Firms (cont.)

Made it easier to borrow in short-term Short-term liquidity available Banks problem: hesitant to borrow money- sign of weakness Result: prevented Fed from getting much-needed liquidity into the system

Establishment of TAF
Term Auction Facility (TAF)
Provides fixed quantities of term credit to depository institutions through an auction mechanism

Borrowers provide anonymity Seems largely to have solved banks hesitant problem

Direct Lending to Borrowers and Investors

2nd set of assets in Feds balance sheet that increased over the crisis Lending directly to market participants
$255 billion 1/8th of assets on Feds balance sheet

Very unconventional for a central bank

Direct Lending to Borrowers and Investors (cont)

Direct Lending to Borrowers and Investors (cont)

2 types of methods
Commercial Paper Funding Facility (CPFF)
Lending directly to ultimate borrowers

Term Asset-Backed Securities Loan Facilities (TALF)

Lending directly to major investors

Direct Lending to Borrowers and Investors (cont)

Commercial Paper Funding Facility (CPFF)
How was CPFF intended to work?
Serve as a backstop for commercial paper issuers enhance the liquidity of the commercial paper providing greater assurance to both issuers and investors that firms will be able to roll over their maturing commercial paper Overall improvement of conditions in credit market

Direct Lending to Borrowers and Investors (cont)

Term Asset-Backed Securities Loan Facilities (TALF)
The Fed allowed the investors to borrow money by allowing them to have their securities as collateral.

How was TALF intended to work?

increase credit availability support economic activity helping the issuance of consumer and business ABS at more normal interest rate spreads.

Purchase of High Quality Assets

3rd major category of assets on the Fed's balance sheet
Treasury securities (Treasury bills, Treasury bonds, etc.) Agency debt (bonds issued by a US governmentsponsored agency, eg. Sallie Mae) Agency-backed MBS (from Fannie Mae, Freddie Mac, Ginnie Mae)

Purchase of High Quality Assets (cont)

Federal Open Market Committee (FOMC) purchases these securities How was it intended to work?
Lowering the cost of credit for households and businesses Improve the availability of credit for households and businesses

Purchase of High Quality Assets (cont)

What good does it do?
Lower mortgage rates helps improve conditions in the housing market, which helps economic and financial conditions in a broad sense Helps households refinance Open market purchases add liquidity to the system

Has monetary policy worked as intended?

Lowering the Federal Funds Rate: Did it work as intended?

Lowering FFR helped decrease some of the effects of financial crisis on credit conditions for US households and businesses. Although these lower interest rates did not prevent a recession, they certainly allowed for a mitigation of the depth of the economic downturn. Worries of Inflation: Inflation reached high levels in early 2008.While some attribute this increase in inflation to the lowering of the Federal Funds rate, most believe it was simply a result of an increase in the price of oil as well as other commodities.

Federal Funds Effective Rate

Term Auction Facility Program (TAF): Did it work as intended?

TAF has proved effective for injecting liquidity into the financial system during this economic crisis. As of September 2009, the Federal Reserve decided to reduce the offered amounts. This is a result of the conditions of short-term funding markets continuing to improve. TAF lending was expected to fall as the financial conditions became more normalized, therefore it is a positive sign that the auction amounts have decreased over time.

Term Auction Facility Program

Has CPFF worked intended?

When the credit markets froze and lending stopped, suddenly, commercial paper was scarce, because lenders were afraid to lend to companies that might suddenly go under. Once the commercial paper stopped flowing , it caused major problems and a cash-flow problem for corporate America.

The Fed stepped in bought $10 billion of commercial paper/week, which increased investor confidence and helped to keep the gears of credit moving. Corporate loans and various insurance products that back commercial debt are now more affordable and accessible. They are letting business continue to function and keep the U.S. economy on track.

How has TALF worked as intended?

This program has done what it was intended to: increase demand and get credit flowing again. It achieved its goals of restarting the market, bringing greater deals in the market Since it was introduced, it has facilitated the sale of more than $100 billion in bonds backed by auto, student and equipment loans and credit-card debt. Also, risk premiumsa measure of the cost of credit have tightened by more than a full percentage point in several sectors The program is likely to make a profit.

Has the purchasing of high quality worked as intended?

assets

The purchases helped drive up the value of these securities and thus drove down mortgage interest rates and helped financial markets. Program hasnt been a complete success because while it reduced the cost of mortgages, credit conditions remained tight and as a result the full affects of the program were not felt. The purchase of high quality assets created greater liquidity, as intended. The purchase of these high quality assets did improve the availability of credit available to homes and business, but the affect was not as large as the Fed had hoped- as credit conditions still remain relatively tight.

How should Central Bank reverse these measures?

Wizard of Oz- Three clicks of those shoes and Dorothy went back to normality

Why reverse?
Risk associated with QE (Quantitative Easing)- could trigger higher inflation. Feds balance sheet expanded from from 6% of US GDP in September 2008 to 15% in March 2009. Uncontrolled expansion of money supply and inflation

Why reverse?
Risk associated with OMO Low interest-rate encourages risk-taking, drives up asset prices and risks double-dip recession.

Potential Reverse Policies

Decrease money supply through reverse repo ( repurchase agreement) Increase banks reserve ratio. M=H(c+1)/(c+b+e) Money Base H=C+R Money Supply M=C+D b: reserve ratio c: cash to deposit ratio e: excess reserve to deposit ratio

Potential Hazards- Japan

Japan has had much experience with quantitative easing since March 2001. Figure 1 illustrates that the quantitative easing strategy that the BOJ ( Bank of Japan) began in March has succeeded in reversing the decline in growth of M1, a narrow money aggregate. However, broader monetary aggregates, such as the M2+CDs aggregate that the BOJ follows more closely, have responded quite modestly.

Monetary Growth effects of quantitative easing- Japan

TALF
High Risk premiums and a decrease in the funding from Asset Back Securities for consumer credit. TALF designed to increase credit availability and economic activity by issuing to consumers ABS at levels prior to the recession. After the recession, it is hoped that the ~$1 trillion currently available as lending will be gradually decreased when ABS interest rate spreads can cope at a normal rate by themselves.

TAF (Term Auction Facility)

A temporary program managed by the Fed designed to "address elevated pressures in short-term funding markets"
Allow depository institutions outside Feds usual jurisdiction to borrow at a rate substantially below the discount rate. These are short term lending loans, designed to inject money to depository institutions for short periods of time (28-day and 35-day loans). While this policy was instituted only in 2007, data is still being gathered to asses whether or not it is feasible after the recession. This can be likened to OMOs for small businesses, possible use after recession.

Review
Many Experts believed Monetary Policy was the best way to combat the financial crisis Several Programs were used the help the economy recover Some were effective, others were less effective Caution must be taken during the recoveryunderlying factors may be important

Questions?

Discussion questions:
Thoughts on Monetary Policy measures: Good/Bad, would you have done differently? Too Soon? How can Fed combat double dip recession? Would same measures work? What are your experiences of the recession? How has it affected your community?

Thanks to:
VEPR and Mr. Thanh Princeton University Classmates of ECO301, Spring 2010, Princeton Alice Su