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Understanding the Response of the Federal Reserve to the Recent Financial Crisis Sandy Krieger April 14, 2010 This presentation presents preliminary findings.

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Presentation on theme: "Understanding the Response of the Federal Reserve to the Recent Financial Crisis Sandy Krieger April 14, 2010 This presentation presents preliminary findings."— Presentation transcript:

1 Understanding the Response of the Federal Reserve to the Recent Financial Crisis Sandy Krieger April 14, 2010 This presentation presents preliminary findings and is being distributed to stimulate discussion and elicit comments. The views expressed in the presentation are those of the author and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.

2 2 Motivation All of Feds actions were directed at protecting the American people from a more severe downturn. Feds goal was to foster access to credit by businesses and individuals to met critical needs and keep the economy moving during a very critical period.

3 3 Federal Reserves Responsibilities Conduct the nations monetary policy Influence monetary and credit conditions in the economy in pursuit of maximum employment, stable prices and moderate long-term interest rates Supervise and regulate banking institutions Ensure safety and soundness of the nations banking and financial system Protect the credit rights of consumers Maintain the stability of the financial system and contain systemic risk that may arise in financial markets Provide financial services to depository institutions, the US governments and foreign official institutions, including playing a role in operating the nations payment system

4 4 Federal Reserve Governance The Feds authority and structure is defined by Congress (Federal Reserve Act) Fed structure Board of Governors in Washington, DC 7 Governors, appointed by Congress -Responsible for bank supervisory and payment system risk policies, approving discount rate change requests 12 Regional Reserve Banks Independent corporations Responsible for the loans to Dis in their districts -Secured to their satisfaction Monetary Policy: FOMC The Governors Reserve Bank presidents 5 voting members; 4 on a rotational basis

5 5 Basic ABCP Conduit Structure Seller Credit Enhancement Provider Liquidity Provider ABCP Conduit AdministratorOwner Issuing Payment Agent Investor Maturity PaymentsPrice of ABCP Maturity PaymentsPrice of ABCP FeesDividends FeesCredit SupportLiquidity Support Fees Cash CollectionsCash Advances Source: Moodys Placement Agent Collateral Agent Hedging Agent Cost of Hedge Hedge Secured Assets and Fees

6 6 Institutional Composition of Each Sector Source: Federal Reserve Flow of Funds (trillions of dollars)

7 7 Funding Sources by Sector Type Inside institutions benefit from explicit guarantees and have access to official sources of liquidity Shadow institutions do not benefit from explicit guarantees and do not have access to official sources of liquidity

8 8 Credit Market Debt Holdings by Institution Type Source: Federal Reserve Flow of Funds, Table L1 (trillions of dollars) (credit market debt is defined as loans and fixed-income securities)

9 9 Evolution of the balance sheet through the crisis

10 10 Problems addressed by new lending facilities (preview) Term Auction Facility : illiquid term markets and the stigma that accompanies discount window borrowing Swap lines: illiquid money markets that became segmented across countries and time zones Primary Dealer Credit Facility: the lack of market-based back-stop credit in repo markets Term Securities Lending Facility : illiquid functioning in repo funding markets illustrated by abnormal rates and high haircuts ABCP Money Market Liquidity Facility: illiquidity in money markets (including the ABCP) that prevented money funds from meeting demands for redemption Commercial Paper Funding Facility: illiquid functioning in short-term commercial paper funding markets Money Market Investor Funding Facility: lack of confidence that money market investors cannot extend terms of investments beyond overnight and remain adequately liquid Term Asset-Backed Securities Loan Facility: lack of available credit due to frozen ABS market

11 11 The first phase of the financial crisis (August 2007 through February 2008)

12 12 What happened in August 2007? Severe pressure on ABCP and term dollar LIBOR markets Some ABCP issuers had subprime exposure Investors ran on the entire sector Sponsoring banks provided explicit and implicit support Need to bring assets on balance sheet pressured term dollar market

13 13 Shadow Bank EntitiesAssets Types Liquidity Support Number of Entities Amount $ Billion Percent of Total $ Multi-sellerReceivables and loansFull Hybrid and OtherCombinationn.a Securities ArbitrageHighly-rated long-term ABSFull Non-Mortgage Single-sellerCredit card and auto loansImplicit SIVsHighly-rated long-term ABSNone CDOHighly-rated long-term ABSPartial Mortgage Single-sellerMortgages and MBSImplicit Total ABCP Funding of Shadow Banks 13 Source: Covitz, Liang, Suarez (2009); June 2007

14 14 SIV Example: Cheyne Finance PLC 10 billion us/euro portfolio managed by Cheyne Capital Management (hedge fund) WAL of assets (liabilities) was 2.9 (0.48) years in August 2007 US exposure of 78% vs 56% for the Moodys-rated SIV sector SIV only had $775 million in committed liquidity (liquidity facilities/breakable deposits) Cheyne folded quickly, defaulting on ABCP in October 2007, and ultimately its MTN issue. 14

15 15 Initial Policy Response to Illiquid Term Markets Lower discount rate and offered term credit at Discount Window But depository institutions borrowed using cheaper term funding from the FHLB system And, limited access of foreign institutions to term dollar funding meant continued pressure on LIBOR-OIS

16 16 Why not the Fed (at least not right away)? All-in-Cost Spread, Discount Window LESS FHLB NY Advance

17 17 Funding: ABCP, FHLB Debt and FHLB Advances

18 18 Policy Response to Illiquid Term Mkts & DW Stigma Lower discount rate and offered term credit at Discount Window Introduced Term Auction Funding and FX swaps in December 2007 to address term dollar funding needs of foreign institutions and stigma associated with DW use

19 19 Pressure in Term Dollar Markets … some improvement in late 2007 (basis points) ABCP crisis Bear Stearns Lehman

20 20 The second phase of the financial crisis (March 2008 through August 2008)

21 21 What happened in March 2008? Repo market Brokers-dealers relied heavily on repo funding, but they had significant residential and commercial exposure on their balance sheets, which made investor nervous Bank-affiliated dealers had indirect access to official liquidity (23A waivers), but stand-alone brokers had no liquidity backstop, making them vulnerable Bear Stearns, Merrill Lynch, Lehman Brothers, Morgan Stanley, Goldman Sachs In March, repo investors ran on the weakest stand-alone dealer Policy response (term dollar liquidity for broker-dealers) Maiden Lane LLC - 13(3) loan Primary Dealer Credit Facility - 13(3) lending Term Securities Lending Facility – 13(3) lending Single tranche OMOs

22 22 Repo market is an important money market for broker-dealers

23 23 Primary Dealer Credit Facility The PDCF provides an alternative source of financing to a dealer that has difficulty financing a security in the market. It was necessary to provide such an alternative in the unusual and exigent circumstances surrounding the near-failure of Bear Stearns.

24 24 PDCF usage high after Bear Stearns and Lehman failures

25 25 Term Securities Lending Facility The TSLF addresses the illiquid functioning in various repo financing markets, including abnormal rates, wide bid-ask spreads, and large and increasing haircuts on collateral. Adds Treasuries to dealers portfolios, reducing their scarcity in the repo market Reduces the roll-over risk for dealers in their financing of the alternative assets used as collateral Format assists in setting the right price for the Treasuries lent Avoids any reserve management problems

26 26 High overnight agency and MBS spreads to Treasury Source: Bloomberg

27 27 The Rise and Fall of Shadow Institutions Funding (The vertical axis scaled to 1.0 in 1994)

28 28 The third phase of the crisis (September 2008 through December 2008)

29 29 What happened - Fall 2008? Failure (or near failure) of at least eight large financial institutions in matter of weeks Break-down in Agency debt and MBS markets accelerates demise of Fannie Mae and Freddie Mac Run by repo counterparties pushes Lehman Brothers into bankruptcy, sending shock waves through repo, money, and term ABS markets Merrill Lynch sold to Bank of America Goldman Sachs and Morgan Stanley become bank holding companies Liquidity crisis pushes AIG to brink of bankruptcy Large securities lending program which funded non-agency RMBS with repo counterparties under pressure as the lenders wanted out Potential downgrade action by rating agency would trigger the need to post massive amounts of collateral against financial guarantees, which the company did not have Run on Money Funds: Reserve Fund breaks the buck Washington Mutual is closed and Wachovia is taken over

30 30 Spread: One-Month London Interbank Offered Rate (LIBOR) to O/N Index Swap (OIS) Rate 30 June 1, 2007 – October 23, 2009 Source: Financial times, Bloomberg, Haver Analytics

31 31 Asset-Backed Commercial Paper Rate 31 Source: Federal Reserve Board/Haver Analytics June 1, 2007 – October 23, 2009

32 32 Public Sector Responses GSEs Conservatorship with keep-well agreement UST MBS purchase program Limited Fed purchases of Agency debt and MBS AIG credit facility Money markets US Treasury guarantee Fed special liquidity programs: AMLF, MMIFF Large systemically important institutions TARP Capital Purchase Program Citigroup and Bank of America ring-fence transactions Term Liquidity Guarantee Program (TLGP) Commercial Paper markets Fed liquidity program: Commercial Paper Finance Facility (CPFF)

33 33 AIG - a $1 Trillion Company In Sept. 2008, AIG was the largest insurance company in the world, comprising 223 companies, operating in over 130 countries, and servicing 76 million customers AIG Commercial Insurance insured over 175,000 entities, employing over 100 million people in the US, including comercial, military and other organizations In the financial markets, AIG was a large issuer of CP and a mortgage lender and guarantor AIG FP was a large participant in the market for a wide variety of derivatives and other financial products At its peak, AIG FP insured assets worth $2.7 trillion across a wide range of asset classes ILFC was the largest commercial customer of Boeing (order value of $12.5Bn), GE, Honeywell, Rockwell International and United Technologies

34 34 Potential Consequence of AIG Failure With a massive surrender of insurance policies resulting from an AIG bankruptcy, there might have been insufficient capital or liquidity to pay all policyholder claims, and existing AIG policyholders might have been unable to obtain insurance coverage from other insurance companies Based on experience of prior failures of insurance companies significantly smaller than AIG, the sudden loss of AIG insurance capacity would have seriously disrupted the market, potentially resulting in a shortage of market capacity and significant price increases for numerous businesses and financial institutions Seizure of insurance subsidiaries by state regulators would have had an adverse impact on state guarantee funds, which are unfunded, resulting in assessments against other insurance companies An AIG failure could have de-stabilized confidence in other insurers and possibly triggered a devastating global run on the industry The scope of the failure could have put retirement savings significantly at risk Rapid unwinding and liquidation of AIGs many investment portfolios would likely have caused enormous downward pressure on valuations across all asset classes held by AIG Default by AIG on its commercial paper could have harmed the money markets (AIG had issued approximately $20 billion in commercial paper, roughly 4 times as much as Lehman) More than 1,400 counterparties of AIGFP would have been affected; losses would be suffered by municipalities, pension plans and investors in $34Bn of purportedly conservative Stable Value funds, potentially triggering a run on plans with 4400 Bn of assets

35 35 Policy Objectives with Respect to Lending to AIG Stabilize markets Post-Lehman bankruptcy Severe financial market distress Stabilize AIG with sufficient liquidity Enable AIG to dispose of certain assets over time Maximize value Avoid undue disruptions to markets Reduce risk of loss to Federal Reserve, the government, the taxpayer Ultimately, render AIG systemically unimportant Operates in more than 130 countries Over 76 million customers globally One of the largest domestic insurance companies – 24 million customers and 50,000 employees in the U.S. Customer base includes commercial, institutional and individual customers AIG Commercial Insurance protects and insures operations of over 180,000 entities that employ 106 million people in the U.S. AIGs domestic insurance subsidiaries are in 19 states and Puerto Rico ILFC is the largest commercial customer of Boeing (order value of $12.5 billion), GE, Honeywell, Rockwell International and United Technologies AIG Facts

36 36 Money Funds: The Problem The Reserve Primary Fund, a Money Market Mutual Fund (MMMF) breaks the buck on September 16, Heavy redemptions are related to investor concern about $785MM in holdings of Lehman Brothers commercial paper. A run on other MMMFs is created. Redemptions for the week ending September 23, 2008 are $120.5 billion. MMMFs have difficulty liquidating asset-backed commercial paper (ABCP), one of their largest holdings, as financial markets cease normal functioning Some sponsors provide support for affiliated MMMFs.

37 37 Understanding the run on money funds

38 38 Money Funds: Solutions The U.S. Treasury Department opened its Temporary Guarantee Program for Money Market Funds on September 29, 2008, which covers share balances as of September 19, Termination: September 18, The AMLF, managed by the Federal Reserve Bank of Boston, began operations on September 22, Termination: February 1, The Money Market Investor Funding Facility (MMIFF), managed by the Federal Reserve Bank of New York, was announced on October 21, Termination: October 30,2009. The Commercial Paper Funding Facility (CPFF), managed by the Federal Reserve Bank of New York, began operations on October 27, Termination: February1, 2010.

39 39 FRB Boston39 AMLF Design Bank (Borrower) Cash $1,000 ABCP $1,000 Purchased at Amortized Cost FRB Boston MMMF Cash $1,000 Non Recourse Note $1000, ABCP Pledged Key Design Features: No loss to MMMFs (purchased at amortized cost) Potential positive spread for borrowing bank (and essentially risk free) No recourse to borrower, but credit risk mitigated by SEC restrictions on MMMFs FRB Boston monitors ratings of pledged ABCP programs and sponsors

40 40 ABCP Money Market Mutual Fund Liquidity Facility (AMLF)

41 41 Fall 2008 Run on the Prime Funds FRB Boston41 MMIFF Announced 10/21/08 AMLF Announced 9/19/08 CPFF Announced 10/7/08 Lehman Announces Bankruptcy 9/15/08 Reserve Fund Breaks the Buck 9/16/08 Source: imoneynet Treasury Temporary Guarantee Program Announced 9/19/08 and Opened 9/29/08

42 42 Commercial Paper Funding Facility Funds the purchase of 3-month unsecured CP or ABCP directly from eligible issuers Restrictions apply FRBNY lends to an SPV, which purchases CP from issuers through primary dealers Purchase rates OIS bps for ABCP OIS bps for CP, with a 100 bps surcharge for non-TLGP issuers

43 43 CPFF

44 44 Impact of CPFF on quantities

45 45 Spread: One-Month London Interbank Offered Rate (LIBOR) to O/N Index Swap (OIS) Rate 45 June 1, 2007 – October 23, 2009 Source: Financial times, Bloomberg, Haver Analytics

46 46 Asset-Backed Commercial Paper Rate 46 Source: Federal Reserve Board/Haver Analytics June 1, 2007 – October 23, 2009

47 47 Fourth phase of the financial crisis (January 2009 through present)

48 48 Shut-down in term ABS markets

49 49 Need for a new investor base

50 Implementation of new-issue ABS Term Asset-Backed Securities Loan Program (TALF) starting in March 2009 Legacy TALF and securities Public Private Investment Program (PPIP) program announced in March 2009 and implemented over summer 2009 Implementation of Federal Reserve large scale asset purchases (LSAP) throughout the year Implementation of Supervisory Capital Assessment Program (SCAP) exercise for large depository institutions Bankruptcy and re-organization of Chrysler and GM with assistance from UST

51 51 TALF and New-Issue ABS Spreads

52 52 TALF and new issue ABS for major asset classes

53 53 Impact of public sector support for legacy assets (basis points) Super senior AM AJ 30% 20% 8% Typical AAA capital structure Super senior

54 54 TALF: Large Impact but Limited Exposure

55 55 Flight by Foreign Official Accounts from Agency Debt Change in foreign holdings held in custody by Federal Reserve (four week cumulative sum) (billions of dollars)

56 56 Impact of LSAP on mortgage loan coupons (percent) (Freddie Mac Primary Market Mortgage Survey Conventional Mortgage Rate LESS 10-year UST )

57 57 Whats Next? Expiration of Special Liquidity Facilities Conclusion of LSAP Portfolio Management Broader Questions Future of Securitization Improvements in Regulation and Supervision Strengthening Capital Requirements Improving Liquidity Addressing Too-Big-To-Fail Resolution Regime for Systemically Important Institutions

58 58 Summary All of Feds actions were directed at protecting the American people from a more severe downturn. Feds goal was to foster access to credit by businesses and individuals to met critical needs and keep the economy moving during a very critical period.

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