Playing for time the Fed attempt to mange the crisis as a liquidity problem

Description
The purpose of this paper is to examine the events leading up to the Great Recession, the US
Federal Reserve’s response to what it perceived to be a short-term liquidity problem, and the programs
it put in place to address liquidity needs from 2007 through the third quarter of 2008.

Journal of Financial Economic Policy
Playing for time: the Fed’s attempt to mange the crisis as a liquidity problem
Robert A. Eisenbeis Richard J . Herring
Article information:
To cite this document:
Robert A. Eisenbeis Richard J . Herring , (2015),"Playing for time: the Fed’s attempt to mange the
crisis as a liquidity problem", J ournal of Financial Economic Policy, Vol. 7 Iss 1 pp. 68 - 88
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Playing for time: the Fed’s
attempt to mange the crisis as a
liquidity problem
Robert A. Eisenbeis
Cumberland Advisors, Sarasota, Florida, USA, and
Richard J. Herring
The Wharton School, University of Pennsylvania, Philadelphia,
Pennsylvania, USA
Abstract
Purpose – The purpose of this paper is to examine the events leading up to the Great Recession, the US
Federal Reserve’s response to what it perceived to be a short-term liquidity problem, and the programs
it put in place to address liquidity needs from 2007 through the third quarter of 2008.
Design/methodology/approach – These programs were designed to channel liquidity to some of
the largest institutions, most of which were primary dealers. We describe these programs, examine
available evidence regarding their effectiveness and detail which institutions received the largest
amounts under each program.
Findings – We argue that increasing fnancial fragility and potential insolvencies in several major
institutions were evident prior to the crisis. While it is inherently diffcult to disentangle issues of
illiquidity from issues of insolvency, failure to recognize and address those insolvency problems
delayed necessary adjustments, undermined confdence in the fnancial system and may have
exacerbated the crisis.
Research limitations/implications – Disentangling issues of illiquidity from issues of insolvency
is inherently diffcult and so it is not possible to specify a defnitive counterfactual scenario.
Nonetheless, failure to recognize and address the insolvency problems in several major institutions until
more than a year after the crisis had begun delayed the necessary adjustment and undermined
confdence in the fnancial system.
Originality/value – This paper is amongthe frst to analyze data showingthe amounts of lendingand
the distribution of these loans across institutions under the Fed’s special liquidity facilities during the
frst 18 months of the fnancial crisis.
Keywords Central banks and their policies, Financial markets and institutions, Financial meltdown
Paper type Research paper
1. Introduction
This paper focuses on one particular aspect of the recent fnancial crisis: howthe Federal
Reserve (Fed) responded to what it described to the public as a short-term liquidity
problem during the period from 2007 through 2008, despite growing evidence of
potential insolvencies among some of the largest banks and investment banks. The Fed
provided large amounts of liquidity when risk spreads suddenly widened in September
of 2007, and even more when risk spreads virtually exploded in September of 2008, after
Fannie Mae and Freddie Mac were placed under government receivership (where they
still remain) and Lehman Brothers entered bankruptcy. We argue that hints of
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1757-6385.htm
JFEP
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Received30 November 2014
Revised30 November 2014
Accepted9 December 2014
Journal of Financial Economic
Policy
Vol. 7 No. 1, 2015
pp. 68-88
©Emerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-11-2014-0074
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increasing fnancial fragility and potential insolvencies appeared much earlier than the
fall of 2007. If these had been recognized and acted upon by the regulatory authorities,
then the most serious fnancial crisis since the Great Depression might have been
substantially mitigated. While it is inherently diffcult to disentangle issues of illiquidity
from issues of insolvency, the failure to recognize and address the insolvency problems
in several major institutions delayed necessary adjustments and undermined
confdence in the fnancial system.
The classical role of the lender of last resort (LLR) is often summarized by a simple set
of rules[1]. The LLR should:
• lend freely;
• against good collateral;
• to solvent institutions; and
• at a penalty rate.
If the LLR follows these rules strictly, the economy benefts from a virtuous circle. So
long as the LLR lends only to solvent institutions, its willingness to lend freely to a
particular institution signals that the institution is sound. This will restore market
confdence in the institution and enable it to regain access to its creditors and
counterparties without borrowing signifcant amounts from the LLR.
In what follows, we briefy describe the events that led up to the crisis, and
concentrate on the policies initiated by the Fed to deal with the crisis and minimize
systemic contagion.
2. Causes of the crisis
In the US Shadow Financial Regulatory Committee’s chapter for the book The World in
Crisis, (2011), the authors noted that “The 2007-2009 fnancial crisis […] had its origins
in USAhousing policies, the subprime mortgage market in particular, and the end of the
real estate bubble in the USA”. While the collapse of the housing bubble triggered the
crisis, the fragility of the fnancial system amplifed the scope and magnitude of what
otherwise might have been a collapse in a relatively small sector of US fnancial markets.
Indeed, the causes reached far beyond housing to include excessively accommodative
monetary policy; international capital infows that kept the risk-free interest rate too low
and contributed to the housing bubble; structural defects in the primary dealer system
and related tri-party repo market; inadequate risk measurement and monitoring by both
institutions and regulators; and relaxed prudential standards. These factors were both
domestic and international in scope and origin. In addition, in the USA, they were
compounded by government policies to subsidize homeownership that encouraged
over-investment in housing and contributed to a housing bubble that ultimately
collapsed.
These policies and the generally benign macroeconomic environment characterized
by exceptionally lowvolatility led borrowers, lenders and investors to increase leverage
and take riskier positions without necessarily perceiving that they were exposing
themselves to a greater risk of insolvency (Wallison, 2011). Borrowers took out
mortgages that they could afford only in good times, lenders made loans that fell below
traditional underwriting standards and investors bought what were (and were disclosed
to be) illiquid, complex securities in enormous amounts, assuming that secondary
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markets would continue to be highly liquid. The resulting housing bubble burst frst in
the subprime sector. It then spread to mortgage-backed securities, other asset-backed
commercial paper (ABCP) and, fnally, the interbank markets, ultimately damaging the
real economy. No one of these factors was likely to have been individually suffcient to
have caused the fnancial crisis, but together they formed what could be termed a
“perfect storm” that destroyed several key fnancial markets and de-capitalized several
important fnancial institutions and helped cause the ensuing recession (see the
Financial Crisis Inquiry Commission’s fnal report, 2011).
3. The unfolding of the crisis
The US Shadow Financial Regulatory Committee (2012) divided the fnancial crisis and
responses to it into three distinct phases:
(1) a liquidity phase from mid-summer 2007 to adoption of the Troubled Asset
Relief Program (TARP) in October 2008;
(2) a solvency phase that extended from the introduction of TARP; and
(3) a recovery phase that began in January 2009 and continues.
Our focus is on the liquidity and solvency phases, during which the Fed perceived that
markets had frozen and several institutions could no longer fund themselves in the
short-term money markets. The Fed’s response was to liberalize existing lending
facilities and to introduce a number of new liquidity facilities to augment funding for
large institutions that experienced diffculty in fnancing their balance sheets.
3.1 Liquidity vs solvency?
Bank managers are sure to argue that their central problem is the lack of access to
liquidity. Similarly, bank supervisors and central banks tend to support this view, both
because they often lack reliable information about an institution’s solvency and because
they believe that providing generous liquidity support may forestall the necessity of
taking diffcult and politically painful choices about resolving an insolvent institution.
3.2 The liquidity phase
The frst unambiguous signs of unease in the key interbank markets appeared in early
June 2007, after Standard &Poor’s and Moody’s Investor Services downgraded over 100
bonds backed by second-line subprime mortgages. A week later, Bear Stearns
suspended redemption from its High-Grade Structured Credit Strategies because of
diffculties in valuing various types of mortgage-backed securities. Bear Stearns
liquidated these funds on July 31, 2007.
The stress in interbank markets became highly visible on August 9, 2007, after the
announcement by BNP Paribas (Dealbook, 2007) that it had suspended calculation of
asset values of three of its funds exposed to subprime debt and halted redemptions. The
bank stated:
The complete evaporation of liquidity in certain market segments of the USA securitisation
market has made it impossible to value certain assets fairly regardless of their quality or credit
rating.
This prompted extraordinary actions by the European Central Bank, which, on August
9, 2007, injected €95 billion overnight to improve liquidity. The Fed scheduled two
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telephonic conferences during August between regularly schedule meetings to address
the deterioration in interbank markets.
The traditional measure of the degree of distress has been the difference between the
London Interbank Offer Rate (LIBOR) and the Treasury Bill Rate (the TED spread; see
Figure 1). For example, before the crisis, a typical TED spread averaged about 25 basis
points through April 2007. It then jumped to an average of about 50 basis points in May.
This doubling of spreads should have raised questions about the cause of increased
anxieties within the interbank market. The TED spread increased sharply from about
50 basis points to 100 basis points on August 10, 2007 (just after the previously
mentioned announcement by BNP Paribas), then to 130 basis points on August 15, 2007,
before peaking at 237.5 basis points on August 20, 2007. On August 10, the Federal
Reserve (2007a) issued a press release indicating that it would provide liquidity through
open-market operations to ensure that the funds market would trade near its target of
5.25 per cent and that the discount window(DW) was open. It subsequently lowered the
discount rate in several stages from 6.25 per cent to 0.5 per cent.
By September 2007, the broad outline of the unfolding crisis was clear, even though
the Fed continued to characterize it as a liquidity crisis. What was initially perceived as
a disruption in a relatively minor sector of the debt market had spilled over to damage
much of the rest of the fnancial system. The process began with a drop in demand and
a sharp fall in the price of subprime-related debt, which was attributable to deterioration
in the performance of underlying subprime mortgages. This led market participants to
realize that (at best) credit ratings indicated the probability of default, and not the overall
risk of asset price volatility, and undermined confdence in the customary valuation
models, which had relied heavily on credit ratings to value tranches of particular issues.
The virtual evaporation of liquidity in the secondary market for subprime-related debt
made it very diffcult to verify the market value of the outstanding debt and raised
troubling questions about models used to forecast losses and the correlation of losses in
the underlying collateral. Valuations were further complicated by the complexity of
asset structures that had been previously virtually ignored. This concern immediately
spread to other complex securities and these market disruptions triggered several
Figure 1.
The LIBOR/Treasury
Bill spread
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knock-on effects. The collateralized debt obligation (CDO) and collateralized loan
markets virtually disappeared (Figure 2).
The fall in prices had an immediate impact on institutions heavily involved in
securitization, which threatened to become self-reinforcing. Collateralized lenders
reacted to the drop in prices by demanding larger haircuts to accept ABCP, when they
would accept it at all. Demands for more collateral pressured borrowers to sell ABCP in
illiquid markets to maintain their access to funds. This put additional downward
pressure on prices, which led to additional demands for more collateral. Borrowers also
tried to reduce the size of their balance sheets as funding costs became uneconomic.
These market responses intensifed pressures on primary dealers and other
participants in the market for subprime mortgages, who were unable to securitize
existing warehouses of mortgages and were forced to seek other forms of funding. The
rapid contraction of the ABCPmarket forced banks to honor backstop liquidity facilities
or take securitized assets back onto their balances sheets. The emerging pressure on
dealer balance sheets and income statements was apparent, even though accounting
disclosures failed to refect the extent of the damage or, importantly, howthe losses that
had already occurred would be allocated across institutions. Institutions attempted to
hoard liquidity to meet contingent commitments and protect against further
disruptions. Attempts to increase their borrowings in interbank markets put upward
pressure on the cost of term funding. Institutions responded by shifting much of their
borrowing to overnight funding markets, but this increased their exposure to the risk
they would be unable to roll over their borrowing if they should suffer a loss of market
confdence.
The Fed viewed this series of events as a liquidity crisis that required intervention by
the central bank to increase bank liquidity. The Fed hoped that if it provided more
liquidity to banks, they would be induced to buy subprime-related assets from other
market participants trying to unload them. Even if the underlying diagnosis is accepted,
this remedy seems dubious. It ignores the fact that many of the market participants
attempting to unload their subprime-related debt were the same banks to which the Fed
was providing liquidity. It is unlikely that more liquidity would induce them to shift
Figure 2.
Weekly outstanding
volume of ABCP
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their portfolio preferences in favor of holding more subprime-related debt (although it
might have mitigated pressures to sell into illiquid markets).
More fundamentally, the inability to fnd a market-clearing price may have deeper
explanations. Normally, when demand shifts downward, the market price will fall until
supply equals demand. Presumably investors would have been willing to pay some
positive price for the distressed debt, and so the underlying problemmust have been the
unwillingness of holders of the debt to sell at that price. This would certainly make sense
if holders of the debt believed the fall in prices was temporary and would be quickly
reversed.
The economic fundamentals offered no support for this view, however.
Delinquencies on subprime mortgages were rising and housing prices continued to fall.
Moreover, structured credit facilities were designed so that losses experienced by the
most junior tranches could not be recouped in subsequent recovery operations.
Alternatively, holders of the distressed debt may have believed they could delay
recognition of the loss (and the unpleasant consequences that might follow, such as
increased regulatory capital requirements and heavier margin requirements, or larger
haircuts imposed by counterparties). In addition, some holders of the distressed debt
may have believed recognition of losses could be postponed more or less indefnitely if
the government could be induced to support the price of the debt. Indeed, the frst draft
of the TARP (and the name of the proposed legislation itself) aimed to do just that.
Although the Fed chose to frame the series of events as a liquidity crisis, the
implications for the solvency of institutions heavily involved in the asset-backed
security (ABS) markets were clear. First, these institutions experienced direct losses on
their holdings of downgraded securities. Second, banks experienced losses from
honoring their implicit (and often explicit) guarantees to back up off-balance sheet
vehicles, whether by extensions of liquidity or purchases of securities that the vehicle
could no longer fnance in capital markets. Third, institutions actively underwriting
securitized debt experienced losses from assets they were holding on their balance
sheets in preparation for securitization. Fourth, the collapse of the ABS markets meant
not only a loss of current revenue but also quite possibly the loss of an important
continuing source of revenue. Banks also faced a capital challenge. They needed to
replace lost capital to meet regulatory requirements and regain market confdence, and
they also experienced pressure to stockpile capital as a precaution against loss of access
to funding. In addition, they needed to prepare for the possibility that they would be
obliged to bring many of their off-balance sheet activities back onto the balance sheet.
Credit default swap spreads indicated that anxieties focused on particular categories of
institutions and specifc institutions within these categories. As Figure 3 shows, US
investment banks experienced the heaviest pressure.
4. The Fed’s policy responses
The Fed devised numerous ways of injecting liquidity into the system without
subjecting borrowers to the “stigma” of being observed to receive funds from the Fed.
These programs included expanded DW access, emergency lending facilities for both
bank and non-bank primary dealers and lending securities, both short and longer term,
from the Fed’s portfolio to institutions needing better-quality collateral to pledge in
overnight markets to obtain funding on more favorable terms. These programs are
discussed in detail by Calomiris et al. (2011) and Eisenbeis (2011). Table I lists the
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principal Fed liquidity facilities during the crisis along with the maximum outstanding
amount under each facility.
Five of the programs including, importantly, the programs available to
non-depository primary dealers, were established under the emergency provisions of
Section 13(3) of the Federal Reserve Act, which authorizes the Fed to lend to various
entities in unusual and exigent circumstances[2]. Because of this, the Fed could not
legally extend these programs beyond the period deemed “unusual and exigent” under
the terms of the statute.
4.1 DW lending
The Fed’s frst response to the crisis was to attempt to make DW borrowing more
attractive. In a conference call on August 10, 2007, the Fed (2007) pledged to provide
reserves as necessary through open-market operations, to promote trading in federal
funds at rates close to the Federal Open Market Committee’s target rate of 5.25 per cent.
In addition, the Fed committed to work against any remaining stigma associated with
borrowing at the DW. The meeting ended with an observation that it might be necessary
to lower the discount rate to reduce the 100 basis point spread between the discount rate
and the federal funds rate.
Just six days later, another special telephonic meeting of the Federal Open Market
Committee was convened to consider lowering the discount rate, as well as liberalizing
other features of the primary credit DW lending. The Fed agreed to lower the spread
between the primary credit rate and the Federal Open Market Committee’s discount rate
to 50 basis points. This reduction in the cost of DWborrowing was accompanied by two
important additional features. Banks would be permitted to borrow for as long as 30
days renewable by the borrower, not just the traditional overnight borrowing. The Fed
agreed to continue accepting a broad range of collateral (including mortgage-related
debt) at the Fed’s existing collateral margins, even though haircuts in the tri-party repo
Figure 3.
The evolution of
credit default swap
spreads from January
2007 through May
2008
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market had increased substantially, particularly with regard to private mortgage-
backed securities.
Despite the Fed’s efforts to make DW borrowing more attractive, very little lending
was done during the fall of 2007. Figure 4 shows that, during 2007, lending volumes
peaked at US$2.9 billion on September 12, 2007, and then tapered off signifcantly until
they began to expand during March 2008, in the wake of the collapse of Bear Stearns.
4.2 The Term Auction Facility
The Fed introduced Term Auction Facility (TAF) in December 2007. The design was
motivated by the Fed’s frustration that its efforts to promote use of the DW had yielded
only minimal participation (Cecchetti, 2009). The Fed believed that the stigma[3]
associated with DW borrowing was inhibiting prospective borrowers from making use
of liberalized access to the DW facility directly.
Wu (2011) and Armantier et al. (2008) examine the effectiveness of the TAF. The
typically minimal TAFauctions ranged fromUS$20 billion to US$50 billion per auction.
The frst ten auctions were over-subscribed and all were above the applicable stop-out
rate. For fve of the frst ten auctions, successful bidders were able to borrow from the
Table I.
Fed liquidity
facilities during the
crisis
Facility
name Facility Date announced Eligible borrowers
Maximum amount
outstanding
Fed liquidity facilities during the crisis
DW Discount window Ongoing Depository institutions 111
TAF Term Auction Facility December 12, 2007 Depository institutions 493
ST
OMO
Single-Tranche Open
Market Operations
March 7, 2008 Primary dealers 80
TSLF Term Securities Lending
Facility
March 11, 2008 Primary dealers 236
PDCF Primary Dealer Credit
Facility
March 16, 2008 Primary dealers 147
AMLF Asset-Backed Commercial
Paper Money Market
Mutual Fund Liquidity
Facility
September 18, 2008 Depository institutions 152
CPFF Commercial Paper Funding
Facility
October 7, 2008 Commercial paper
issuers
351
Programs for central banks and non-bank, non-primary dealer borrowers
CBLS Central Bank Liquidity
Swaps
December 12, 2007 Banks 583
Money Market Investor
Funding Facility
October 21, 2008 Money market
investors
0
Term Asset-Backed
Securities Loan Facility
November 25, 2008 ABS investors 48
Notes: Maximum amounts outstanding in billions of dollars based on weekly data as of Wednesday.
Primary Dealer Credit Facility includes other broker-dealer credit. Central bank liquidity swaps are
conducted with foreign central banks, which then lend to banks in their jurisdiction
Source: Fleming (2012)
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TAF at rates that were anywhere from 8 to 42 basis points below rates at which they
could have borrowed at the DW. Thus, for several of the auctions, the TAF provided a
subsidy over traditional DW borrowing to the successful bidders. Wu (2011) suggests
that the introduction of the TAF reduced LIBOR-overnight index swaps (OIS) spreads
by 31 basis points, and the three-month LIBOR-OIS spread by about 44 basis points, in
the frst and into the second quarter of 2008. He found no effect on counterparty risk
premiums.
4.3 Central Bank Liquidity Swaps program
The TAF was part of a two-pronged effort announced on December 17, 2007. The
Central Bank Liquidity Swaps (CBLS) program was introduced to reduce liquidity
pressures on major fnancial institutions operating in US and European money markets.
While TAF provided liquidity to US institutions and the US affliates of foreign
depository institutions, CBLS attempted to alleviate dollar liquidity problems abroad,
using foreign central banks as the intermediary. The need for liquidity was forcing
institutions based abroad to liquidate dollar-denominated assets. The swap program
permitted foreign central banks to draw on predetermined swap lines, as needed, to
provide short-term dollar funding to depository institutions in local money markets,
mainly in the European Monetary Union, Sweden, Switzerland and the UK[4]. The
programwas subsequently widened on at least two occasions, frst by upping the size of
the lines and then removal of the size caps. The largest amounts extended during any
one week under that program were about US$642 billion.
The Fed hoped that by increasing the availability of dollars in foreign markets,
fnancial market stability in the USA would be enhanced. To evaluate the effectiveness
Figure 4.
Primary credit
extension through
the DW, April
2007-April 2011
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of the swap program, Fleming and Klagge (2010) examined LIBOR spreads; the
comparative cost of borrowing dollars directly fromthe foreign central bank vs the cost
of borrowing in euros, for example, and then buying dollars in the foreign exchange
market; and, fnally, the auction rates for dollars from foreign central banks. Before the
crisis, spreads were close to 0; they rose to over 300 basis points in the late fall of 2008
and fnally settled in a range of from2 to 25 basis points by year-end 2008 and thereafter.
As for the relative cost of borrowing in the euro market and purchasing dollars, that
spread tended to followthe path of the LIBORspreads, but the cost appears to have risen
much more.
In one of the fewstudies of the swap programconducted outside the Federal Reserve
System, Aizenman and Pasricha (2011) examine the exchange rate impacts of the swap
programs, and fnd signifcant short-run positive impacts on the exchange rates for
certain emerging markets (those to which US banks had the greatest exposures), but less
of an impact on other emerging markets. However, those impacts also appeared to be
relatively short lived and may have subsequently been reversed.
4.4 Single-Tranche Open Market Operations
Secured lending markets began to show signs of strain early in 2008. Primary dealers
rely heavily on this market to fund their positions. As lenders became concerned about
the possibility of a decline in the value of collateral, and the credit risk of their
counterparties, they responded by demanding larger haircuts and greater compensation
for lending against riskier collateral, and by halting lending against certain types of
collateral. To ease liquidity pressure on primary dealers, the Fed announced on March 7,
2008, that it would initiate a series of Single-Tranche Open Market Operations
(ST OMOs) directed toward primary dealers. Fleming (2012) offered additional details.
Primary dealers could bid to borrow funds through repos for a term of 28 days while
providing any collateral that would be eligible in conventional open-market operations.
Like TAF, this program was designed to provide term funding via an auction format,
but it was directed at non-depository primary dealers. The program was relatively
small, peaking at US$80 billion, and was overshadowed by later programs to provide
liquidity assistance to non-depository primary dealers, most notably the Primary Dealer
Credit Facility (PDCF), introduced nine days later on March 16, 2007 (see the PDCF
section below).
4.5 Term Securities Lending Facility
To further enhance the access of primary dealers to liquidity, the Fed created the Term
Securities Lending Facility (TSLF) program on March 11, 2008. This program
broadened the Fed’s securities lending programto include all of the primary dealers, not
just the depository institutions. It permitted the primary dealers to borrow securities
overnight from the System Open Market Account for as long as 28 consecutive days.
The dealers could, in turn, repo these higher-quality, borrowed securities, using themas
collateral in the market for overnight funds. This enabled them to avoid liquidating
securities at fre-sale prices.
The Fed used an auction process to allocate securities among bidders. Each morning
the securities were taken back into the Fed’s portfolio so that the program was off the
balance sheet. This enabled the Fed to enhance the liquidity of primary dealers without
reporting an increase in bank reserves on its own books. Thus, the effect of the TSLF
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was to reallocate bank reserves away from smaller banks or other holders of Fed funds
to the primary dealers. While the intent was to make funds available to dealer banks, it
is not obvious that the TSLF increased the availability of credit more generally,
especially as smaller banks and other holders of Fed funds might have used them to
support lending and asset acquisition.
4.6 Primary Dealer Credit Facility
The rapidity of the collapse of Bear Stearns on March 13, 2007, made clear that ST
OMOs and the TSLFwere not suffciently fexible to meet the emergency liquidity needs
of non-depository primary dealer banks. On the day that JPMorgan Chase agreed to take
over Bear Stearns (with a $29 billion subsidy), the Fed announced the creation of the
PDCF. The new facility enabled the Fed to make overnight loans to primary dealers at
the DW’s primary credit rate. In effect, this was an extension of the privilege of DW
borrowing to non-depository primary dealers at the primary credit rate. The Fed relied
on the “unusual and exigent” circumstances clause of the Federal Reserve Act to extend
this privilege to non-depository institutions.
The PDCF was more fexible than the single-purpose open market operations or
auction facilities because it was available to non-depository primary dealers at any time
and allowed them to borrow against a wider range of eligible collateral. Later, the Fed
announced liquidity support for certain securities subsidiaries of Goldman Sachs,
Morgan Stanley and Merrill Lynch; and for the London-based broker-dealer of Citigroup
under terms parallel to the PDCF (Fleming, 2012, p. 7).
Cecchetti (2009) indicated that one of the purposes of the PDCF was to reduce the
spreads between the rates on ABSs that served as collateral for interbank borrowing,
and the rates on Treasury securities that were regarded as higher-quality collateral in
the interbank and repo markets. During the frst three weeks of the PDCF, outstanding
borrowing averaged US$30 billion per day.
Although the PDCFwas initially billed as a way of providing liquidity to the primary
dealers, Figure 5 shows that two institutions were the main benefciaries of the facility
from its inception in March 2007 through June of that year: Barclays and Bear Stearns.
After the collapse of Lehman Brothers in September 2008, use of the facility expanded
greatly, but even then, there were only four major benefciaries: Morgan Stanley,
Goldman Sachs, Citigroup and Bank of America. Since none of the institutions were in a
robust fnancial condition when they accessed the PDCF, the program appears to have
provided life support for institutions with questionable economic capital rather than to
have provided a broad liquidity support to the market.
The market effects of the program are hard to specifcally identify. Cecchetti (2009)
provides some evidence that the 90 basis point spread between US agency securities and
US Treasuries fell the day after the program was announced, and declined modestly
thereafter to about 50 basis points[5]. But no statistical tests were performed, so the
spread effect is at best an indirect index of program effectiveness.
5. Which institutions received the largest amount of liquidity assistance?
This question could not be answered until Bloomberg won a suit against the Fed under
the Freedom of Information Act, and a team of reporters sifted through the massive
amount of data released by court order. Figure 6 shows total peak and average
borrowing amount over the period from August 2007 through December 2009 under
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Figure 5.
Lending under the
PDCF vs TED
spread
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seven Fed programs: DW, TAF, ST OMO, TSLF, PDCF, AMLF and the CPFF[6].
Institutions that had primary dealer status are identifed by an asterisk. Note that all 12
institutions that drewthe peak amounts fromthe Fed’s liquidity programs had primary
dealer status. In addition, 9 of the 12 had the largest average daily balance outstanding
from August 2007 through December 2009, and 5 of the 12 were headquartered abroad.
These totals refect the Fed’s direct (collateralized) exposure to these banks, but do not
include whatever amounts they may also have received indirectly through the CBLS
Lines. The important difference between the two channels is that under the CBLS, the
Fed’s credit exposure is to the counterparty foreign central bank, which is usually
considered the highest-quality exposure in that country. The foreign central bank, not
the Fed, then assumes the credit risk in lending the funds to local banks.
It is also instructive to examine howmuch these institutions borrowed under each of
the Fed’s liquidity programs. Figure 7 disaggregates the total amount borrowed by each
of these institutions by each of the seven Fed special liquidity facilities: DW, TAF,
ST OMO, TSLF, PDCF, AMLF and CPFF. Overall, DW borrowing was relatively
unimportant, except in the case of Wachovia, which was forced to merge with Wells
Fargo; and Dexia and Hypo Real Estate Holding, two European fnancial institutions
that failed during the crisis. These data raise doubts about whether the Fed was
restricting its primary credit lending to solvent institutions. In any event, they certainly
do not dispel the presumption that borrowing from the Fed through the primary credit
window signals impending insolvency, which might have been the best hope of
Figure 6.
Total peak and
average borrowings
from Fed liquidity
facilities from
August 2007 through
December 2009
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eliminating the “stigma” that concerned the Fed so greatly during the crisis. The TAF
was very important to Bank of America and Wells Fargo; and less so for Citigroup,
Royal Bank of Scotland, Deutsche Bank and Dresdner Kleinwort Securities. For the
other banks, TAF borrowings were relatively inconsequential.
ST OMOs accounted for half or more of the outstanding credit at Credit Suisse,
Goldman Sachs, BNP Paribas, Countrywide and Cantor Fitzgerald. Morgan Stanley,
Royal Bank of Scotland, UBS, Deutsche Bank and Barclays also benefted from the ST
OMO, but for a much smaller proportion of their outstanding borrowings from the Fed.
Apart from these ten institutions, the ST OMO had negligible impact.
The TSLF accounted for a third or more of the borrowing at Morgan Stanley,
Citigroup, Royal Bank of Scotland, Goldman Sachs, Deutsche Bank, Barclays and BNP
Paribas. It was much less important to Bank of America, UBS, JPMorgan Chase, Merrill
Figure 7.
Average borrowing
(April 2007-
December 2009),
disaggregated by
facility
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Lynch, Credit Suisse and Countrywide. For the other banks, the TSLF was irrelevant.
The impact of the AMLF was even more concentrated. It was hugely important for State
Street and JPMorgan Chase, but not for any the other institutions.
The CPFF produced substantial benefts for UBS, Citigroup, Dexia and Fortis, which
were all under serious fnancial stress and had questionable solvency. Barclays also
benefted, and the CPFF accounted for the majority of a trivial amount of borrowing by
HSBC, but the program did not matter for the other institutions.
5.1 Special benefts for special institutions
Overall, it is remarkable that the benefts of each of these programs were so narrowly
focused. In most cases, it appears that the programs were tailored for the needs of a
handful of institutions. None of the programs had the broad impact that one might
expect to observe if they had been designed to address the liquidity needs of the broader
market. In several cases, it appears that the Fed may have been engaged in disguised
bailout lending, as the institutions that drew heavily from these programs had dubious
economic capital. In fact, half of these institutions failed during the crisis, required a
government-assisted merger, or received substantial government subsidies (in addition
to access to these liquidity programs)[7].
The prominence of primary dealers on this list – all 20 of the primary dealers in 2007
appear – raises questions about why they appear to have received special treatment.
Primary dealers are banks or securities frms that have received authorization to trade
directly with the Fed. They must make bids or offers when the Fed conducts
open-market operations, provide information to the Fed’s open-market trading desk and
participate actively in auctions of US Treasury securities[8].
The Fed has been conscious of the special status and potential implicit subsidy that
designation as a primary dealer might convey; it decided in 1993 to stop surveillance
over the primary dealers and, instead, to focus solely on the quality of the collateral they
pledge. The hope was that this would blunt any perception that these institutions had a
privileged position. Yet, it did not dispel the perception that such institutions had a
special status – at least, in part, because they were required to meet demanding criteria
before being designated as primary dealers. Several central banks, governments and
some institutional investors continue to insist on transacting only with primary dealers,
and of course, primary dealers beneftted from spreads earned in intermediation. Thus,
abandoning Fed oversight of primary dealers may have inadvertently exacerbated the
problem. It did not eliminate the perception that primary dealers had a special status, yet
it surrendered one potentially important constraint over moral hazard – regulatory
oversight.
The fact that so many of the designated primary dealers required and received
special liquidity assistance during the crisis certainly reinforces the presumption that
these institutions may be too important to fail – Lehman Brothers notwithstanding. In
addition, it raised the question of whether the special category of frms is still essential
to the functioning of debt markets in the USA. Improvements in information and
communications technology since the primary dealer system was established surely
reduce the need for the Fed to have a “special relationship” with a handful of institutions.
Moreover, it seems likely that more bidders for new issues of government securities
would result in more favorable prices for the Treasury. The European Central Bank, for
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example, is able to conduct transactions with literally hundreds of counterparties
without obvious diffculty.
6. Policy concerns shift from illiquidity to insolvency
After the horrifying series of events during the fall of 2008 – the placement of Fannie
Mae and Freddie Mac in conservatorship, the bankruptcy of Lehman Brothers, the
bailout of AIG, the run on institutional money market funds and the seizing-up of much
of the commercial paper market – the Fed was obliged to recognize that improvising yet
another special liquidity program would not quell the crisis. The Fed and the Treasury
confronted the possibility that the fundamental issue was doubts about the solvency of
many of the largest fnancial institutions. They appealed to Congress for US$700 billion
to fund the TARP. The aim was to stabilize the fnancial system by buying troubled
assets. After an initial false start, Congress passed the Emergency Economic
Stabilization Act of 2008 on October 3, 2009, which authorized the funding of a program
to purchase troubled assets in the hope of stabilizing the fnancial system. Although
TARP appeared to be yet another attempt to provide liquidity to the fnancial systemby
purchasing “troubled assets” fromthe institutions that held them, the Treasury changed
course within a few days and used the funds to inject capital into the nation’s largest
fnancial institutions (and others on an as-needed basis) through a Capital Purchase
Program.
This was a turning point in the crisis. Offcials no longer characterized the crisis as a
liquidity problem affecting specifc markets and a few unlucky institutions that were
exposed to these markets. The Treasury was focused on recapitalizing weak fnancial
institutions. The Fed shifted from channeling liquidity to the major primary dealers
(while offsetting those efforts with sales of assets from its portfolio) to one of
unprecedented monetary expansion.
Once the TARP program was launched, the banking agencies attempted to restore
confdence by requiring that the largest banks pass a Supervised Capital Assessment
Program. They compelled the 19 largest banks to demonstrate that they could maintain
adequate capital under the most severe of the three regulator-specifed stress scenarios
during the frst quarter of 2009. However, 11 of the 19 largest banks failed the test. They
were obliged to eliminate the shortfall of capital immediately, however, by drawing on
the Capital Purchase Program. This recapitalization succeeded in restoring public
confdence in the large fnancial institutions. The losses at those institutions were large
enough to raise questions about their solvency. From March 2007 to February 2009,
losses in the banking system exceeded US$1.6 trillion, with the 19 largest institutions
accounting for more than two-thirds of the total.
6.1 Why the long delay in recognition of solvency problems?
When so many of the primary dealers experienced fnancial stress, why did authorities
focus mainly on the liquidity symptoms rather than examining the underlying problem
of impending insolvencies? It seems clear (albeit with the beneft of hindsight) that the
fnancial disruptions arising in mid-2007 differed from traditional, temporary liquidity
crises. They were rooted in three fundamental problems that required a different
solution.
First was the reliance of several large institutions on a business model that required
the funding of longer-term assets with overnight liabilities. Although maturity
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mismatches have been a recurrent problem in fnancial history, this mismatch was
different from earlier examples, such as the savings and loan (S&L) crisis in which
assets with maturities of 20 to 30 years were funded with liabilities of one- to two-year
durations. In the recent crisis, several institutions were simply warehousing longer-term
assets for a short interval before they could be securitized and placed with investors who
preferred to hold longer-termassets. The mismatch seemed temporary and, indeed, had
been so as long as the securitization process could be completed as expected. When the
secondary market dried up, however, it was impossible to place new securitizations.
Warehousing operations, which institutions expected to be very short-term
commitments, needed to be fnanced for a much longer term. This proved a challenge
because many mortgage-related securitizations were no longer acceptable for
collateralized loans (or could be pledged only as haircuts that were uneconomic). The
potential threat to the solvency of these institutions made it increasingly diffcult to
renew overnight loans at usual rates. Indeed, the experience suggests that highly
leveraged short-term-duration mismatches can become very risky positions. The
authorities clearly perceived part of the problem and focused on trying to restore
liquidity to the secondary market for mortgage-related debt, but given the deterioration
in the underlying fundamentals of the housing market, this was impossible without
allocating the losses that had already been incurred.
Second, the authorities appear to have underestimated the leverage that some of the
largest institutions had achieved. This is highly surprising because, in 1998, the Basel
Committee had agreed to reduce the minimum required amount of equity to be held
against risk-weighted assets from roughly 4 to 2 per cent. In effect, the bank regulators
were permitting banks to take on leverage ratios of 50:1. Even this understates the
magnitude of the policy blunder because risk-weighted assets tend to be roughly 50 per
cent of total assets, and so the permissible leverage ratio increased implicitly to 100:1[9].
Interestingly, AIG facilitated regulatory arbitrage with its Regulatory Capital Swaps
Program that shifted credit risk, according to the then-current capital adequacy
guidelines, from banks to AIG, thereby reducing their regulatory capital requirements
(Carney, 2009; Nocera, 2009). Certainly, many fnancial institutions did not take full
advantage of the opportunity to increase leverage, but the authorities were simply
tracking the wrong capital concept. The new defnition of Tier 1 capital provided only
half the margin of safety required under the original defnition, yet there is no indication
that the authorities realized they had authorized a massive expansion of leverage[10].
Minimum capital ratios based on risk-weighted assets suffered from yet another
major defect. The risk-weighted assets were lower than they should have been because
the regulators relied heavily on self-reporting and politically motivated risk weights
that understated the risks of mortgages, interbank lending and sovereign debt; and
failed to properly consider the interest rate and funding risks inherent in the business
models being employed by several major banks[11]. Moreover, the regulatory ratios
failed to refect market values, which meant that regulatory capital was likely to be
substantially overstated when market values of assets fell.
The problemof excessive leverage was mitigated to some extent in the USAbecause
the banking regulators maintained a minimum capital-to-asset ratio[12]. But the
regulatory measure of leverage was subject to another major faw: the denominator, the
total on balance sheet assets, hugely underestimated the actual scale of banks’
risk-taking. The measure neglected off-balance sheet positions and off-balance sheet
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vehicles that might need to be taken onto the balance sheet in times of stress. Moreover,
regulators failed to take account of the leverage inherent in collateralized borrowing,
which had become a major source of funds for many of the fnancial institutions most
active in capital markets. Given the possibility of rehypothecating collateral, it was
possible to leverage borrowing several times on the basis of the same underlying
collateral.
Heightened leverage exacerbated the risk in maturity mismatches and the damage
inficted by any other shock. This feature also served to differentiate the current crisis
fromthe earlier problems with S&Ls. Leverage taken on by some of the largest fnancial
institutions was an order of magnitude greater than that of the earlier S&Ls.
Third was the problemof complexity – with regard to both organizational structures
and fnancial instruments. The complexity of legal structures adopted by many large
banks, involving literally a thousand or more subsidiaries, made it diffcult for
regulators (and, often management) to properly understand an institution’s exposure to
risks. This may also have discouraged the regulatory authorities from dealing with
issues of insolvency, as the complexity of some legal structures that crossed multiple
national borders and an even greater number of regulatory jurisdictions defed an
orderly resolution. Complexity of legal structures may also have made it diffcult for
regulators and market participants to understand the fragility of secondary markets in
which mortgage-backed securities were traded. For example, regulators regarded the
special-purpose vehicles established by banks to conduct securitizations as bankruptcy
remote. Hence, the regulatory authorities thought the sponsoring institutions faced
minimal risks and did not require as much capital as if the assets had remained on bank
balance sheets, and so the required capital for such activities was much lower than if the
activities remained on a bank’s balance sheet. This disparity invited regulatory
arbitrage by the sponsoring fnancial institutions.
Complexity of new fnancial instruments also inhibited regulatory scrutiny and
market discipline. Many of the assets that originated in the securitization process were
diffcult to value. Moreover, it was diffcult to anticipate how losses would be allocated
if the securities should default. This was particularly a problem in private-label
securitizations because many market participants and the regulatory authorities relied
primarily on the risk ratings provided by independent ratings organizations rather their
own independent analysis.
None of these problems – vulnerability to funding, interest-rate risk in the business
model underlying the securitization of mortgages and the excessive leverage and
complexity in instruments and institutions – could be addressed by the provision of
liquidity support. Indeed, the provision of liquidity may have delayed the necessary
restructuring process and the allocation of losses already incurred.
7. Concluding comments
With regard to Bagehot’s (1873) and Thornton’s (1802/1939) rules, how do the liquidity
programs measure up? Without doubt the Fed lent freely. It did, however, accept some
rather dubious collateral at haircuts that were substantially below those determined in
the market. Nonetheless, it appears not to have suffered losses as a result. The rate on
most Fed facilities was not much of a penalty. It was usually set only slightly above the
primary credit DWrate. But, in most cases, it did provide an incentive for institutions to
repay as quickly as possible. From the list of the largest recipients of the Fed liquidity
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support during the crisis, it is apparent that the Fed placed little emphasis on solvency.
Perhaps, the lack of effcient resolution tools biased the Fed’s decision in favor of the
generous provision of liquidity. This provision of liquidity to fnancial institutions with
questionable solvency will not diminish the stigma associated with discount-window
borrowing from the Fed.
To date, a certain amount of progress has been made to rectify some of the problems
noted above. Accounting standards have been refned, but primary reliance upon book
values rather than market prices has not changed. Regulatory reliance upon ratings
issued by the ratings organizations has been written out of banking regulations. Capital
requirements have been strengthened and augmented by regular stress tests designed
to determine whether an institution can maintain adequate capital in the event
regulator-specifed macro-shocks. These stress tests should be augmented with an
emphasis on shocks likely to affect particular institutions. The Shadow Committee has
expressed reservations about the continued reliance upon risk-based capital standards
that employ arbitrary weights, and has urged greater emphasis on a simple leverage
requirement that would be more transparent and less subject to manipulation (Shadow
Financial Regulatory Committee, 2012a).
In addition, the Federal Reserve is in the process of imposing heavier capital
requirements on institutions with assets greater than US$50 billion – a welcome change
from the pre-crisis trend of applying differentially lighter capital requirements on the
largest institutions. With the Federal Deposit Insurance Corporation (FDIC), the Fed is
requiring that large institutions submit “living wills” that will describe how they could
be resolved under bankruptcy. The two agencies are also developing procedures that
would trigger remediation of fnancially troubled institutions, including federal
intervention to facilitate an orderly resolution when necessary (Shadow Financial
Regulatory Committee, 2012b). At the same time, the ShadowCommittee has expressed
concerns about the proposed capital defnitions used to measure capital suffciency in
the proposed process.
The process would also apply to institutions that the Financial Stability Oversight
Council designates as “systemically important”. Relative to the regulatory framework
before the crisis, this is substantial progress. But challenges still remain with regard to
the cross-border issues and the possibilities for risk transference that arise when
complex institutions operate in a global fnancial marketplace. Despite the
implementation of the living will requirement, organizational complexity remains,
differential rules and regulations apply and uncertainty remains about whether and
how a large complex fnancial institution can be resolved in an orderly fashion.
Notes
1. The role of the LLR has been clearly recognized and analyzed since the days of Thornton
(1802/1939) and Bagehot (1873). For a summary of these rules, see Humphrey (1989); for a
contrasting view, see Goodhart (1999).
2. See Brave and Genay (2011) for a description of these programs.
3. Ashcraft et al. (2010) provide a compelling alternative explanation for the relatively limited
borrowing fromthe primary credit DW. US depository institutions had access to a lower cost
government-sponsored liquidity backstop: The Federal Home Loan Bank System (FHLBS).
Indeed, the FHLBS remained the largest lender to US depository institutions until the fall of
2008.
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4. Swaps were arranged with the Reserve Bank of Australia, the Banco Central do Brasil, the
Bank of Canada, Danmarks Nationalbank, the Bank of England, the European Central Bank,
the Bank of Japan, the Bank of Korea, Banco de México, the Reserve Bank of New Zealand,
Norges Bank, the Monetary Authority of Singapore, Sveriges Riksbank and the Swiss
National Bank. Those arrangements terminated on February 1, 2010, but some were
re-established temporarily in May 2010.
5. Cecchetti (2009) goes on to note other possible explanations for the decline in the spread.
6. The totals do not include subsidies to Bear Stearns, Citi, Bank of America or AIG.
7. This does not take into account the TARP program that required all of the largest US banks
to accept an infusion of government equity capital.
8. The relationship between the Fed and the primary dealers is governed by the Primary Dealers
Act of 1988 and the Fed’s operating policy, “Administration of Relationships with Primary
Dealer”.
9. This point was made eloquently by Paul Tucker, former Deputy Governor of the Bank of
England, in a speech at Yale University on August 1, 2014.
10. Of course, Tier 2 capital was never relevant as going-concern capital and provided no real
constraint on institutions taking greater leverage.
11. Banks outside the USA and US investment banks may have also understated their risks by
crafting internal models that could be used for regulatory purposes. The USA had delayed
adoption of Basel II, and after the crisis erupted it became irrelevant.
12. This constraint did not apply, however, to investment banks. Moreover, the Fed actively
sought to eliminate the leverage ratio.
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About the authors
Robert A. Eisenbeis is Vice Chairman of Cumberland Advisors and former Executive Vice
President and Director of Research at the Federal Reserve Bank of Atlanta.
Richard J. Herring is Jacob Safra Professor of International Banking at the Wharton School of
the University of Pennsylvania, and Founding Director of the Wharton Financial Institutions
Center. Richard J. Herring is the corresponding author and can be contacted at: herring@
wharton.upenn.edu
For instructions on how to order reprints of this article, please visit our website:
www.emeraldgrouppublishing.com/licensing/reprints.htm
Or contact us for further details: [email protected]
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