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Understanding the Policy Response to the Financial Crisis

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Understanding the Policy Response to the Financial Crisis Powered By Docstoc
					 Understanding the
Policy Response to
the Financial Crisis
Macroeconomic Theory Honors
                     EC 204
Key Problems in the Crisis
   Bank Solvency
         Declining home prices and rising mortgage defaults put
          banks in danger of insolvency.
         Policy Response: TARP and Regulatory Reform.

   Credit Market Illiquidity
         Failure of major financial institutions (Bear Stearns,
          Lehman, AIG, GSEs) precipitates freezing-up of credit
          markets.
         Policy Response: Fed gets creative: TAF, TSLF, CPFF,
          AMLF, TALF, etc…
Bank Solvency
   It’s all about balance sheets…
                        Firstbank 's Balance Sheet
                        Assets                Liabilities
            ________________________________________________
                                       |
            Reserves    $200           |Deposits       $1,000
                                       |
            Loans       $800           |
                                       |



                        Secondbank 's Balance Sheet
                        Assets               Liabilities
            ________________________________________________
                                      |
            Reserves    $160          |Deposits       $800
                                      |
            Loans       $640          |
                                      |
Bank Solvency
   More accurate representation of a typical bank…Owners
    have to put up some equity!


                     Assets             Liabilities and OwnersÕEquity
            ________________________________________________
                                     |
            Reserves        $200     |Deposits                    $750
                                     |
            Loans           $500     |Debt                        $200
                                     |
            Securities      $300                        s
                                     | Capital (OwnerÕ Equity)    $50
Bank Solvency

   Banks make money through leverage.
   Leverage ratio = Assets/Bank Capital.
   Example has leverage ratio of 1000/50 = 20.
   For every dollar of capital, the bank has 20 dollars
    of assets and 19 dollars of deposits and debt.
   Implication: Bank can lose much of its capital
    quickly.
Bank Solvency

   Consider a drop of 5% in value of its assets.
   This represents $50.
   But this is the total value of the bank’s capital.
   A leverage ratio of 20 leads mean a 5% fall in asset
    value will wipe out the bank’s capital!
Bank Solvency: Transmission
of the Crisis
   Securities held by banks included mortgage-backed
    securities and other risky assets. As defaults on these
    securities rose, bank capital came under pressure:

                     Assets             Liabilities and OwnersÕEquity
            ________________________________________________
                                     |
            Reserves        $200     |Deposits                    $750
                                     |
            Loans           $500     |Debt                        $200
                                     |
            Securities      $300                        s
                                     | Capital (OwnerÕ Equity)    $50
Bank Solvency: Transmission
of the Crisis
   Insurance contracts on these securities bring additional
    parties into the crisis. Debt of the troubled financial
    institutions in turn becomes a problem for other investors and
    institutions…
                     Assets             Liabilities and OwnersÕEquity
            ________________________________________________
                                     |
            Reserves        $200     |Deposits                    $750
                                     |
            Loans           $500     |Debt                        $200
                                     |
            Securities      $300                        s
                                     | Capital (OwnerÕ Equity)    $50
Bank Solvency - The Policy
Response

   As Treasury Secretary Geithner has said: “Its all
    about capital, capital, capital…”
   (1) TARP - Troubled Asset Relief Program ($700B)
       Phase I: Putting capital directly into the banks
       Phase II: Entice investors to buy the bad assets
   (2) Regulatory reform
   (3) Support housing market - expand GSE lending,
    loan modification programs, tax incentives
Bank Solvency - The Policy
Response: TARP

   TARP I: Add to capital
   TARP II: Remove bad securities/add some capital

                    Assets             Liabilities and OwnersÕEquity
           ________________________________________________
                                    |
           Reserves        $200     |Deposits                    $750
                                    |
           Loans           $500     |Debt                        $200
                                    |
           Securities      $300                        s
                                    | Capital (OwnerÕ Equity)    $50
Bank Solvency - The Policy
Response: TARP II

   TARP II: Deals with two sorts of troubled assets

       Risky home loans:
         FDIC will lend 85% of cost to investor, additional 7.5% in Treasury
        equity, investor comes up with just 7.5% equity. Government and
        investor split any capital gain on asset. Government gets interest on
        loan. Loan is “Non-recourse.”

       Risky mortgage-backed securities:
        Asset managers provide 25% equity stake, Treasury matches this with
        equal amount of equity, and provides loan for remaining 50%. Loan is
        non-recourse.

       Some TARP funds also to be used as credit protection to expanded
        Federal Reserve lending facility for ABS.
Bank Solvency - The Policy
Response: Regulatory Reform

   Create a Systemic Regulator
   Transparency for derivatives and other exotic securities
   Oversight of hedge funds, insurance companies, money market
    funds
   Capital ratios
   Ability to takeover financial companies that present dangers to the
    system

   Intended to provide better understanding of overall risk to financial
    system and to ensure adequate capital to cover potential risks.
Bank Solvency - The Policy
Response: Regulatory Reform

   Again, can use the simple balance sheet to understand how such
    reforms would work…


                     Assets             Liabilities and OwnersÕEquity
            ________________________________________________
                                     |
            Reserves        $200     |Deposits                    $750
                                     |
            Loans           $500     |Debt                        $200
                                     |
            Securities      $300                        s
                                     | Capital (OwnerÕ Equity)    $50
Bank Solvency - The Policy
Response: Housing Market

   Attempts to support housing market and stem rise in default rate
    on mortgages:
       Expand GSE lending
       Loan modification programs
       Tax Incentives
       Fed purchases of long-term securities -- bring down mortgage rates


   Evidence that mortgage market has responded, as rates continue
    at low levels. But high unemployment represents a strong
    headwind.
Credit Market Illiquidity
   Federal Reserve has responded in three key
    ways to the breakdown in the credit system.
       Traditional role as lender of last resort - both
        using OMO and new approaches.
       Provision of liquidity directly to borrowers and
        investors in key credit markets.
       Support for specific institutions (AIG, Citi, BoA).
Credit Market Illiquidity
   Lender of last resort:
       Cut federal funds rate from 5.25 to near zero
       Extended repayment period for discount window
        borrowing
       Term Auction Facility - all 7000+ commercial
        banks eligible -- broader types collateral
       Facilities for lending to primary dealers - lengthen
        term and allow broader types of collateral
Credit Market Illiquidity
   Provision of credit to markets:
       Commercial paper market
       Money market mutual funds
       Asset-backed loan markets -- consumer, credit
        card, auto, student, business loans (non-
        recourse) -- Expanded to include GSE debt, other
        MBS and L.T. Treasuries
Credit Market Illiquidity
   Loans for Specific Institutions:
       Begun with Bear Stearns workout
       AIG
       Citi
       BoA
Credit Market Illiquidity
   Implications of Fed policy response:
       Balance sheet of Federal Reserve has changed
        drastically
       Both composition and size
       Banks holding large amounts of excess reserves
       Huge decline in money supply multiplier
    The Fed’s Balance Sheet:
    July 2007
   Assets                                          Liabilities
   Treasury Securities   $790.6            Currency                         781.4


   Repurchase Agreements      30.3                   Commercial Bank Reserves
    16.8

   Loans                             0.2             U.S. Treasury Deposits
    42.4                                     and Official Foreign Liabilities


   Foreign Exchange        20.8            Other                               5.7

   Gold                     11.0           Capital                             34.1

   Other                             27.5

   Total Assets             880.4          Total Liabilities Plus Capital      880.4
    The Fed’s Balance Sheet:
    March 2009
   Assets                                             Liabilities
   Treasury Securities        $422.7                  Currency
    898.0


   Mortgage-Bkd Securities           237.0            Commercial Bank Reserves
    795.7

   Loans                             913.0            U.S. Treasury Deposits
    278.0                                                       and Official Foreign
    Liabilities


   CB Liquidity Swaps        328.0           Other factors Absorbing Reserves
                                                                            1307.3

   Gold                       11.0           Capital and other liabilities     55.0
         Total Assets of the Federal Reserve
Since the beginning of the financial market turmoil in August 2007,
the Federal Reserve's balance sheet has grown in size and has
changed in composition. Total assets of the Federal Reserve have
increased significantly from $869 billion on August 8, 2007.
         Selected Assets of the Federal Reserve
The increase in the size of the Federal Reserve's balance sheet has
been accompanied by a change in the composition of the assets held.
The level of securities held outright has declined, on net, while the
various liquidity facilities have added a host of other assets.
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    Credit Extended through Federal Reserve Liquidity
                        Facilities
Among the liquidity facilities, the largest changes in assets have resulted
from credit extended through the Term Auction Facility, the Commercial
Paper Funding Facility, and the central bank liquidity swap lines.
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          Selected Liabilities of the Federal Reserve
On the liabilities side of the Federal Reserve's balance sheet, the amount of
currency increased somewhat, but reserve balances (deposits of depository
institutions) have increased dramatically, as have Treasury's deposits with
the Federal Reserve.
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