Question

A. During the 2008 financial crisis and the subsequent recession, how did major US banks respond to the actions of the Federal Reserve?

B. Discuss how those monetary policy actions affect US businesses and households?

C. Explain how the actions of the Federal Reserve were both similar and different to what happened in the Great Depression?

Answer 1

(A) The Federal Reserve and other organs of the US Government responded by flooding the markets with money and other liquidity, reducing interest rates, providing extraordinary assistance to major financial institutions, increasing Government spending, and taking other steps to provide financial assistance to the markets.

When real estate prices began to collapse in the second half of 2007, some investors started shorting real estate markets. The leveraged credit market dried up and billions of dollars of pending buy-out deals collapsed. Billions more in mortgage-backed securities (MBS) and collateralised debt obligations (CDOs) were written down. Several CEOs of major US financial institutions lost their jobs. Others saved their jobs by obtaining capital infusions from sovereign wealth funds, hedge funds, private equity funds and other pools of risk capital.

Real estate prices continued to collapse in early 2008, resulting in billions of dollars of additional CDO markdowns, the collapse and rescue of Bear Stearns, and extraordinary measures by the Federal Reserve to de-stigmatise the discount window for commercial banks and make emergency liquidity facilities available to the large investment banks. As the Federal Reserve responded to the crisis by reducing interest rates and flooding the market with money, the value of the dollar plummeted relative to other currencies. By the summer of 2008, the price of oil, agricultural products and other commodities – which are generally denominated in US dollars – soared almost in inverse proportion to any decline in the dollar.

The interbank credit markets seized up. The market value of US financial institutions, especially US mortgage giants Fannie Mae and Freddie Mac, [1] collapsed throughout the summer. The US Government was particularly concerned about Fannie Mae and Freddie Mac because of their size and importance to the US housing market. On 30 June 2008, these two institutions had combined liabilities of over US$5.5 trillion, on a combined total regulatory capital base of approximately US$100 billion. Moreover, a widespread perception existed that their obligations were backed by an implicit guarantee from the US Government. The US Treasury asked Congress for a blank cheque – the power to inject unlimited amounts of additional capital into Fannie and Freddie, arguing that if the market knew that the Treasury had a ‘bazooka’ instead of a ‘squirt gun’, it was substantially less likely that the Treasury would be required to provide any financial assistance at all. Congress gave the Treasury that authority on 30 July 2008. [2]

The market value of Fannie and Freddie, however, continued to collapse throughout August. The Government determined that many of their assets needed to be written down, and concluded that they would not be able to plug the hole by raising additional capital from the capital markets. Alarmed that a failure of Fannie or Freddie could pull down the rest of the financial system, the US Treasury decided to exercise its new ‘bazooka’ authority on 6 September 2008 – approximately five weeks after receiving it – concluding that such action would calm the financial markets. The Government put Fannie and Freddie into conservatorship and pledged to inject up to US$200 billion of new capital in the form of senior preferred stock and warrants. The terms of the transaction resulted in an immediate dilution of 80 per cent of common shareholder value, and a sharp drop in the value of junior preferred stock. The value of Fannie’s and Freddie’s senior and subordinated debt, however, soared because it was senior to the Government’s investment.

Rather than calming the markets, the ‘rescue’ of Fannie and Freddie may have added fuel to the worldwide financial panic that continued throughout September and October. In any event, on the following weekend Lehman Brothers and AIG collapsed, and Merrill Lynch was bought at what was then thought to be a fire sale price by Bank of America. The Federal Reserve exercised its emergency powers under section 13(3) of the Federal Reserve Act to rescue AIG, but the Government allowed Lehman Brothers to fail. The terms of the AIG rescue were similar to Fannie and Freddie – the Government received senior preferred stock and warrants, resulting in an immediate dilution of 80 per cent of common shareholder value, and a sharp drop in the value of junior preferred stock. But the value of AIG’s senior and subordinated debt soared, and the counterparties on its credit default swaps and other financial contracts were made whole.

After the AIG collapse, the US Treasury asked Congress for express authority to invest up to US$700 billion in toxic mortgage and other assets in order to clean up the balance sheets of the US financial sector. While the Treasury’s request for what was later called the Troubled Asset Relief Program (TARP) was pending before Congress, Washington Mutual (the largest thrift in the United States) failed and was sold to JP Morgan, and Wachovia was rescued by Citigroup and then Wells Fargo. Commodity prices, which had spiked during the summer as the dollar fell, reversed course and began to fall as the market began to fear a depression more than a weakened US dollar.

The House rejected TARP on 30 September 2008, resulting in the largest one-day drop in the Dow Jones Industrial Average of 778 points, or US$1.3 trillion in market value. The Senate quickly passed a bill during the first week of October, the House reconsidered its action, and President Bush signed the bill into law on the same day the House approved it.

During the second week in October, the Treasury announced its Capital Purchase Program (CPP), which involved making investments of up to US$250 billion in the preferred stock of US insured depository institutions and their holding companies. The US Federal Deposit Insurance Corporation (FDIC) temporarily increased deposit insurance coverage to US$250,000 per person per institution, as well as announcing the creation of the Temporary Liquidity Guarantee Program (TLGP), which would provide credit support to debt capital market issuances and non-interest bearing transaction accounts.

The next several weeks saw a stampede of US financial institutions seeking to acquire insured depository institutions in the United States in order to qualify for CPP money. The US Government announced an additional US$20 billion in capital support and a related US$301 billion asset guarantee programme for Citigroup in late November. The US Government announced a similar programme of extraordinary support for Bank of America in early 2009 to facilitate BofA’s acquisition of Merrill Lynch, which continued to haemorrhage value between signing and closing. Similar failures, rescues and financial assistance programmes were announced throughout 2009 after the height of the panic receded.

The financial panic of 2008, and the economic uncertainty created by various Government actions taken or feared subsequently, have resulted in the worst recession since the Great Depression. It is far worse than the shrinkage caused by the US savings and loan crisis of the late 1980s and early 1990s. Unemployment has persisted for nearly a year at close to ten per cent, and many believe that the percentage of the normal workforce out of work is actually much higher, possibly as high as 17 per cent, because of how US unemployment figures are calculated. They include people who are actively searching for employment, but not those who have become so discouraged that they have given up searching for a job altogether or those who have obtained part-time employment. Fears of future inflation are rampant, while the risk of deflation in the near term is not out of the question.

Meanwhile, the US continues to be in the midst of the largest wave of bank and thrift failures since the US savings and loan crisis ended in the early 1990s. The FDIC resolved over 25 failed institutions in 2008, 140 in 2009 and more than 100 as of July 2010. As of 31 March 2010, the FDIC had nearly 780 insured institutions on its ‘problem list’, with over US$430 billion in aggregate assets, [3] suggesting that it may be forced to resolve many more closed institutions before the current wave of failures is over. At the same time, the Deposit Insurance Fund, which is used to resolve failed institutions, has fallen to a negative balance.

(B)  Housing demand, residential construction, and home prices have all continued to fall so far this year. Following a decline at an annual rate of 43 percent in the second half of 2007, sales of new homes decreased at an annual rate of 32 percent in the first five months of 2008. However, sales of single-family existing homes, which dropped at an annual rate of 26 percent in the second half of last year, have been about unchanged this year. Moreover, pending home sales, which provide a glimpse of the pace of existing home sales in the months ahead, on net leveled out in the spring, hinting at some stabilization in transactions in the resale market. Still, for the overall housing sector, the challenging mortgage lending environment and the concerns of prospective homebuyers about further declines in house prices are likely continuing to depress housing demand.

As new home sales have continued to decline, homebuilders have struggled to work down their substantial overhang of unsold houses. As a consequence, residential construction activity has been pared further this year. In the single-family housing sector, new units were started at an annual rate of 674,000 in May--down more than 13 percent this year and roughly 60 percent since the peak reached in the first quarter of 2006. Despite these deep production cuts, the stock of unsold homes has moved down only 20 percent from its record high in early 2006. When evaluated relative to the three-month average pace of sales, the months' supply of unsold new homes has continued to rise and stood at 10-1/2 months in May. In the multifamily sector, starts averaged an annual rate of about 320,000 units during the first five months of 2008, a level of activity at the lower end of its range in the past several years. All told, the decline in residential investment trimmed the growth rate of real gross domestic product (GDP) about 1 percentage point in the first quarter of 2008 and appears to have held down the second-quarter growth rate by about the same amount.

After having posted robust gains in the middle of last year, real business fixed investment lost some steam in the fourth quarter and eked out only a small advance in the first quarter of 2008. Economic and financial conditions that influence capital spending deteriorated appreciably late last year and early this year: Business sales slowed, corporate profits fell, and credit conditions for some borrowers tightened. In addition, the heightened concern about the economic outlook may have caused some firms to postpone or abandon plans for capital expansion this year.

Real business outlays for equipment and software were flat in the first quarter. Growth in real spending on high-tech equipment and software slowed to an annual rate of about 10 percent, down from the 13 percent pace recorded in 2007. In addition, business spending on motor vehicles tumbled. Investment in equipment other than high tech and transportation dropped at an annual rate of 3-3/4 percent in the first quarter after a smaller decline in the previous quarter. The available indicators suggest that capital spending on equipment and software fell in the second quarter: Business purchases of new motor vehicles reportedly slipped again; shipments of nondefense capital goods (adjusted to exclude both transportation items and goods that were sent abroad) were lower, on average, in April and May than in the first quarter; and the tone of recent surveys of business conditions remained downbeat.

Nonresidential construction activity, which exhibited considerable vigor in 2006 and 2007, slowed appreciably in the first quarter of 2008. Real outlays for new commercial buildings declined sharply in the first quarter, and increases in outlays for most other types of building stepped down. More-recent data on construction expenditures suggest that spending on nonresidential structures may have bounced back in the second quarter. However, deteriorating economic and financial conditions indicate that this rebound may be short-lived. In addition to the weakening of business sales and profits, vacancy rates turned up in the first quarter (the latest available data). Moreover, the financing environment has remained difficult; bank lending officers have reported a significant tightening of terms and standards for commercial real estate loans, and funding through the commercial mortgage-backed securities (CMBS) market has continued to be extremely limited.

The sluggish pace of business investment in recent months is due in part to the weakening of domestic profitability and the tighter credit conditions faced by some businesses. In the first quarter of 2008, total economic profits for all U.S. corporations were down slightly from their level four quarters earlier; a nearly 20 percent rise in receipts from foreign subsidiaries was not sufficient to offset a 2-1/2 percent fall in domestically generated profits. Although profits as a share of output in the nonfinancial corporate sector have declined in recent quarters, they remain well above previous cyclical lows. For companies in the S&P 500, operating earnings per share fell 17 percent over the year ending in the first quarter. This decline was more than accounted for by plummeting earnings at financial firms, which reported large write-downs on leveraged loans and mortgage-related assets.⁶ For nonfinancial firms in the S&P 500, earnings rose nearly 11 percent over the four quarters ending in the first quarter of 2008; energy-sector firms had a strong 31 percent increase in earnings, whereas earnings at other nonfinancial firms rose 4-1/2 percent.

(c)

Faced with economic contraction, deflation, and tanking markets, the Federal Reserve resorted to unorthodox means to lower interest rates and pump liquidity into the market.

Quantitative easing of 2008-09? No. That was U.S. monetary policy in 1932, as the central bank bought $1 billion in Treasury securities over a period of two quarters and brought down interest rates dramatically. Had this policy remained in place for longer, or had the Fed adopted something like forward guidance,Michael Bordo and Arunima Sinha conclude that "the Great Contraction would have been attenuated significantly earlier." In their new study, A Lesson from the Great Depression That the Fed Might Have Learned: A Comparison of the 1932 Open Market Purchases with Quantitative Easing (NBER Working Paper No. 22581), the researchers use the policy action in 1932 as a prism through which to analyze the effects of the Fed's more recent quantitative easing (QE) policies.

The researchers observe some similarities between the economic circumstances of 1929-32 and 2008-09, though the magnitude of the problems differed greatly. Unemployment in both eras was high and rising by standards of the day (25 percent in 1932, 8.7 percent in March 2009) and the economy was contracting (down 20 percent in 1932, 4 percent in March 2009). In both periods, Treasury yields were historically low, and Congress and the public were eager for the Fed to act. The size of the Fed's intervention in 1932—bond purchases equal to about two percent of GDP, or $16 billion in today's dollars—was roughly proportionate (in terms of GDP) to the purchases of long-term Treasury securities in the first QE program, between November 2008 and March 2009.

There were some key differences, however. The U.S. was on the gold standard in 1932; in 2008 exchange rates floated freely. The Fed did not announce its 1932 intervention, nor did it give any indication of its duration or size. This was a significant difference from the situation in 200809, when the central bank delivered a drumbeat of communications as the Great Recession deepened. In 1932, the Fed's portfolio was more heavily concentrated in medium-term Treasury notes relative to bonds than it was in 2008-09. Financial markets were also much more segmented than they were 80 years later. The segmentation was manifested in the fact that it was more difficult for households to access the markets for Treasury notes and bonds compared to institutional investors. This market segmentation meant that investors couldn't easily substitute one type of government bond for another. Finally, the Fed used other unconventional policy tools in the 2008-09 period, such as the purchase of mortgage-backed securities, which it did not use in 1932.

Despite these differences, the researchers argue that the Fed's Depression-era moves constitute an experiment in monetary policy that can be used to analyze the first QE program. Those moves allowed the Fed to engineer dramatic drops in interest rates in only two quarters. The interest rate on Treasury bills fell 90 basis points, yields on Treasury certificates and notes dropped 114 basis points, and Treasury bond rates declined 42 basis points.

The researchers simulate what might have happened in 1932 had the Fed announced the size and duration of its securities pur-chases ahead of time and held on to those securities for an additional two quarters before selling them off in the following two quarters. Under that scenario, output growth would have risen 0.5 percentage points. This exercise suggests that the Fed's 1932 purchases were effective in reducing the risk premium for bond investors and thus bond yields.

Since the markets for Treasury securities today are far less segmented than they were in 1932, institutional investors are in a much better position to arbitrage away the difference between returns on long- and short-term bonds. As a result, the Fed in 2008-09 used other unconventional tools, such as the issuance of forward guidance, to influence interest rates. In response to these Fed announcements, yields on 10-year government bonds fell 107 basis points during the period, by one measure, while five-year Treasury notes dropped 74 basis points, and one-year notes decreased 25 basis points.