Question

3) Between February 2008 and Summer 2009, the Fed supplemented its open market operations with a greatly expanded program of direct lending (both overnight and short term 28 and 84 day loans) to commercial banks, investment banks, brokerage and primary dealer units of bank holding companies. It also agreed to accept a wider range of short-term securities (instead of accepting only T-Bills) as collateral on these loans and even initiated a program to buy commercial paper from money market funds. Explain why the Fed created all these extraordinary direct lending facilities instead of simply relying on traditional open market purchases of Treasury securities. 4 pts

4) As conditions in short term financial markets improved by summer of 2009 the Fed closed down its lending under these programs mentioned in Q3 above. However, throughout the next 4 years the Fed increased substantially its purchases of longer term mortgage backed securities and Treasury notes from banks in a series of 3 “Quantitative Easing” (QE) Programs.

A) Assume that both lender & borrower confidence levels start to return to normal and financial and physical investment levels start to rise much more strongly in the next 12 months than in the last few years. What potential problems will the extraordinary growth in banks’ reserve deposits and in the size of the Fed’s portfolio of longer term Treasury and Mortgage backed bonds that has resulted from 3 rounds of Quantitative Easing create then for the Fed? 4pts

B) What relatively untested policy tools will help the Fed deal with this problem? Explain. ( Hint: you may wish to look at www.federalreserve.gov then click monetary policy…then Policy Normalization: principles and Plans) 4pts.

Answer 1

3)

The economic crisis of 2008 was one of the biggest downturn the US economy faced after the great depression. The experts have pointed out many reasons for the crisis among which the most important was the subprime mortgage crisis that leads to the bankruptcy of many financial institution that forced the economy into deep recession.

At the beginning of the twenty first century the US federal government took the policy to promote home ownership to those with income below median. The government forced various financial institutions to extend more loans to those with low and medium income. Many financial institutions offered the loan at lower down payment and without proper scrutiny of the borrower. The easy available loans and the federal government policy rises the demand for the housing resulted in the rising housing prices in 2001 to 2005.

To mandate the government policy HUD forced the two GSE financial institution to offer loans to low and middle income people. These tow institution also bought many mortgages from other financial institutions. Knowing that the risk of the loan can be passed on to these institutions the banks made subprime mortgage loans to many borrowers. The HUD policy also mandates the institution to lower their down payment so that many people with relative lower income can have access to homes. On the other hand, the Fed expansionary monetary policy kept interest rate at historically low levels. This increases the attractiveness of the adjustable rate mortgages. All this things decreases the credit standards between 1995 and 2005.

All of these factors increase the demand for housing and their prices. Increasing number of subprime loans put an upward pressure to the default rate. Also the ARM loans interest rate reset and increases the monthly payment. These two factors force the borrower to default on their loans and thus the house price began to fall at the end of 2006.

Thus, at the time the economy began collapsing the interest rate was too low to decrease. On the other hand, the bad loans makes the financial instituion skeptic about future loans. Thus though simple open market operation injects enough excess reserve fails to generate additional loans and thus expand money supply. Therefore, the Fed has to take other policies to lift the economy from the crisis.