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Remember The Global Financial Crisis?! – Response to the Crisis

Weak Fire Fighting Tools: Capital and Resolution

Capital

  • No Treasury, FDIC, or Fed authority to inject capital

Resolution Authority

  • FDIC could safely wind down failing banks but could not wind down complex banks or shadow banks

 

Weak Fire Fighting Tools: Liquidity

Existing

  • Discount window lending to commercial banks

Emergency Authorities

  • 13(3) authority to lend to non banks in “unusual and exigent circumstances”
  • No authority to purchase financial assets other than Treasuries and Agencies

 

Weak Fire Fighting Tools: Guarantees

Existing

  • FDIC-insured deposits up to $100k

Not Included

  • Deposits above $100k, business transaction accounts, foreign deposits, repo, commercial paper for banks
  • Any liabilities of shadow banks

Emergency Authorities

  • FDIC’s systemic risk exception
  • Treasury’s Exchange Stabilization Fund

 

“On the eve of the crisis, our financial capacity was strong, but our firefighting tools were weak.”

Policy Considerations

  • The reality of operating in extreme uncertainty
  • Hard to know what works; a lot of it is about confidence
  • We were living with the constant and acute fear that the crisis would get away from us
  • Our strategy was ultimately to decide to do too much, rather than risk doing too little

 

The Framework for Crisis Resolution

Fiscal

  • Stimulus large relative to fall in private demand Quick and sustained

Monetary

  • Negative real rates
  • Sustained to help facilitate deleveraging

Financial

  • Classic lender of last resort provision of liquidity
  • Guarantees
  • Support for funding markets
  • Capital
  • Resolution and restructuring

 

What We Did: Letting it Burn

  • Standard monetary policy: lowered interest rates aggressively
  • Tried to get liquidity into the banking system by reducing the stigma of the discount window
  • Liquidity swaps for foreign central banks
  • Fiscal stimulus through modest tax rebates…
  • But didn’t lend beyond banks
  • We did not step in to finance the securities the market didn’t want to finance
  • And we allowed the weaker non-banks to fail
  • More than two dozen mortgage lenders failed, including New Century in April 2007

 

What We Did: Early Escalation

  • Broke the line past banks—lent directly to nonbanks PDCF, TSLF, Bear Stearns
  • Went to Congress for Fannie/Freddie bazooka, prepared for war

All this helped slow the burn

 

What We Did: Breaking the Panic

  • Dramatically expanded liquidity into critical markets (CP and ABCP) and shadow institutions
  • Provided additional support to systemic institutions: AIG, Citigroup, and Bank of America
  • Provided guarantees to $3.4 trillion money fund industry and the entire banking system
  • Injected capital into more than half of the banking system by assets
  • Deployed unlimited central bank swap lines to support the global system
  • Provided bridge financing to major auto companies

 

Triage in a Panic

  • How do you decide which firms to save and which to allow to fail?
  • How should you balance concerns about moral hazard with the risk of accelerating a run on the financial system?
  • When should you impose haircuts on bank creditors and when should you guarantee them?

 

From Lehman to AIG to WaMu

In a period of four weeks in September 2008, the United States:

  • Put Fannie and Freddie into conservatorship, guaranteeing their creditors but forcing their equity holders to absorb losses.
  • Helped encourage the acquisition of a failing investment bank (Merrill Lynch) by Bank of America.
  • Failed to find a buyer for Lehman Brothers, another failing investment bank.
  • Acted to prevent the failure of a large global insurance company, AIG.

Imposed losses on the creditors of a large failing bank (WaMu) in the context of facilitating its merger with JP Morgan.The pressures that brought all these firms to the brink of collapse were symptoms of the broader financial panic and deepening recession. But the losses imposed on Lehman’s and then WaMu’s creditors accelerated the panic, dramatically intensifying the crisis.

 

Fog of War, Moral Hazard, Politics

  • Why such a disparate, inconsistent, seemingly erratic response?
  • Was it fog of war, concern about moral hazard, fear of political opposition, lack of appreciation for the fragility of the financial system, lack of creativity, limitations on authority?

Mostly it was the limitations of authority

  • The Fed could not lend to an institution that was not a bank, except under limiting conditions
  • In the absence of a willing buyer, the Fed did not have the authority to lend on a scale that would save Lehman. Just like we did not have the authority to save Bear on our own.
  • AIG, in contrast, had businesses of sufficient value that we could lend on a scale to prevent its collapse.

 

Haircuts and Runs

  • FDIC had emergency authority that allowed it to guarantee the creditors of a bank
  • In the case of WaMu, however, the FDIC chose not to use that authority
  • This added fuel to the fire, accelerating the panic, and spreading it to the broader banking system

The FDIC, to its credit, reversed course weeks later by:

  1. Facilitating a solution to Wachovia’s problems that would have protected its creditors
  2. Agreeing to guarantee new borrowing by bank holding companies

If you haircut creditors in a systemic panic, when all firms look vulnerable, you risk intensifying the crisis, and forcing broader interventions to prevent the collapse of the financial system

 

Resolution: What We Did

  • Powell doctrine to revive growth—fiscal, monetary, financial
  • $800 billion fiscal stimulus
  • Continued monetary stimulus: zero bound and quantitative easing
  • Coordinated global Keynesian response
  • Stress test to restore confidence and recapitalize the system
  • Expanded scope of backstop to credit markets
  • Hardened the guarantee of the banking system (BHCs and GSEs too)

 

The Stress Test: How and Why Did It Work?

  • Transparency, firm by firm, about losses in the extreme event.
  • Device for triage, for determining nationalization.
  • Tool for recapitalizing the financial system.
  • Helped maximize the chance that capital would come from the private sector.

 

The Stress Test Calmed Fears of Catastrophic Failure

Why did it work?

  • Loss estimates were credible.
  • We hardened the guarantees on liabilities.
  • Fiscal and monetary policy escalation got traction.

Confidence improved by global cooperation and massive mobilization of dollar-based financial support for EM.

“We put enough money in the window.”

Summary

  • Escalated slowly and messily
  • Eventually moved to overwhelming force
  • That wasn’t enough to prevent massive economic damage
  • Felt like a long time—but in the arc of history, we put out the financial fire and restored economic growth remarkably quickly
  • In some ways, did the opposite of the policy strategy in the Great Depression
  • Avoided “Sweden” (full nationalization) and “Japan” (drift and forebearance)

 

What Went Wrong? Home prices skyrocketed, people borrowed more than they could afford, and then millions lost their jobs

By the fall of 2009, nearly 9 million Americans lost their jobs and 1 in 5 mortgages were underwater; 2 million mortgages were in foreclosure, and another 7 million were at serious risk of foreclosure

 

Key Policy Constraints

We Could Not

  • Discharge homeowner debt in bankruptcy—“cramdown” legislation failed twice
  • Create a “Home Owners’ Loan Corporation”—exceptionally complicated and Congressional action was needed
  • Start another mortgage refinancing program—again, required legislation Undertake widespread mortgage debt forgiveness— Administration pursued targeted “principal reduction” but we couldn’t force FHFA to use its authority

We needed greater resources and authority to alleviate the pain of homeowners

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)

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Remember The Global Financial Crisis?! – Panic

Repo – A New Type of Banking

  • A sale and repurchase agreement (“repo”) is a deposit of cash at a “bank” which is short-term, receives interest, and is backed by collateral. Depositor takes legal ownership of the collateral.
  • Carved out of Bankruptcy Code; unilateral termination by non-defaulting party.
  • Two types of repo: bilateral and tri-party. Both types caused trouble in the crisis.
  • Collateral may be “rehypothecated”.
  • Collateral value typically exceeds the amount of cash deposited, this is called a haircut For example, deposit $98, receive a bond worth $100—a 2% haircut.

 

Lehman Brothers

  • As of March 2008, the situation at Lehman Brothers was just as precarious as it was at Bear Stearns, and perhaps Lehman only survived longer than Bear because some shady accounting made them look better than reality.
  • After the government-supported rescue of Bear Stearns in March 2008, the Federal Reserve created the Primary Dealer Credit Facility (PDCF) to provide liquidity to non-bank dealers like Lehman.
  • The PDCF was critical to Lehman’s survival over the next six months, as they tried to get rid of their worst assets and improve their capital and liquidity position.

 

Lehman Weekend – September 2008

  • On September 10, 2008, Lehman reported $28 billion in shareholder equity, $4 billion higher than a year earlier. But it was simply impossible to know if this equity cushion was accurate.
  • For one thing, Lehman reported $54 billion in real estate assets. Some market participants thought the true value was closer to half of that, which would effectively wipe out Lehman’s equity.
  • At the same time, Lehman’s counterparties in derivatives, commercial paper, and repo were pulling back, shortening terms, and demanding more collateral.
  • Most notably, JP Morgan, Lehman’s clearing bank in the tri-party repo market, demanded $5 billion and received $3.6 billion on 9/9, and demanded and received $5 billion on 9/12.

 

Lehman Weekend – September 12-14, 2008

  • Over the weekend of 9/12 – 9/14, the U.S. government tried unsuccessfully to arrange a private rescue for Lehman.
  • The government insisted there would be no public money spent on the rescue.
  • Bank of America chose to buy Merrill Lynch instead of Lehman.
  • On Saturday, Barclays agreed to buy Lehman, but by Sunday the deal was effectively blocked by UK regulators.
  • Without sufficient liquidity to operate the next day, and otherwise out of options, Lehman filed for bankruptcy early in the morning on September 15.

 

MMMFs

  • Money-Market Mutual Funds (MMMFs) are a specific type of investment company that is only permitted to own a narrow range of securities. In return for accepting this narrow investment range, they had the right (at this time) to report “stable values” for their share prices.
  • On September 16, 2008, Reserve Primary Fund “broke the buck” due to exposure to Lehman Brothers commercial paper. This led to a run on many MMMFs – mostly by institutional investors – and then quickly to an explicit guarantee from the U.S. government.
  • We really should have seen this coming – but we did not. Because MMMFs had significant problems in August 2007 as a result of the Asset-Backed Commercial Paper (ABCP) runs.
  • McCabe (2010) shows that MMMFs assets under management grew during the ABCP runs of 2007, but that is because the implicit promises of many sponsors were honored: 43 MMMFs were bailed out by their sponsors/fund-families. This level of support was unprecedented.
  • In September 2008, this support was not possible, and the resulting runs transferred more than $400 billion from prime MMMFs (which support many components of private finance) to government-only MMMFs (which do not).

 

AIG

Main weaknesses:

  • Credit-default-swap (CDS) mark-to-market losses and collateral calls.
  • Cash collateral investment losses in securities lending business.
  • Funding pressure in CP and repo.
  • Ratings downgrade triggers additional collateral calls.
  • Liquidity puts on CDOs.

After Lehman, markets are in turmoil and no private rescue is possible.

Fed led rescue of $85 billion, later supplemented by more from Fed and TARP.

 

The Run on Repo

  • $350 billion of short-term funding ran away from ABCP.
  • From MMMFs, about the same amount.
  • Combine these drains with uncertainty about the subprime exposure on balance sheets, and there is massive pressure on repo markets.
  • This pressure manifests in spreads (on underlying ABS), repo rates, and haircuts.
  • The statistical evidence in Gorton and Metrick (2012) confirms a significant relationship between LIBOR-OIS and ABS spreads.
  • Regression evidence also suggests that the main driver of haircuts was uncertainty about future spreads on the ABS collateral.

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)