The best in Sports and Finance

Posts tagged “FED

Remember The Financial Crisis?! – What have we learned?

The economic costs of the crisis were brutal

  • Real GDP fell more than 4% and took more than 3 years to return to the pre-crisis peak
  • Public debt has increased by more than 30% of GDP, mostly due to cyclical forces
  • At market bottom, $15 trillion in household wealth had disappeared

But these costs would have been much greater in the absence of an effective financial rescue

 

Policy Failures – Before and During the Crisis

Failures Ex Ante

  • Home equity was too thin
  • Capital cushions were too thin—and, more importantly, too narrow in scope
  • Too much issuance of shortterm, deposit-like liabilities, without regulatory constraints on leverage and without access to the safety net

Failures In the Crisis

  • We escalated too late, mostly because of limitations of authority
  • Fiscal policy turned too tight too soon
  • Mortgage restructuring authority, resources, and incentives were too weak

 

“Too big to fail” is less of a problem

  • The largest institutions are subject to a systemic capital surcharge
  • The FDIC has resolution authority to manage the failure of systemic institutions
  • We imposed tougher concentration limits on the financial system
  • The Fed’s emergency lending authority has been curtailed, and the FDIC’s emergency guarantee authority has been eliminated

 

Unfinished Business

  • Lots of economic damage remains from the crisis
  • The housing finance system is still broken
  • Our firefighting tools are too weak
  • The regulatory oversight structure is a mess

 

Tough questions on housing finance

  • How do we balance the imperatives of mortgage accessibility and market stability?
  • Should we have mandatory down payment requirements? And how high should those down payments be?
  • What should the government’s role be in the new system? Guarantee should be explicit, limited in scope, more expensive—with greater role for private capital But government needs authority to step in during crisis
  • How do we transition to the new system?

 

Firefighting authorities are too weak

  • Our shock absorbers are thicker and broader than they were
  • But we will always need firefighting authorities
  • Guarantee authority is essential for breaking panics and for recapitalizing the system
  • The scope of the standing lender of last resort authority is still too narrow
  • We need more “break-the-glass” authority for the President

 

The costs of regulatory balkanization

  • There’s too much opportunity for regulatory arbitrage
  • Regulators and regulations are too slow to adapt to changing markets and institutions
  • The rules are too complex
  • There’s little accountability
  • There’s too much regulatory capture

 

Principles to govern a streamlined system

  • Functional specialization
  • More budgetary independence from Congress
  • Stronger enforcement
  • Better firefighting authority

 

Rule 01  – If you want peace, prepare for war

  • The extreme crisis is unimaginable ex ante
  • Manias are not preventable, and there’s no over-the-horizon radar for preempting panics and crashes
  • So design the system not to prevent failure, but to be safe for failure
  • This means you need strong shock absorbers

 

Rule 02 – Design the shock absorbers for the extreme crisis and apply them broadly

  • Impose capital, leverage, and funding requirements on bank-like institutions; systemic surcharge on the biggest
  • Place margin requirements on repo and derivatives
  • Design for the migration problem: Use the regulated system to impose limits on the shadow system Build in the ability to expand the perimeter of prudential regulation
  • Require thick down payments for home mortgages
  • Have clear accountability for the design and enforcement of these limits

 

Rule 03 – The supplemental arsenal of ex ante tools

  • Don’t let your banking system get too large relative to the size of your economy (size and concentration limits)
  • Don’t let your “banks” borrow too much in foreign currency
  • Transparency
  • Deterrence and enforcement

 

Rule 04 – Maintain strong financial capacity and a powerful firefighting arsenal

  • Shock absorbers will not save you from the risk of the extreme crisis, so you need firefighting tools and the capacity to use them
  • The key sources of financial strength are: Relatively low public debt levels A credible central bank, with a strong record on inflation
  • Your firefighting arsenal must include: Liquidity for vulnerable parts of the system Guarantee authority for banks and banklike institutions Capital and resolution authority

 

Rule 05 – When the fire starts, let it burn—but build a firebreak around the core

  • At the beginning of a crisis, there is a fog of diagnosis—idiosyncratic or systemic?
  • To get it right, let the fire burn—and let the system adjust
  • Escalate slowly at the beginning, but accelerate quickly when necessary
  • And set the perimeter of protection so that you capture the solvent and the systemic, but not the insolvent and the peripheral

 

Rule 06 – When it’s time to escalate, apply the Powell Doctrine

  • Use overwhelming force—fiscal, monetary, and financial Fiscal: as much as you can get Monetary: expansive throughout crisis and deleveraging Financial: liquidity, guarantees, capital, resolution
  • None of these are powerful enough to work in isolation
  • Together they must be powerful enough to remove risk of depression

 

Rule 07 – Plan for the long war

  • Crises that follow booms entail long periods of deleveraging
  • That makes growth weak and fragile
  • Need sustained period of monetary policy accommodation to keep real rates negative
  • And sustained fiscal support
  • Avoid applying the brakes too early

 

Rule 08 – Impose conditions on the rescue

  • Bagehot: Lend freely at a penalty rate
  • Ideally, limit the scope of the rescue to the core of the financial system
  • Price it to be valuable in the panic, but expensive when the panic breaks
  • No naked, unconditional guarantees
  • The guarantees should cover catastrophic risk, but not all risk
  • Put the non-viable firms into resolution
  • Accelerate restructuring and recapitalization of the core of the system to fuel the recovery
  • Do the hard stuff early and quickly

 

Rule 09 – Distinguish the systemic from the idiosyncratic

  • Faced with a systemic panic, do the opposite of what makes sense in a typical crisis
  • Rather than imposing haircuts, you have to guarantee liabilities
  • Rather than worrying about the potential costs of each specific intervention, you must try to limit the risk of broader failures and the greater costs they will entail
  • You have to be prepared to take more potential risk if you want to limit actual risk to the taxpayer
  • If you misdiagnose the systemic crisis as a normal crisis, then you will end up having to nationalize everything and socialize more risk

 

Rule 10 – Keep some perspective on moral hazard

  • You can’t design a financial system or an effective financial rescue that eliminates moral hazard risk—you can wound moral hazard but you can’t kill it
  • You can’t break a panic without creating moral hazard
  • In a systemic crisis, the failure of small firms can jeopardize the stability of the system
  • Without a firewall of guarantees around the core of the system, you won’t be able to get private capital to come in, and you won’t be able to allow failure and facilitate restructuring
  • Preserving ambiguity around when you escalate and how broad to extend liquidity support buys you some market discipline
  • Systemic capital surcharge and limits on size and/or consolidation are necessary

 

Conclusion – Accept the central paradox of financial crises

  • It cannot be morally responsible to allow depression in the hopes of deterring future risk-taking
  • What seems politically compelling in the moment is perilous and irresponsible
  • What seems unjust is just; what seems risky is prudent
  • You can’t solve the crisis by trying to fix the problems that caused the crisis; you have to solve the crisis first

 

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)


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)


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)


Remember The Global Financial Crissis?! – Anxiety (2)

Northern Rock: Narrative

Northern Rock – History

  • Northern Rock began in the nineteenth century as a mutually owned “building society”, with a business focused on serving its local community.
  • The bank went public in 1997 and grew at an annual rate over 20 percent for the next ten years, with total assets of 113.5 billion pounds, the fifth largest U.K. bank by mortgage assets, as of June 2007.
  • Northern Rock focused on prime lending, had minimal subprime exposure, and the U.K. housing market remained strong in the summer of 2007.
  • But rapid growth starting in 1997 outstripped the traditional deposit base, and the bank had to rely on non-traditional funding sources.

 

Repo – 2007

  • Over the summer of 2007, some of these nontraditional funding sources began to dry up, and efforts to organize a private rescue for the bank failed.
  • On 9/13/07, the BBC broke the news that Northern Rock had sought assistance from the Bank of England; the BoE granted that assistance the next morning. The run on retail-branch deposits began that day.
  • At the time of the run, full deposit insurance in the U.K. was capped at 2000 pounds, and then 90 percent up to 35,000 pounds.
  • Despite the public nature of the retail-branch run, the real story was a wholesale run that had intensified in the previous month.

 

Northern Rock – The Puzzle

“The real question raised by the Northern Rock episode is not so much why retail depositors are so prone to loss of confidence that lead to bank runs, but instead …

why sophisticated lenders who operate in the capital markets chose suddenly to deny lending to a bank that had an apparently solid asset book and virtually no subprime lending.”

(Shin, p.102)

Northern Rock and the Global Financial Crisis

The “Monolines” – Background

  • Since they began in the 1970s, bond insurers main business was to provide credit enhancement to municipal bond offerings.
  • This insurance was provided by specialized companies that do not sell other types of insurance products – hence the name “monolines”.
  • In the roaring 2000s, they expanded into insurance provision for structured products (securitizations and CDOs).
  • January 2008, MBIA and Ambac (the two largest insurers), had a combined $265 billion in structured-product guarantees.
  • Starting in mid-2007, the markets became worried about these insurers.

 Source: FCIC, p. 276

Auction Rate Securities – Background

  • The traditional way to sell securities is with a primary offering, followed by the management of a secondary market. For some types of securities, the secondary markets are so illiquid that investors are scared away.
  • Auction rate securities (ARS) are a solution to this illiquidity, with a broker-dealer holding periodic auctions of long-term bonds to reset the interest rates based on demand.
  • Historically, broker-dealers reputational concerns meant that they provided a backstop to the market, holding paper to manage shortterm liquidity disruptions.
  • ARS are used for a very quiet type of securities: mostly studentloan pools and municipals.
  • The municipal securities were given credit enhancement by the monolines … uh-oh.

Bear Stearns

  • In mid-2007, Bear Stearns was the fifth-largest investment bank in the United States, with assets of about $400 billion.
  • The firm was a significant player in all parts of the subprime space, from loan origination to trading.
  • The first problem occurred in June 2007, with a suspension of redemptions in two Bear-managed hedge funds.
  • For reputational reasons, Bear bailed out these funds after liquidation on 7/31 by paying off their lenders and taking the collateral onto its own balance sheet.
  • This action, and the losses from other asset holdings, were not nearly enough to drive Bear Stearns into insolvency. So what happened?

What happened? A remarkable combination of liquidity pressures that took virtually everyone by surprise.

  • Prime brokerage withdrawals
  • “Novations” of derivatives
  • Collateral calls
  • Maturity shortening on secured “repo” loans
  • And, finally, a run on repo

 

Aftermath

  • The Federal Reserve supported a JP Morgan buyout of Bear Stearns, initially set at $2 per share, later raised to $10.
  • After Bear Stearns policymakers introduced several new tools to support liquidity in interbank markets.
  • The markets did not learn their lesson. The failure of Lehman Brothers six months later followed a similar script.
  • Some argue that Fed actions during the Bear Stearns crisis created a false sense of complacency and belief that there would always be support for other “too-big-to-fail” institutions – a belief that proved false and damaging before Lehman.
  • An alternative explanation is that these wholesale banking operations were inherently fragile – in ways that were simply not understood at the time – and our regulatory system was not equipped to handle their rapid failure.

 

Summary

  1. Institutions with subprime exposures began to fail in early to mid 2007.
  2. These failures were not expected to be a problem for broader economy, but led to stresses in wholesale funding markets, notably the ABCP market.
  3. These tensions would contribute to failures of seemingly unrelated or sufficiently insulted firms and markets: Northern Rock, auction rate securities and Bear Stearns.
  4. The vulnerabilities were not fixed, and there would be worse problems to come.

 

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)