4 “discount rate”: The discount rate is the rate at which the Fed lends to banks in its capacity as lender of last resort. A bank that is considering borrowing at the discount window’s “penalty rate” might worry that doing so signals to markets that it is unable to secure funding on reasonable terms from private sources. While the Fed would not announce the banks that borrowed from the discount window in real time, the disappearance of a bank from interbank lending markets could spark rumors that it was relying on the Fed for funding, calling into question its health. By cutting the discount rate, we tried to signal that use of the discount window should be viewed more as an economic decision, rather than an act of desperation.
5 find some way to use the discount window: The Federal Open Market Committee, which includes presidents of the regional Fed banks, sets the federal funds rate that is regularly adjusted to conduct monetary policy. But the decision to change the discount rate is made by the Federal Reserve Board in Washington, a separate body. Generally, changes to the discount rate are made simultaneously with changes to the Fed funds rate, which means that the FOMC is involved in the decision as a matter of practice. But in the heat of the crisis, when we were making decisions that involved new uses of the discount window, there was often not much advance consultation with or warning to the other Reserve Bank presidents.
6 “structured investment vehicles”: SIVs were off-balance-sheet entities—generally “sponsored” by big banks—that issued debt and used the proceeds to buy assets, such as CDOs or MBS, which in turn served as the collateral for the debt SIVs would issue. Typically, the SIVs would buy assets that were widely traded but did not mature for years, and finance themselves with short-term funding. Their assets were more liquid than those of banks in normal times, but in some ways they had risks similar to a bank’s—but without bank-like safeguards. Banks didn’t always have a legal obligation to pay off the debts of the SIVs with which they were affiliated, but for reputational or other reasons, they often ended up assuming these obligations even when they were not contractually bound to do so. SIVs were often structured to circumvent accounting rules, allowing banks to avoid reflecting them in their financial statements. The result was that investors, regulators, and even the banks themselves underappreciated the amount of risk that banks were exposed to as a result of their SIV-sponsoring activities.
7 count lower-quality capital: One goal of capital is to allow firms to absorb losses without having to file for bankruptcy, but low-quality capital lacked this feature. For example, firms still have to make interest and principal payments on subordinated debt to avoid default, even in periods of distress. At this time, the only way for such investors to take losses was for the bank to file for bankruptcy. Common equity can absorb losses pre-bankruptcy, meaning it is the first line of defense to keep a bank alive.
8 foreign exchange swap lines: Under these swap arrangements, the Fed and the European Central Bank (for example) would exchange dollars and euros at the prevailing market exchange rate, while promising to reverse the transaction at the same exchange rate on a specified future date, plus interest. The ECB could then use these dollars to provide liquidity to European banks in need of dollar funding.
9 haircuts for bondholders and other creditors: A bondholder “haircut” occurs when lenders receive less than they are owed from borrowers. For example, if company A owes $100 to company B and after going into bankruptcy repays only $80 of that loan, company B is said to have received a “haircut” of 20 percent.
Five: The Fall
1 “TED spread”: The three-month Treasury-Eurodollar, or TED, spread measures the difference in borrowing costs on three-month Treasury bills and the cost that banks pay to borrow from each other for three months, as reflected in the London Interbank Offered Rate (LIBOR).
2 prime money market funds: There are three primary types of money market funds: Treasury and government funds that buy Treasury and agency securities; tax-exempt funds, which invest in short-term municipal securities; and prime funds, which typically pay higher rates of interest by investing in a broader range of riskier securities, including unsecured commercial paper and asset-backed commercial paper. Institutional investors use money market funds for cash-management purposes and are often more likely to move their money at the first sign of stress than individuals or retail investors. The $300 billion outflow was primarily shifted out of riskier prime funds into the other, safer types of money market funds.
3 a four-fifths stake: This equity stake was delivered to a trust that existed independently of the government and operated for the benefit of the taxpayer.
Six: “We’re Going to Fix This”
1 the government could buy $500 billion of its assets: Technically, the bank that sells $500 billion in mortgage assets to the government would get $500 billion in cash, another asset, so its leverage ratio would still be 40:1 immediately after the transaction. But either by netting out cash, a risk-free asset, or paying down $500 billion in liabilities, the bank’s leverage ratio would be reduced to 20:1.
2 capital alone wouldn’t stop a run already in progress: We had no way of determining then how much capital would be enough, but we knew we wouldn’t have unlimited amounts of capital to deploy. That meant that guarantees were needed alongside capital to credibly backstop the system.
3 “fear index”: The Chicago Board Options Exchange Market Volatility Index, or VIX, is a measure of market volatility popularly referred to as the “fear index.” The measure is based on the implied volatility of options on the S&P 500 index of stocks. The VIX captures investor expectations of near-term stock market volatility—how uncertain investors are about whether and how far the S&P will rise or fall.
4 two complex new Maiden Lane vehicles: Among AIG’s major liquidity needs were their securities lending operations and the credit default swaps written by AIG Financial Products on collateralized debt obligations. Maiden Lane II and III addressed these issues, respectively, by purchasing the underlying collateral from AIG and its counterparties and canceling the CDS contracts that AIG owed against them. This eliminated the risk that these contracts would continue to result in additional margin calls that would further drain AIG’s cash.
Seven: Into the Fire
1 hardworking homeowners who were underwater: A home is “underwater” or has “negative equity” when the mortgage debt on the home exceeds its value. Thus, a $100,000 home with a $120,000 mortgage would have negative equity of $20,000.
2 Bank shareholders had no idea whether they would face substantial dilution: When a firm increases its number of shares of common stock, existing shareholders are “diluted,” meaning they own a smaller percentage of the future profits of the company. For example, if a firm with one million shares outstanding needs to raise $1 million at $1 per share, it would issue one million additional shares. Its existing shareholders would then own half the company instead of the entire company. Of course, the firm would also have $1 million of additional cash, but if the new shares were issued at a discounted value, the value of existing shareholders’ holdings would have been correspondingly diminished. So, if a bank might be forced to raise capital or receive a big government capital injection at a low price in the future, investors might be scared away, causing a downward spiral in the stock price.
3 the problem of having the government set prices … seemed insurmountable: Similar challenges applied to ring fencing: The complexity of determining which distressed assets to guarantee and how the government would share losses with the banks made a ring fencing approach very difficult, too. The previous Citi and BofA ring fences demonstrated that complexity: The announcement of the Citi ring fence, though critical at the time, was followed by months of haggling over which assets would be backstopped, and the BofA ring fence was actually never finalized.
4 mortgage servicers: Most homeowners don’t pay mortgage payments directly to their lenders. Instead, their payments go to “mortgage servicers,” companies that process payments
and perform other services tied to mortgages and mortgage securities. Our efforts to keep Americans in their homes would require the competence and cooperation of the mortgage-servicing industry, but these firms were not prepared for the complexity of the challenge.
Nine: Getting Better, Feeling Worse
1 by year’s end, we had recouped about two-thirds of the federal outlays for bank rescues: Following the release of the stress test results in May 2009, a number of participating banks requested to repay their TARP funds. Treasury and the bank regulators allowed this under two conditions: first, that banks had already met the capital need identified by the stress test; and second, that they demonstrated their ability to raise private capital and issue long-term debt without the support of an FDIC guarantee. Under these conditions, nine of the nineteen institutions repaid $67 billion in TARP funds in June 2009, while raising nearly $30 billion in additional common stock. After extended discussions between Treasury and bank regulators, banks were issued guidance in November 2009 allowing them to repay $2 of TARP preferred equity for each dollar of new common equity they raised. Bank of America, Wells Fargo, and Citigroup all repaid TARP funds before the end of 2009 on the heels of this guidance. By the end of December we had gotten nearly $180 billion of cash back from the bank-rescue programs out of a total maximum outstanding of about $245 billion, or about two-thirds of the total bank rescues.
2 Chart, Extraordinary Commitments, but Not for Long: Federal Reserve includes Discount Window, Term Auction Facility (TAF), Primary Dealer Credit Facility (PDCF), ABCP MMMF Liquidity Facility (AMLF), AIG, Term Asset-Backed Securities Loan Facility (TALF), Commercial Paper Funding Facility (CPFF), Maiden Lane, Maiden Lane II, Maiden Lane III, Asset Guarantee Program (AGP), Term Securities Lending Facility (TSLF), and central bank swap lines. Excludes all Federal Reserve purchases under the quantitative easing programs. Federal Deposit Insurance Corporation (FDIC) includes temporary increase in deposit insurance from $100,000 to $250,000 (pre-Dodd-Frank Act), Transaction Account Guarantee (TAG) through December 2010 (does not include Temporary Unlimited Coverage for Noninterest-Bearing Transaction Accounts under the Dodd-Frank Act), Temporary Liquidity Guarantee Program (TLGP), and Asset Guarantee Program (AGP). U.S. Treasury Department (Treasury) includes TARP, temporary guarantee program for money market funds, agency MBS purchase program, and gross draws under GSE preferred stock purchase agreements.
3 changed the trajectory of the recovery: 11 million households—22 percent of mortgage borrowers—were underwater, of which three quarters were current on their mortgage payments. A large share of the money spent to eliminate negative equity would have been directed to current borrowers, and as a result the overall economic impact of that would be very small. My economics team figured that increases to wealth from the reduction of negative equity would result in only an annual three- to five-cent increase in GDP for every dollar spent on debt reduction; by contrast, a dollar of stimulus used to increase income would have at least ten times that effect in the year it was received.
Ten: The Fight for Reform
1 This was a necessary condition, though not a sufficient condition: As discussed in chapter 3, low interest rates were only partly a function of monetary policy. The Fed increased short-term rates by over 4 percentage points between 2004 and 2006, but a huge amount of foreign money was flooding the country’s capital markets, pushing down interest rates for longer-term products like mortgages.
2 the crisis became a kind of Rorschach test: A Boston Fed paper by three economists—Christopher Foote, Kristopher Gerardi, and Paul Willen—called “Why Did So Many People Make So Many Ex Post Bad Decisions?: The Causes of the Foreclosure Crisis” explored the data behind the causes of the housing bubble and foreclosure crisis. Instead of fraud, misplaced incentives, or new products, the twelve facts they present about the crisis make a compelling case that distorted beliefs about home price appreciation drove lenders and borrowers to make overly optimistic decisions about investments in housing.
3 repeal of … Glass-Steagall limits on bank activities: While much attention has been given to Congress’s formal repeal of Glass-Steagall in 1999 through the Gramm-Leach-Bliley Act, in practice many of the law’s original restrictions had already been lifted through regulatory changes during the 1980s and 1990s.
4 a surefire panic accelerant: Secured creditors are protected by the collateral underlying their loans in the event that a borrower defaults, which substantially reduces the risk that they will lose money. But imposing haircuts on secured creditors would mean that they could no longer count on the full value of their collateral to backstop their loan, making them far more likely to run for the exits during times of financial distress.
5 Chart, Stronger New Global Shock Absorbers: Basel I: Tier 1 Common requirement extrapolated from regulatory guidance that common equity should be the “dominant component” of the 6 percent Tier 1 Capital “well capitalized” standard. Basel III: 7 percent Tier 1 Common includes a 4.5 percent minimum and a 2.5 percent capital conservation buffer. Common capital surcharge reflects the 2.5 percent maximum surcharge currently applied to the largest global banks. The only U.S. bank currently in the 2.5 percent bucket is JPMorgan. In total, eight U.S. banks are subject to a common capital surcharge as of November 2013 under BIS standards, which will be phased in through 2019. Basel III Adjustments: In addition to increasing capital requirements, Basel III substantially increased the risk weights on certain types of assets and limited the extent to which various factors could count to the common equity requirement.
Eleven: Aftershocks
1 eurozone: “Eurozone” denotes the subset of sixteen European nations—later seventeen when Estonia joined at the beginning of 2011, then eighteen when Latvia joined at the beginning of 2014—that comprise the economic and monetary union using the euro as its currency, not to be confused with the “European Union,” which is a broader set of twenty-eight countries that collectively function more like a trading bloc.
2 “the Boehner Rule”: Under any plausible budget plan, the Boehner Rule would require massive spending cuts. In May 2011, Treasury put out a fact sheet that explained: “Even if the House Republican Budget were made law immediately, the debt limit would still have to be increased within the next several weeks. Additionally, according to Congressional Budget Office and House Budget Committee estimates, the spending included in the House Republican Budget Resolution would necessitate a nearly $2 trillion increase in the debt limit by the end of Fiscal Year 2012. Moreover, it would require trillions of dollars in additional debt limit increases beyond that amount for the next several decades.” The Boehner Rule would have required trillions of dollars of additional spending cuts beyond the extreme cuts in the Republican budget proposals, which would have hurt the economy as it was trying to recover.
Epilogue: Reflections on Financial Crises
1 projected to generate a positive return for the taxpayer of more than $150 billion: We will earn well over a hundred billion dollars on our crisis response programs. The FDIC now estimates it will “lose” $88 billion on the small bank failures; however, by law it has to recoup these costs through higher deposit insurance fund assessments on all banks, so taxpayers have no exposure to those potential losses. By making the deposit insurance fund assessment based on total assets rather than total insured deposits, Dodd-Frank shifted the burden of higher deposit insurance fees toward large banks.
2 Chart, Projected Taxpayer Returns from the Crisis Response: All estimates reflect the conventions adopted by OMB and CBO for the respective programs for budget purposes, including both realized gains to date and projected future returns unless otherwise noted. These estimates may change due to future market conditions. Some estimates include financing costs (when required by law or budgetary conventions for the particular program), while others are projected on a cash-in/cash-out basis. Charts include income and costs for the financial stability programs only. They do not include figures related to the Recovery Act or tax
revenues lost from the financial crisis. Unless otherwise noted, data come from Treasury Department, “The Financial Crisis Five Years Later,” or relevant financial disclosures from the Federal Deposit Insurance Corporation, Federal Reserve Board, and U.S. Treasury Department.
Federal Reserve Board
Federal Reserve General Liquidity Programs. Reflects gross income and fees from each program on a cash-in/cash-out basis. For more information, see “Federal Reserve Liquidity Facilities Gross $22 Billion for U.S. Taxpayers” (http://libertystreeteconomics.newyorkfed.org/2012/11/federal-reserve-liquidity-facilities-gross-22-billion-for-us-taxpayers.html).
Bear Stearns Commitment. Reflects net realized gain/income of $765 million of accrued interest and $1.5 billion mark-to-market value of remaining assets in Maiden Lane LLC. Source: November 2013 Quarterly Report on Federal Reserve Balance Sheet Developments.
U.S. Treasury Department
TARP Bank, Credit and Auto Programs. Estimates of the impact of TARP programs and investments on the Federal budget. Includes financing costs and a market risk-adjusted discount rate. Includes Treasury portion of $425 million termination fee from Bank of America that was apportioned between the Treasury, Federal Reserve, and FDIC, and proceeds from Citigroup TruPS provided in consideration for ring fence. Source: Treasury Department, “The Financial Crisis Five Years Later,” TARP Monthly 105(a) Report to Congress.
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