The Fed played an important role, however, in providing liquidity, in making sure that the panic was controlled. I will talk briefly about this in general and then I will present two case studies that will illustrate some of the issues. The Federal Reserve has a facility called the discount window, which it uses routinely to provide short-term funding to banks, maybe a bank that finds itself short of funding at the end of the day. It wants to borrow overnight. It has collateral with the Fed. Based on that collateral, it can borrow overnight at the discount rate, which is the interest rate the Fed charges. So the discount window, which allows the Fed to lend to banks, is always operative. No extraordinary steps were needed to lend to banks. The Fed always lends to banks. We did make some modifications in order to reassure banks about the availability of credit. And to get more liquidity into the system, we extended the maturity of discount window loans, which were normally overnight loans. We made them longer-term and we had auctions of discount window funds, in which firms bid on how much interest they would pay. The idea there was by having a fixed amount that we were auctioning, we would at least assure ourselves that we got a lot of cash into the system. The point here is that the discount window, which is the Fed’s usual lender of last resort facility lending to banks, was operative and we used it aggressively to make sure that the banks had access to cash to try to calm the panic.
But our financial system is a lot more complicated than the one that existed when the Fed was created in 1913. We have many different kinds of financial institutions in markets now. And as I said, the crisis was like an old-fashioned bank crisis, but it happened to all different kinds of firms and in different institutional contexts. So the Fed had to go beyond the discount window. We had to create a whole bunch of other programs, special liquidity and credit facilities that allowed us to make loans to other kinds of financial institutions, on the Bagehot principle that providing liquidity to firms that are suffering from loss of funding is the best way to calm a panic. All these loans were secured by collateral. We were not taking chances with taxpayers’ money. But the cash was going not just to banks but also more broadly into the system. Again, the purpose of this was to enhance the stability of the financial system and get credit flows moving again. Let me emphasize that this is the traditional lender of last resort function of central banks that has been around for hundreds of years. What was different was that it took place in a different institutional context than just the traditional banking context.
Here are some of the institutions and markets that we addressed through our special programs. Banks were covered by the discount window. But another class of financial institutions, broker-dealers (financial firms that deal in securities and derivatives), were also facing very serious problems. They included Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, Morgan Stanley, and others. The Fed provided cash or short-term lending to those firms on a collateralized basis as well. Commercial paper borrowers received assistance, as did money market funds. In the modern financial system, not just mortgages but also auto loans, credit cards, and all different kinds of consumer credit are funded through the securitization process. For example, a bank might take all of its credit card receivables, bundle them together into a security, and then sell them in the market to investors, much as mortgages are sold, and that is called the asset-backed securities market. The asset-backed securities market essentially dried up during the crisis, and the Fed created some new liquidity programs to help get it started again, which we were successful in doing.
I should mention that although the Fed’s lending to banks was totally standard lending through the normal discount window, these other types of lending required the Fed to invoke emergency authority. There is a clause, 13(3), in the Federal Reserve Act that says that under unusual and exigent circumstances (basically, in an emergency), the Fed can lend to entities other than just banks. This authority had not been used by the Fed since the 1930s. But in this particular case, with all these other problems emerging in different institutions and in different markets, we invoked this authority and used it to help stabilize a variety of different markets.
Let me give you a case study that will help you understand what we did and how it helped the economy. I want to talk a little bit here about money market funds. Money market funds are basically investment funds in which you can buy shares, and the funds take your money and invest it in short-term liquid assets. Money market funds historically almost always maintain a one-dollar share price. So they are very much like a bank, and they are often used by institutional investors such as pension funds. A pension fund with thirty million dollars in cash probably would not put that into a bank because that much money is not insured; there is a limit to how much deposit insurance covers.
So what a pension fund might do instead of putting the cash in a bank would be to put the money into a money market fund, which promises one dollar for each dollar put in, plus a little bit of interest on top, and invests in very short-term, safe, liquid assets. So it is a reasonably good way to manage your cash if you are an institutional investor.
As I said, money market shares do not have deposit insurance, but the investors who put their money into a money market fund expect that they can take their money out at any time, dollar for dollar. So they treat it like a bank account, basically. The money market funds in turn have to invest in something, and they tend to invest in short-term assets such as commercial paper. Commercial paper is a short-term debt instrument issued typically by corporations, short-term in that its maturity is ninety days or less. A nonfinancial corporation might issue commercial paper to allow it to manage its cash flow. It might need some short-term money to meet its payroll or to cover its inventories. So ordinary manufacturing companies such as GM or Caterpillar would issue commercial paper to get cash to manage their daily operations. Financial corporations, including banks, would also issue commercial paper to get funds that they could then use to manage their liquidity positions and to make loans to the private economy. Figure 25 is a diagram of how a money market fund works. On the left, you see investors investing their excess cash in the money market fund. The money market fund buys commercial paper, which is basically a funding source for both nonfinancial businesses, such as manufacturers, and for financial companies that would lend it to other borrowers.
Figure 25. Money Market Funds and the Commercial Paper Market
What happened to this arrangement during the 2008 crisis? Lehman Brothers created a huge shock wave. It was an investment bank, a global financial services firm; it was not a bank, so it was not overseen by the Fed. It held lots of securities and it did a lot of business in the securities markets. It could not take deposits, not being a bank. Instead, it funded itself in short-term funding markets, including the commercial paper market. Lehman invested heavily in mortgage-related securities and also in commercial real estate during the 2000s. As house prices fell and delinquencies on mortgages rose, Lehman’s financial position got worse and it was also losing lots of money on its commercial real estate investments. So Lehman was becoming insolvent, it was losing money on all of its investments, and it was coming under a lot of pressure. And indeed, as Lehman’s creditors lost confidence, they started withdrawing funding from Lehman. For example, investors refused to roll over Lehman’s commercial paper and other business partners said, “Well, we’re not going to do business with you anymore because we’re afraid you’re not going to be here next week.” So Lehman was losing money and increasingly unable to fund itself. It tried with the help of the Federal Reserve and the Treasury to find somebody willing either to put more capital into the firm or to acquire the firm. It was unable to do that, so on September 15th, as I mentioned, it filed for bankruptcy. This was an enormous shock that affected the whole global financial system.
One of the many effects of the failure of Lehman Brothers was on money market funds. One particular fairly large money market fund held, among its other assets, commercial paper issued by Lehman. W
hen Lehman failed, that commercial paper became either worthless or at least completely illiquid for a long time. Suddenly, this money market fund could no longer pay off its depositors at a dollar per share. It didn’t, and it lost money. Now, suppose you are an investor in a money market fund and you know that if you ask for your dollar back, you can get it. But you also know that the fund does not have enough cash to pay everybody a dollar. What are you going to do? The same thing nineteenth-century bank depositors would do if they heard that their bank had lost money. So, investors in this fund and then in other money market funds began to pull out their money, just like a standard bank run. We had a very intense bank run or, in this case, a money market fund run, in which investors in these funds began to pull out their money just as quickly as they could.
Figure 26. Net Flows to Prime Money Market Funds, September 7–24, 2008
Source: IMONEYNET and Federal Reserve Board staff adjustments
The Fed and the Treasury responded very quickly to the situation. The Treasury provided a temporary guarantee that investors would get their money back if they did not pull it out right then. And the Fed created a backstop liquidity program, under which it lent money to banks, which in turn used that money to buy some of the assets of the money market funds. That gave the money market funds the liquidity they needed to pay off their depositors and
helped to calm the panic.
To give you a sense of what was happening, Figure 26 shows the daily money outflows from the money market funds. This is a two-trillion-dollar industry. You see the Lehman bankruptcy, and a couple of days later you see the money market fund breaking the buck, which meant that it was unable to pay its investors a dollar a share. Following that announcement, you can see that for two days, about one hundred billion dollars a day was flowing out of these funds. Within two days, the Treasury announced the guarantee program and the Fed came in to support the liquidity of these funds. And as you can see, the run ended pretty quickly. This was an absolutely classic bank run and a classic response: providing liquidity to help the institution being run provide cash to its investors, and providing guarantees. That successfully ended the run.
But that was not the end of the story, because the money market funds were also holding commercial paper. And as they began to face runs, they in turn began to dump commercial paper as quickly as they could. As a result, the commercial paper market went into shock. This is an excellent example of how financial crises can spread in all different directions. Lehman failed. That, in turn, caused the money market funds to experience a run, which led to a shock in the commercial paper market. So, everything is connected to everything else and it is really hard to keep the system stable. As the money market funds withdrew from the commercial paper market, there was a sharp increase in rates in the commercial paper market, and lenders were not willing to lend for more than maybe one day to commercial paper borrowers, which in turn affected the ability of those companies to function and the ability of those financial institutions to fund themselves.
Once again, the Federal Reserve, responding in the way Bagehot would have had it respond, established special programs. Basically, it stood as a backstop lender; it said: “Make your loans to these companies, and we will be here ready to backstop you if there is a problem rolling over these funds.” That restored confidence in the commercial paper market.
Figure 27 shows commercial paper rates. Once again, you can see the panic phenomenon, a sharp increase in rates, which really understates the pressure because it does not include the fact that for many companies, they could not get funding at any interest rate. Or if they got funding, it was only for overnight or very short-term periods. The Fed’s actions restored confidence in that market, and you can see the response: rates came back down at the beginning of 2009.
Figure 27. Cost of Short-Term Borrowing, 2007-2009
Note: Spread between the A2/P2 nonfinancial rate and the AA nonfinancial rate Source: Depository Trust & Clearing Corporation
A lot of what I have been discussing you probably did not read too much about in the newspapers. I was working with these critical markets and providing broad-based liquidity to financial institutions to try to bring the panic under control. But the Fed and the Treasury also got involved in trying to address problems with some individual critical institutions.
In March 2008, as I mentioned, a Fed loan facilitated the takeover of Bear Stearns by JPMorgan Chase, avoiding a failure of that firm. The reasons we undertook that action were, first, at the time the financial markets were quite stressed and we were fearful that the collapse of Bear Stearns would greatly add to that stress and perhaps set off a full-fledged financial panic; and second, we judged that Bear Stearns was solvent. At least JPMorgan Chase thought so; it was willing to buy the firm and to guarantee its obligations. So by lending to Bear Stearns, the Fed was acting consistent with the proposition that it should make loans that are likely to be paid back. The Fed felt that it was well secured in making that loan.
In the second example, AIG was very close to failure in October 2008. AIG, again, was the world’s largest insurance company. It was a complicated company. It was a multinational financial services company with many constituent parts, including a number of global insurance companies. But part of the company, called AIG Financial Products, was involved in all kinds of exotic derivatives and other types of financial activities, including, as I mentioned, the credit insurance that it was selling to the owners of mortgage-backed securities. So when the mortgage-backed securities started going bad, it became evident that AIG was in big trouble and its counterparties began demanding cash or refusing to fund AIG, and it came under tremendous pressure.
In our estimation, the failure of AIG would have been basically the end. It was interacting with so many different firms. It was so interconnected with both the U.S. and the European financial systems and global banks. We were quite concerned that if AIG went bankrupt, we would not be able to control the crisis any further. Now, fortunately, from the perspective of lender of last resort theory, although AIG was taking a lot of losses in its financial products division, underlying those losses was the world’s largest insurance company. So AIG had lots and lots of perfectly good assets. Therefore, it had collateral that it could offer to the Fed to allow us to make a loan to provide the liquidity it needed to stay afloat.
And so, to prevent the collapse of AIG, we used AIG assets as collateral and loaned AIG eighty-five billion dollars. Later, the Treasury provided additional assistance to keep AIG afloat. That was highly controversial. The action was legitimate, we thought, first in terms of lender of last resort theory because it was a collateralized loan—and the Fed has in fact been fully paid back—and second, because AIG was a critical element in the global financial system. Over time AIG stabilized. It has repaid the Fed with interest. The Treasury still owns a majority of its stock, but AIG has been paying back the Treasury as well.
I would like to emphasize that what we had to do with Bear Stearns and AIG is obviously not a recipe for future crisis management. First, it was a very difficult and, in many ways, distasteful intervention that we had to do to prevent the system from collapsing. But clearly, there is something fundamentally wrong with a system in which some companies are “too big to fail.” If a company is so big that it knows that it is going to get bailed out, that is not at all fair to other companies. But even beyond that, “too big to fail” gives these big companies an incentive to take excessive risks, where they will say: “Well, we’ll take big risks. Heads I win, tails you lose. If the risks pay off, we make plenty of money. And if they don’t pay off, the government will save us.” That is a situation that we cannot tolerate.
So, the problem we had in September 2008 was we really did not have any tool—legal tools or policy tools—that allowed us to let Bear Stearns and AIG and the other firms go bankrupt in a way that would not cause incredible damage to the rest of the system. And therefore we chose the lesser of two evils and prevented AI
G from failing. That being said, we want to be sure that this never happens again. We want to be sure that the system is changed so that if a large systemically critical firm like AIG comes under this kind of pressure in the future, there will be a safe way to let it fail, so that it can fail and the consequences of its mistakes can be borne by its management and shareholders and creditors without bringing down the whole financial system.
Finally, let me say a few words about the consequences of the crisis. We did stop the meltdown. We avoided what would have been, I think, a collapse of the global financial system. That was obviously a good thing. But one thing that I was always sure of and the Federal Reserve was always sure of was that a collapse of some of these big financial firms was going to have very serious collateral consequences. There were people arguing even as late as September 2008, “Well, why don’t you just let the firms collapse? There is a system that can take care of it: bankruptcy. Why don’t you let them fail?” We never thought that was a good option. Particularly, if the whole system had collapsed, we would have had extraordinarily serious consequences.
As it was, even though we prevented a total meltdown, there were still very serious collateral impacts not just on the U.S. economy but on the global economy as well. So following the crisis, even though the crisis was brought under control, the U.S. economy and much of the global economy went into a sharp recession. U.S. GDP fell by more than 5 percent, which is quite a deep recession. Eight and a half million people lost their jobs and unemployment rose to 10 percent.
The Federal Reserve and the Financial Crisis Page 8