The Forward Wonk #10: The Fed's Reaction to The Financial Crisis
What Triggered the Financial Crisis and What The Fed Did About It
Welcome to the 10th issue of The Forward Wonk!
Today’s issue will take about 7 minutes to read
This is our second issue in our series about the Federal Reserve and Monetary Policy. Read the first issue, The Fed's Response to Coronavirus.
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Today, we’ll continue our discussion about the Fed by exploring what they did in response to the Financial Crisis of 2007-2008. Like last time, there really isn’t a need to focus on the details — it’s more important to understand the motivations behind the decisions and the intended actions.
How did the Financial Crisis Start?
You’ve probably read thousands of explanations debating the causes of the financial meltdown that eventually began the Great Recession. Honestly, we could spend countless hours examining the various factors contributing to the crisis, but thankfully we’re not economists trying to inflate our publication count so we don’t have to. For our understanding, we just need the context for American financial markets.
*Disclaimer*: Much of the following discussion is going to be a gross oversimplification. Many things went wrong during the Financial Crisis, but the Fed’s power is limited to stabilizing financial markets so we’ll take a high-level overview into one cause of the financial panic before discussing the Fed’s actions.
The origins of the crisis can be traced back to emerging economies. In the early and mid-2000s, many emerging economies exploded in wealth and that money flowed into financial markets across the world. Western financial markets found themselves awash with new money and governments lacked the will to regulate markets so they basically let investors do whatever they wanted.
Wall Street in 2005
So investors took this money and invested it into various assets, helping create bubbles — the biggest one being the bubble in the housing market. During the early 2000s, the US housing market began booming and home values drastically appreciated. Investors, wanting to also profit from this historically safe market, worked with banks to create a variety of mortgaged-back securities (MBS) and other debt instruments to profit off of mortgages and home values. It’s not important to know all the specifics of an MBS, other than its an investment product made up of mortgages.
Banks, now making money from both the mortgages and the MBSs, expanded mortgage programs and made it easier for people to be approved for them. Rating agencies (the agencies that measure the risk of investment products like MBSs) believed that the MBSs wouldn’t fail because of the housing market’s historical safety, and rated them highly. This gave everyone — banks, investors, the government — confidence that MBSs wouldn’t fail and weren’t a risky investment. While this was happening, the government created incentives for people to buy homes. Then in 2007, people realized that homes were too expensive and they couldn’t pay back their mortgages.
When this happened, pandemonium erupted. It turned out that almost every bank possessed a large number of MBSs and created multiple layers of financial assets on top of them. When people became unable to pay back their mortgages, it made all the MBSs worthless. The worthless MBSs created tremendous financial stress for the banks, causing banks to run out of money and become insolvent. When the banks were unable to regularly operate, the whole economy began to contract. Banks need to be able to provide people and businesses with money — either through loans or deposits — and when banks can’t do that, it creates negative shocks across the economy.
TLDR; Here’s what happened:
The housing market was strong, and there was an influx of money in the financial system, so investors used it to try to profit off of the housing market.
Investors created many investment products from home mortgages. These became very lucrative, so they made more of these and created incentives for people to buy homes.
This led to home prices go up even further, which led to people buying homes they couldn’t afford. People are unable to pay their mortgages.
The investment products made up of the mortgages failed, dragging banks (and other companies) down with them.
This is (kinda) what happened. A lot of decisions being made without thinking of the second or third-order consequences that built up a financial version of a house of cards. Once home values were pumped too high and people found themselves unable to pay their mortgages back, the whole system collapsed.
You’re the Fed chairperson, so what do you do?
The Fed’s Response to The Financial Crisis
Late 2007 and Early 2008
You notice that banks are beginning to get rid of any MBSs they have. The stock market tumbles. You start reducing interest rates.
You commit to working with central banks across the world. Many of the actions you do in the next year will be mirrored by your colleagues in England, Canada, the EU, and Switzerland.
You establish the Term Auction Facility (TAF), to auction short term loans to institutions that needed liquidity.
You work with the Bush Administration and Congress to craft the Economic Stimulus Act of 2008. The housing market and consumer spending still tumble as the stimulus isn’t enough to ward off a recession.
Spring 2008
You also create a Primary Dealer Credit Facility (PDCF) which gives loans to large Treasury security brokers in exchange for collateral.
You establish a Term Securities Lending Facility (TSLF) to allow provide liquidity in Treasury markets by accepting MBSs.
Coordinate with the European Union, Sweden, and Switzerland to lower the prices on U.S. dollar liquidity swaps in an attempt to improve the liquidity of US dollars. This makes it cheaper for other countries to get US dollars for their banks.
The investment bank Bear Sterns nearly collapses and you help finance JP Morgan buy the bank.
Reduce interest rates even further.
Summer 2008
Not much is done publicly as you hope that your measures are enough to ward off a recession.
You’re trying to convince Congress to pass further fiscal stimulus, but Congress is unwilling to do so given that it’s an election year.
Fall 2008
Expand U.S. dollar liquidity swaps to Australia, Singapore, Norway, Denmark, Brazil. Mexico, South Korea, and Sweden.
Loan $85 billion to AIG after letting Lehman Brothers fail (which wasn’t a good look, oof).
Commit to not letting Wachovia default. This paves the way for Wells Fargo to buy them.
You create a Commerical Paper Funding Facility (CPFF), a Money Market Mutual Fund Liquidity Facility (MMLF), and an Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) to help companies and mutual funds.
You also grow sick of naming things and wish central bankers and economists were more clever with their acronyms.
You cut interest rates again.
You announce that you’ll begin the widescale purchasing of MBS and other housing debt products in a round of Quantitative Easing. These purchases happen throughout 2009 and 2010.
Winter 2008 and Beyond
You cut interest rates to 0%.
You issue something called forward guidance, by announcing that interest rates will be near zero for a number of months.
The Fed’s actions can be distilled down into these five categories:
Lowering Interest Rates
Part of the traditional monetary policy toolkit to encourage lending and reduce business costs.
Minimizing International Pressures
Ensures the entire global financial system has access to valuable dollars.
Issuing Forward Guidance*
The Fed lets the world know that low interest rates are here to stay for a while. This influences the decisions of households, businesses, and investors as they now anticipate a long-term recession.
Quantitative Easing*
The Fed never embarked on such a widescale purchasing of assets. It eventually bought mortgage-backed securities, debt from Freddie Mac and Fannie Mae, and long-term Treasury securities.
The goal of these QE programs was two-fold. First, these purchases attempted to stabilize the housing market, the epicenter of the crisis. Second, it attempted to lower long-term borrowing rates and let credit flow more freely.
Ease Credit Flows and Costs*
By establishing various facilities to provide credit to different and institutions, the Fed attempted to ensure that credit continued to flow to businesses and households.
The asterisk (*) represents new, nontraditional monetary policy measures the Fed undertook.
In January 2011, the US Financial Crisis Inquiry Commission presented the Financial Crisis as “avoidable” and found the causes to be:
Widespread failures in financial regulation, including the Federal Reserve's failure to stem the tide of toxic mortgages;
Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk;
An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis;
Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.
We know that the Fed’s actions along wasn’t enough to prevent the Great Recession. While the Fed moved quickly to innovate monetary policy, they were still caught flatfooted at the beginning of the crisis. Blame rightfully deserves to be placed upon the Fed, but also on Congress and the White House for failing to understand and act upon the crisis. The Financial Crisis represented an enormous failure to mitigate risk and coordinate meaningful responses. Thankfully, the Fed seems to have learned from its mistakes as shown by their quick responses to the coronavirus recession.
Closing Time
Economic policy is nebulous, filled with jargon, and unnecessarily complicated. I hope that you all gained a further understanding of the causes and responses to the Financial Crisis. If you did, share it with a friend! In the meantime, this is what I’ve been reading and listening to:
It’s 2022. What Does Life Look Like? (NYT Op-Ed)
Money talks: U.S. town prints own currency to boost coronavirus relief (Thompson Reuters News)
Economics needs reconciliation if it is to be a force for positive change (Compassionate Economics, a popular economics blog)
My Affection (with PARTYNEXTFOOR) by Summer Walker
And Vik’s puzzle:
Until next time,
Visakh
Crossword Answers:
ACROSS
AOL
RAMOS
ELIZA
TENET
SOS
DOWN
AMINO
OOZES
LSAT
RET
ALES