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1
Global Financial Crisis
Part 3
Econ 730
Spring 2020
2
We have discussed the “run on repo”, but there were fundamental
underlying causes of the crisis.
Causes of crisis
1. Deterioration of household balance sheets
2. Increased riskiness of portfolios of financial institutions
3. Proliferation of new financial instruments (ABSs)
4. Credit default swaps (CDSs) 5. Rating agencies
6. Risk-taking incentives for employees of financial institutions
7. Regulatory policies
8. General miscalculation of systemic risk
3
Deterioration of household balance sheets
• As we have noted, many homeowners took on mortgages they could not afford to repay.
• Perhaps they believed that they could refinance loans if the price of their house rose.
• Clearly many borrowers were very unsophisticated. Increased riskiness of portfolios of financial institutions
• Shadow banks grew in importance in the financial system.
• They were much less regulated than commercial banks. Indeed, to
some extent they were “self-regulated”.
• Leverage ratios were too high and liquidity ratios too low.
4
Proliferation of new financial instruments (ABSs)
• As discussed previously, ABSs in principle diversified risk
• They reduced incentives for loan originators to gather information.
It was much harder for loan “packagers” to gather this information.
There was, in fact, a lot of lying about quality of loans.
• There was also a systematic underestimation of the risk of a
nationwide downturn in home prices. The so-called “black swan”
problem.
Credit default swaps (CDSs)
• These are essentially insurance contracts against default
• But the insurance companies (particularly AIG) could not pay off.
Their business was like selling earthquake insurance in Seattle.
5
Rating agencies
• These private companies (Standard & Poor’s, Fitch’s, Moody’s) were
given the job of rating ABSs.
• They were paid by the sellers of ABSs, who had the incentive to
shop around for best rating.
• Also, their algorithms were known, so packagers of loans could
package them in such a way that they just barely received an AAA
rating.
Risk-taking incentives for employees of financial institutions
• Another example of moral hazard. Employees at financial
institutions did not bear the full cost if an investment went
bankrupt.
• They were prone to making excessively risky investments.
6
Why Did a Mortgage Crisis lead to the GFC?
• Before the crisis, banks used the ABSs as collateral for repo.
• ABSs were considered safe. Especially if the ABS was a claim to the
“upper tranche” of mortgage payments.
• To be double-sure, many holders of ABSs bought insurance.
Insurance pays off when the asset loses value. These are called
“credit default swaps”.
o AIG, a global insurance company, was a big insurer of ABSs
• But the ABSs did lose value. And they lost so much value that AIG
could not pay off on the insurance, and itself was effectively
bankrupted.
7
Illiquidity, Fire Sales, Crisis
It is easy to see what might have happened in the absence of policy
intervention:
• Banks would have to sell assets at fire-sale prices.
• The drop in asset prices would worsen the balance sheets of other
financial institutions, as well as private investors.
• Financial institutions would become insolvent.
• Even the solvent institutions would be reluctant to make new loans.
o Businesses rely on loans in the short run as working capital
o Businesses rely on loans to finance long-term investments
o Households rely on loans to buy homes
o Households rely on loans to make many other purchases
• The economy could have spun into a depression worse than the
Great Depression
8
Policy Reaction by the Fed and other policymakers
• The Fed and other central banks around the world quickly lowered
short-term interest rates to zero (the “zero lower bound”, ZLB) to
make it cheap to borrow.
• The Fed entered the market for ABSs, and purchased billions of
dollars worth
o This was entirely unprecedented. It was as if the Fed was in the
business of making home loans, car loans, business loans.
• The Fed took over AIG, and paid off all of the insurance claims
o It was controversial that the Fed paid these claims off in full.
o Courts have subsequently ruled that the Fed overstepped its
authority in taking over AIG, and rewarded previous owners of
AIG exactly zero dollars.
9
• The Fed engineered mergers of financial institutions
o A bank may have been solvent if its assets were valued fairly,
but insolvent when valued at fire-sale prices.
o That is
True value of loans + liquid assets > deposits
Fire sale value of loans + liquid assets < deposits
o Banks that were more liquid could buy the illiquid banks. Then
the assets of the illiquid bank can be valued at the fair market
value.
• The Fed extended loans directly to banks at low interest rates
• The Fed loaned dollars to central banks around the world, so they
could lend to their banks that needed dollars
o A lot of short-term funding for banks around the world is in
dollars.
10
It is worth emphasizing that the Fed’s actions were entirely unprecedented. They have been criticized for bailing out the banks, but they averted a catastrophe. It took an enormous amount of courage to undertake these policies. By luck, Ben Bernanke, was chair of the Fed. He was the leading academic expert in financial crises
11
Balance sheet for central bank (in “normal times”)
Assets Liabilities
U.S. Treasury assets
Loans to private banks
Other assets
Foreign exchange reserves
Currency In circulation
Reserve balances at Fed
• Before 2007, almost all securities held by the Fed were U.S.
Treasury assets.
• Loans to private banks are almost always close to zero, because of
stigma
• Fed holds low levels of foreign exchange reserves
• Banks held low reserve balances at Fed before 2007. Before 2007,
reserve balances paid zero interest.
12
The Fed’s Balance Sheet in Recent Years
First look at balance sheet of the Fed in December 2007, before the
onset of the crisis and before the Fed undertook extraordinary actions.
The first page shows the Fed’s assets. The major part of its assets are
Treasury securities. The Fed held over 754 billion dollars of Treasury
securities – bills, notes and bonds.
Most of the Fed’s loans to banks are in the form of repurchase
agreements, although there are also “other loans”.
Even in December 2007, the Fed had set up a special facility that
made it easier for banks to borrow from the Fed. This was called the term
auction facility, and one of the asset items on the balance sheet is the
loans the Fed had made to banks, called term auction loans.
13
Foreign exchange reserves are included as part of other assets. We
do see gold on the balance sheet which are counted as part of foreign
exchange reserves. Also, special drawing rights are a type of international
bond set up by the International Monetary Fund, and are considered part
of foreign exchange reserves.
“Treasury currency outstanding” refers to coins in circulation. It
appears as an asset of the Fed because of an accounting trick.
The total assets of the Fed add up to just over 929 billion dollars in
December 2007. The next part includes the Fed’s liabilities.
As we noted earlier, usually banks do not hold many deposits at the
Fed. So most of the Fed’s liabilities are currency in circulation. In this
balance sheet, currency amounts to 829 billion dollars.
14
The deposits of banks at the Fed are labeled “Reserve Balances with
Federal Reserve Banks” and total only 4.781 billion dollars.
There are a few other liabilities of the Fed. First, the U.S. Treasury
holds deposits at the Fed. Those are 4.529 billion dollars. Then there are
“service-related required clearing balances.” These also are deposits by
private banks at the Fed. They are there for technical reasons. Then
there are “reverse repurchase agreements” under which there is 40.5
billion dollars for “foreign official and international accounts”. These are
in essence loans from foreign central banks.
The gist of the balance sheet is that in normal times, the Fed’s
assets are mainly in the form of Treasury bonds, with a small amount of
foreign reserves and bank loans, and its main liability is currency.
15
Reserve Bank credit, related items, and
reserve balances of depository institutions at
Federal Reserve Banks
Wednesday
Dec 26, 2007
Reserve Bank Credit 877,148
Securities held outright 754,612
U.S. Treasury (1) 754,612
Bills (2) 241,856
Notes and bonds, nominal (2) 470,984
Notes and bonds, inflation-indexed (2) 36,911
Inflation compensation (3) 4,862
Federal agency (2) 0
Repurchase agreements(4) 42,500
Term auction credit 20,000
Other loans 4,535
Primary credit 4,513
Secondary credit 0
Seasonal credit 22
Float -336
Other Federal Reserve assets 55,837
Gold stock 11,041
Special drawing rights certificate account 2,200
Treasury currency outstanding (5) 38,807
16
Total factors supplying reserve funds 929,196
Currency in circulation(5) 829,193
Reverse repurchase agreements (6) 40,542
Foreign official and international accounts 40,542
Dealers 0
Treasury cash holdings 246
Deposits with F.R.Banks, other than reserve balances 11,535
U.S. Treasury, general account 4,529
Foreign official 97
Service-related 6,615
Required clearing balances 6,615
Adjustments to compensate for float 0
Other 293
Other liabilities and capital 42,900
Total factors, other than reserve balances,
absorbing reserve funds 924,415
Reserve balances with Federal Reserve Banks 4,781
17
Next, we look at the Fed’s balance sheet in December 2008. Things
had changed dramatically at that point, as the crisis was in full swing.
The first page shows the Fed’s assets. The Fed’s holdings of Treasury
securities had actually dropped since December of 2007. It was holding
only 476 billion dollars of Treasury assets and 20 billion of other Federal
government agency bonds, for a total of 496 billion as compared to 754
billion in December, 2007. The Fed had sold Treasury bonds in order to
raise money to make more direct loans to banks and the private sector.
The Fed’s direct lending to banks and other entities in the private
sector increased enormously. Its repurchase agreements, which are
essentially a direct loan to a bank, increased from 42.5 billion dollars to
80 billion dollars.
18
There is a striking increase in “other loans” from 4.5 billion dollars in
2007 to over 450 billion dollars in 2008.
First, there was a large increase in “primary credit”. Primary credit is
a direct loan from the Fed to banks. The major difference between
primary credit and a repurchase agreement is that the latter is essentially
a loan with collateral. If the bank cannot repurchase the securities it has
sold to the Fed, then the Fed has possession of the securities and so
makes no losses. It’s possible that a bank could default on primary credit
and the Fed would lose the value of that loan.
Under “other loans” we see that there is a large item for loans to
primary dealers and brokers. This is just another way of classifying loans
to banks.
19
Then there is one large asset called credit extended to American
International Group, Inc. These are loans that the Fed made directly to
AIG, a large global insurance company whose crazy lending practices
contributed greatly to the crisis.
Then we see another huge item called “Net Portfolio Holdings of
Commercial Paper Funding Facility LLC.” This was over 330 billion
dollars. In essence, this represents direct lending by the Fed to the
private sector.
Commercial banks and investment banks make loans to businesses
which they can then sell in financial markets as securities. These are
called commercial paper. Investors can invest by buying commercial
paper. For example, a bank might group together a thousand business
loans that it has made into one big asset. These facilities of the Fed
funded purchases of commercial paper.
20
reserve balances of depository institutions at
Federal Reserve Banks
Reserve Bank credit, related items, and
Wednesday
Dec 24, 2008
Reserve Bank credit 2,241,288
Securities held outright 496,892
U.S. Treasury (1) 476,014
Bills (2) 18,423
Notes and bonds, nominal (2) 410,491
Notes and bonds, inflation-indexed (2) 41,071
Inflation compensation (3) 6,029
Federal agency (2) 20,878
Repurchase agreements (4) 80,000
Term auction credit 450,219
Other loans 186,630
Primary credit 84,898
Secondary credit 40
Seasonal credit 3
Primary dealer and other broker-dealer credit (5) 38,190
Asset-backed commercial paper money market
mutual fund liquidity facility 23,993
21
Credit extended to American International
Group, Inc. (6) 39,507
Other credit extensions 0
Net portfolio holdings of Commercial Paper
Funding Facility LLC (7) 331,686
Net portfolio holdings of LLCs funded through
the money market investor funding facility (8) 0
Net portfolio holdings of Maiden Lane LLC (9) 26,966
Net portfolio holdings of Maiden Lane II LLC (10) 20,049
Net portfolio holdings of Maiden Lane III LLC (11) 28,191
Float -1,334
Other Federal Reserve assets 621,990
Gold stock 11,041
Special drawing rights certificate account 2,200
Treasury currency outstanding (12) 38,843
Total factors supplying reserve funds 2,293,372
22
Currency in circulation (12) 886,651
Reverse repurchase agreements (13) 88,317
Foreign official and international accounts 88,317
Dealers 0
Treasury cash holdings 233
Deposits with F.R. Banks, other than reserve balances 426,994
U.S. Treasury, general account 118,058
U.S. Treasury, supplementary financing account 289,247
Foreign official 1,190
Service-related 4,414
Required clearing balances 4,385
Adjustments to compensate for float 29
Other 14,085
Other liabilities and capital (14) 76,190
Total factors, other than reserve balances,
absorbing reserve funds 1,478,384
Reserve balances with Federal Reserve Banks 814,987
23
There are a few items with the name “Maiden Lane LLC”. The Federal
Reserve Bank of New York is located on Maiden Lane in New York. When
one large investment bank, Bear Stearns, nearly went bankrupt, the Fed
and other government officials arranged for JP Morgan Chase to buy Bear
Stearns (at a very low price.) Chase agreed to do so only if the Fed agreed
to purchase some of the riskier assets held by Bear Stearns. This was the
first Maiden Lane LLC. The second and third Maiden Lane corporations
came about when the Fed had to bail out AIG. The U.S. government took
over AIG, and the Fed bought AIG’s assets. These are held by the two
Maiden Lane corporations, “Maiden Lane II” and “Maiden Lane III”.
Notice also that “Other Federal Reserve Assets” increased
tremendously. It was equal to 55.8 billion dollars at the end of 2007 but
had soared to nearly 622 billion dollars at the end of 2008.
24
Part of that huge increase was in the form of loans to foreign central
banks. Foreign central banks needed dollars. They were running short of
dollar reserves, or at least they were afraid they might run short. Private
banks in their countries were demanding dollars.
• Why didn’t these central banks not simply buy dollars on foreign
exchange markets?
In December 2008, the Fed’s assets were 2.28 trillion dollars, as
compared to 929 billion dollars in December 2007. That is a huge change
in the Fed’s asset holdings which is completely without precedent.
On the next page are the Fed’s liabilities in December 2008. There is
not much change in the amount of currency in circulation. It is around
887 billion dollars at the end of 2008 compared to 829 billion dollars at
the end of 2009.
25
“Reverse repurchase agreements” by foreign central banks had
increased substantially. Foreign central banks wanted to hold more U.S.
dollar reserves, and one way they held them was through these loans to
the Fed.
Notice next the very big increase in Treasury holdings at the Federal
Reserve. The Treasury was making loans to the Fed at this time. The Fed
used these loans to help finance its purchase of the assets we have
discussed. As we mentioned earlier, usually the Fed is a lender to
Treasury. In December 2007, it held 755 billion dollars in Treasury assets.
It did also hold 4.5 billion dollars in an account for the Treasury, which
the Treasury used to pay for government purchases. Since that account
is a liability for the Fed, the Fed’s net lending to the Treasury was around
750 billion dollars.
26
In December of 2008, things had changed dramatically. First, the Fed
held only 476 billion dollars in Treasury assets. On the liability side, it had
borrowed around 407 billion from the Treasury. It was very nearly a net
borrower from instead of a net lender to the Treasury! Its net lending
was only 69 billion dollars at that point.
Then notice that banks’ reserve balances with the Federal Reserve
soared to 815 billion dollars from only around 5 billion dollars in late
2007. Banks wanted to hold their assets in the form of Federal Reserve
deposits. Fed deposits are very safe assets, as opposed to the very unsafe
loans banks had been making. If the private banks held large deposits of
these safe assets, their investors were reassured and the banking system
as a whole was much safer. The Fed encouraged banks to hold deposits
at the Fed by offering interest on the reserves.
27
If you look at the Fed’s balance sheet in late 2017, you will see that
the value of the Fed’s assets are much higher than they were even in
December 2008. In early November, 2017, the Fed’s assets totaled $4.4
trillion. This is $1.6 trillion greater than their level at the end of 2008, and
nearly five times the level of December, 2007.
What happened? After 2008, the Fed had lowered its policy interest
rate to zero (or, actually, to nearly zero – it was 0.25 percent.) The Fed
realized it could not influence the economy any longer by lowering
interest rates, since they had hit their lower bound, often called the “zero
lower bound.”
So the Fed undertook a policy of “quantitative easing” – of buying
securities, and flooding the private economy with money.
28
Even though this policy could not lower the very short-term interest
rates that the Fed directly controlled, the Fed had hopes that it would
have an effect of lowering longer-term interest rates such as mortgage
interest rates, and thereby still have a stimulative effect on the economy.
The composition of the Fed’s assets has changed again. Now the Fed
is holding a lot of Treasury securities – around $2.5 trillion. This reflects
the Fed’s policy of buying long-term Treasury bonds as a way of lowering
long-term interest rates to help stimulate the economy.
The Fed also has now bought nearly $1.8 trillion of mortgages
formerly held by Fannie Mae and Freddie Mac. These two entities are
private companies set up originally by the government to help finance
loans to home buyers.
29
The Fed, on the other hand, now holds no commercial paper – it no
longer is in the business of making loans directly to businesses, etc. In
fact, the Fed made a lot of money on these loans, which it returned to
the U.S. Treasury.
The Fed has also sold off a lot of the assets it bought from Bear
Stearns and AIG, again at a profit. It has been repaid on most of the loans
it made to foreign central banks. The Fed’s bold actions in late 2008 and
early 2009 were risky, but necessary to save the economy. In the end,
the taxpayer and U.S. citizen were double winners. Not only did the Fed
help (along with the Treasury) keep the financial system from failing and
rescue the global economy falling into an abyss, but the Fed earned
income on its assets which reduce the taxpayer’s burden!
So the Fed’s $4.4 trillion in assets are now primarily in the form of
Treasury securities and mortgage loans.
30
On the liability side, currency in circulation has increased to nearly
$1.6 trillion from around $900 billion in late 2008. Reserves held at the
Fed by private banks has continued to grow, so that it is now around $2.3
trillion. Remember, this compares to only $4.8 billion in late 2007 (and
$815 billion in late 2008.)
The last several years have been exciting ones for the Fed!
When the Fed began its policy of quantitative easing, there was
concern among some people that all of these liabilities of the Fed will lead
to inflation. The main item of worry is the large holdings of reserves by
private banks at the Fed.
31
On the one hand, we should be happy that banks are now holding
such a large amount of secure assets, rather than making dangerous risky
loans. The worry is that the banks will eventually want to take their assets
out of reserves and lend them. However, inflation has not materialized.
The U.S. economy has not experienced inflation as a result of
quantitative easing. In fact, inflation has remained slightly below the
Fed’s target of an annual rate of 2 percent.
The Fed now is moving toward “normalizing” monetary policy. It is
gradually raising short-term interest rates above their previous lows, and
the Fed is beginning slowly to sell off some of its assets.
32
European Debt Crisis
Later in the semester we will turn to the problem of sovereign
default – of governments not being able to pay off their loans to outside
investors.
The European Debt crisis arose when Greece could not pay back its
loans, as we detailed earlier. This led to concern that other countries
such as Spain, Italy, Portugal and Ireland might also default.
One cause of the European Debt Crisis was the Global Financial
Crisis. The downturn in the European economies caused by the GFC
made it harder for European countries to pay back their loans.
We will model this in detail later in the semester!
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