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Global Financial Crisis

Part 3

Econ 730

Spring 2020

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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

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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.

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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.

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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.

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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.

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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

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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.

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• 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.

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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

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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.

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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.

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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.

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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.

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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

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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

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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.

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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.

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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.

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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

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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

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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

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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.

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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.

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“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.

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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.

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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.

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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.

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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.

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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.

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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.

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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!