Federal Reserve responses to the subprime crisis

Federal Reserve responses to the subprime crisis

The U.S. central banking system, the Federal Reserve, in partnership with central banks around the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy. [http://www.federalreserve.gov/newsevents/speech/bernanke20080110a.htm]

ignaling

In August 2007, the Federal Open Market Committee announced that "downside risks to growth have increased appreciably," a signal that interest rate cuts might be forthcoming. [ [http://www.federalreserve.gov/newsevents/press/monetary/20070817b.htm FRB: Press Release-FOMC statement-17 August 2007 ] ] Between 18 September 2007 and 30 April 2008, the target for the Federal funds rate was lowered from 5.25% to 2% and the discount rate was lowered from 5.75% to 2.25%, through six separate actions. [ [http://www.federalreserve.gov/newsevents/press/monetary/20070918a.htm FRB: Press Release-FOMC Statement-18 September 2007 ] ] [ [http://www.federalreserve.gov/newsevents/press/monetary/20080318a.htm FRB: Press Release-FOMC statement-18 March 2008 ] ] The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility via the Discount window.

Open market operations

The Fed and other central banks have conducted open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates charged to member banks (called the discount rate in the U.S.) for short-term loans. [cite web | title = FRB: Speech--Bernanke, The Recent Financial Turmoil and its Economic and Policy Consequences--15 October 2007 | url=http://federalreserve.gov/newsevents/speech/bernanke20071015a.htm | accessdate=2008-05-19 | year = 2008 ] Both measures effectively lubricate the financial system, in two key ways. First, they help provide access to funds for those entities with illiquid mortgage-backed securities. This helps these entities avoid selling the MBS at a steep loss. Second, the available funds stimulate the commercial paper market and general economic activity. Specific responses by central banks are included in the subprime crisis impact timeline.

Term auction facility

The Fed is using the Term auction facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly amount of these auctions to $100 billion during March 2008, up from $60 billion in prior months. In addition, term repurchase agreements expected to cumulate to $100 billion were announced, which enhance the ability of financial institutions to sell mortgage-backed and other debt. The Fed indicated that both the TAF and repurchase agreement amounts will continue and be increased as necessary. [ [http://www.federalreserve.gov/newsevents/press/monetary/20080307a.htm FRB: Press Release-Federal Reserve announces two initiatives to address heightened liquidity pressures in term funding markets-7 March 2008 ] ] During March 2008, the Fed also expanded the types of institutions to which it lends money and the types of collateral it accepts for loans. [ [http://biz.yahoo.com/ap/080320/fed_credit_crisis.html Investment Firms Tap Fed for Billions: Financial News - Yahoo! Finance ] ] Dead link|date=July 2008

Reducing foreclosures

Fed Chairman Bernanke also delivered a speech 4 March 2008 titled "Reducing Preventable Mortgage Foreclosures." He advocated several solutions, including the reduction of loan principal amounts. [ [http://www.federalreserve.gov/newsevents/speech/bernanke20080304a.htm FRB: Speech-Bernanke, Reducing Preventable Mortgage Foreclosures-4 March 2008 ] ] This solution was highlighted to address a growing concern that an estimated 8.8 million U.S. homeowners (10%) with negative equity (homes worth less than the mortgage principal) will have a financial incentive to "walk away" from the property, further exacerbating the crisis. [ [http://biz.yahoo.com/ap/080306/housing_woes.html Housing Market Spirals, No End in Sight: Financial News - Yahoo! Finance ] ] Dead link|date=July 2008

Funds and guarantees

In March 2008, the Fed also provided funds and guarantees to enable bank J.P. Morgan Chase to purchase Bear Stearns, a large financial institution with substantial mortgage-backed securities (MBS) investments that had recently plunged in value. This action was taken in part to avoid a potential fire sale of nearly U.S. $210 billion of Bear Stearns' MBS and other assets, which could have caused further devaluation in similar securities across the banking system. [ [http://www.msnbc.msn.com/id/23662433/ JPMorgan to buy Bear Stearns for $2 a share - U.S. business - MSNBC.com ] ] [ [http://www.msnbc.msn.com/id/23638138/ After Bear Stearns, others could be at risk - U.S. business - MSNBC.com ] ] In addition, Bear had taken on a significant role in the financial system via credit derivatives, essentially insuring against (or speculating regarding) mortgage and other debt defaults. The risk to its ability to perform its role as a counterparty in these derivative arrangements was another major threat to the banking system. [ [http://www.economist.com/finance/displaystory.cfm?story_id=10881453 Investment banks | The $2 bail-out | Economist.com ] ]

Mortgage lending rules

In July 2008, the Fed finalized new rules that apply to mortgage lenders. Fed Chairman Ben Bernanke stated that the rules "prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments...Other measures address the coercion of appraisers, servicer practices, and other issues. We believe the new rules will help to restore confidence in the mortgage market." [ [http://www.federalreserve.gov/newsevents/testimony/bernanke20080715a.htm FRB: Testimony-Bernanke, Semiannual Monetary Policy Report to the Congress-15 July 2008 ] ]

Commercial Paper Funding Facility (CPFF)

On October 7, 2008 the Federal Reserve further expanded the collateral it will loan against, to include commercial paper. The action made the Fed a crucial source of credit for non-financial businesses in addition to commercial banks and investment firms. Fed officials said they'll buy as much of the debt as necessary to get the market functioning again. They refused to say how much that might be, but they noted that around $1.3 trillion worth of commercial paper would qualify. There was $1.61 trillion in outstanding commercial paper, seasonally adjusted, on the market as of October 1, 2008, according to the most recent data from the Fed. That was down from $1.70 trillion in the previous week. Since the summer of 2007, the market has shrunk from more than $2.2 trillion. [ [http://biz.yahoo.com/ap/081007/financial_meltdown.html Fed Action] ]

References


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