Dealing With Financial Turmoil: The Fed’s Response David C. Wheelock* Federal Reserve Bank

1. Dealing With Financial Turmoil: The Fed’s Response David C. Wheelock* Federal Reserve Bank of St. Louis November 6, 2008 *Views expressed are not necessarily official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

2. The Housing Slump: Root of the Crisis • Declining sales and rising vacancy rates • Less construction • Falling house prices • Rising foreclosure rates • Cause mortgage-backed securities to decline in value, resulting in large financial losses and uncertainty about viability of counterparties.

3. Sales of Existing Homes Annual Rate Last Observation: Sept 2008

4. Home Vacancy Rate Percent Last Observation: Q3:2008

5. Months Supply of New and Existing Single Family Homes Months Last Observation: Sept 2008

6. U.S. Building Permits and Housing Starts Thousands Last Observation: Sept 2008

7. Median Sales Price of Existing Single Family Homes Year over Year % Change Last Observation: Sept 2008

8. The Growth In House Prices: United States Average Year over Year % Change Last Observation: 2008:Q2

9. The Housing Boom (Bubble?) • Many economists discounted the “bubble” notion: • Income growth was high • Interest rates were low • But, house prices rose much faster than GDP, rents, or median household income

10. House Price and GDP Growth S&P/Case Shiller Home Price Index and U.S. GDP Growth, 2001 = 1 House Price Index GDP Last Observation: 2Q 2008

11. House Prices Compared to Rent Note: OFHEO Purchase only index begins in Q1:1991. Value set equal to C-S index for Q1:1991. Rent Price is from CPI index. Last Observation: 2008:Q2

12. House Prices Compared to Median Income Note: Income is Nominal U.S. Median Income. US Ratio is C-S HPI. Regional Ratios are OFHEO HPI.

13. What Caused the Boom? House prices had been rising since the mid-1990s, but accelerated in 2002-03, coinciding with: • Low interest rates • Rising household incomes • Mortgage market innovations (“originate to distribute” – subprime loans and securitization)

14. House Price and Personal Income Growth Percent Last Observation: 2008:Q2

15. House Price Growth and Mortgage Rate HPI growth rate Mortgage rate Last Observation: 2008:Q2

16. Large Increase in Non-Prime Mortgages, 1995 - 2006

17. What Ended the Boom? House price appreciation began to fall in the second half of 2005, coinciding with: • Slowing of U.S. personal income growth • Rise in mortgage rates • Hurricane’s Katrina and Rita

18. Consequence of the housing slump…

19. Financial Distress

20. Falling House Prices and Financial Distress • Rise in mortgage defaults and foreclosures • Mainly on subprime, adjustable rate loans • Significant losses on mortgage-backed securities and derivatives (especially private-label MBS’s, even highly-rated securities) • Uncertainty about the viability of counterparties caused risk spreads to increase and trading in financial markets to fall sharply.

21. House Prices and Foreclosure Rate Rate of New Foreclosures % Change in House Prices Case-Shiller Index Last Observation: 2008:Q2

22. U.S. Foreclosure Rates by Loan Type Rate of New Foreclosures Last Observation: 2008:Q2

23. How this Became a Crisis • “Originate to Distribute” lending model • Principal/agent problems – originators often didn’t have skin in the game • Investors relied on ratings agencies that used backward-looking valuations and had their own principal/agent issues • Fannie Mae and Freddie Mac had conflicting objectives, were highly leveraged but lightly regulated. • Credit default swaps and other over-the-counter derivatives ($50+ trillion!)

24. Interest Rate Spreads and Illiquid Markets Percent Last Observation: October 31, 2008

25. Commercial Paper OutstandingSeasonally Adjusted, Billions of Dollars Last Observation: October 22, 2008

26. The Fed’s Response

27. The TAF, TSLF, and PDCF • Term Auction Facility (TAF): Fed auctions fixed amount of reserves to DIs; provides liquidity while avoiding the stigma of borrowing at the discount window. • Term Securities Lending Facility (TSLF): Fed lends Treasury securities to DIs in exchange for other marketable assets. • Primary Dealer Credit Facility (PDCF): Lending facility for all primary dealers, including non-DIs.

28. Bailouts and Non-Bailouts • Bear Stearns (March ’08): Fed lent $30 billion to facilitate JPMorgan’s acquisition of Bear. Concern about systemic risk. • Fannie/Freddie (Sept. ’08): Treasury places in conservatorship, replaces CEOs. • Lehman (Sept. ’08): Allowed to fail. • AIG (Sept. ’08): Fed lends up to $85 billion (increased later to $120); CEO replaced. Systemic risk – huge amount of credit default swaps outstanding.

29. The $700 Billion TARP Troubled Asset Relief Program • Capital Purchase Program – Treasury will purchase preferred stock in a qualifying financial firm. • $125 billion in nine largest banks • $125 billion in other banks that apply and qualify • Other program(s) may include purchases of MBSs and loans, insurance of troubled assets, and assistance to borrowers.

30. Commercial Paper, Money Market Funds • Commercial Paper Funding Facility (CPFF): Fed will purchase highly-rated unsecured and asset-backed commercial paper. • Money Market Mutual Fund Liquidity Facility (AMLF): Fed loans to banks to purchase asset-backed paper from MMMFs. • Money Market Investor Funding Facility (MMIFF): Sets up special vehicles to buy money market instruments. Fed committed up to $540 billion.

31. Old Fashioned Monetary Policy • The FOMC has sharply cut the fed funds rate target – negative real rate throughout 2008. • Monetary base growth – up sharply since September (“quantitative easing”).

32. Target Fed Funds Rate minus Yr/Yr CPI Inflation Percent Forecast Expected Fed Funds Futures, CPI MA Forecast Last Observation: Sept 2008

33. St. Louis Adjusted Monetary Base, Yr/Yr Growth, SA Percent Last Observation: 10/20/08

34. Summary (1) • The financial crisis was triggered when house prices began to decline and subprime mortgage defaults increased. • Subprime accounts for about 10 percent of mortgage market. Subprime ARMs represent about 7 percent of loans, but 43 percent of foreclosures. • Some $85 billion of losses on non-prime mortgage loans has mushroomed into some $1.4 trillion of losses world wide (IMF estimate).

35. Summary (2) • Systemic failure centered in MBSs and other derivatives that have lost substantial market value. • The Fed (and other agencies) have attempted to contain the crisis and re-start financial markets by providing liquidity and acting as lender of last resort.

36. Questions?