Forefront in the Classroom :: Spring 2010 Volume 1 Number 2

The Federal Reserve Bank of Cleveland’s policy publication, Forefront, is a great tool for generating topical class discussions.

The Fed's Exit Strategy Explained

Beginning in 2008, the Federal Reserve purchased $1.25 trillion worth of mortgage-backed securities, dramatically increasing the asset side of the central bank’s balance sheet. Read more (PDF)

Exit Strategy

  1. Commercial banks are required to keep some of their money in a reserve account with the Fed. Currently banks have over $1 trillion in excess reserves over the required amount. What will happen if the bulk of this money on reserve enters the banking system all at once?
    • If the bulk of the money on reserve enters the banking system all at once it could cause inflationary pressures. To keep the reserves from entering the banking system all at once, Congress gave the Fed power to pay interest on reserves. Increasing the interest rate paid on reserves would increase the incentive for banks to keep money in their reserve accounts. The Fed can also raise the federal funds rate (the rate at which banks borrow from each other overnight).
  2. What other tools could the Fed use to manage the supply of bank reserves?
    • Term deposits – banks put money on deposit for a specified amount of time such as six months.
    • Reverse repos – the Federal Reserve lends out securities from its portfolio and banks use reserves on deposit as payment, keeping those reserves out of the marketplace.
    • Redemption of maturing mortgage-backed securities or their outright sale – with sales, banks would pay for the securities by having their reserve balances debited.

The Community Reinvestment Act and the Economics of Lending in Lower-Income Neighborhoods

The Community Reinvestment Act helped end the practice of redlining. But 33 years after its introduction, it may be time to consider whether the CRA needs a twenty-first century overhaul. Read more (PDF)

  1. The term redlining came about in 1935 when a team from the Home Owners Loan Corp. launched a project to help families avoid foreclosure by color-coding neighborhoods in 239 cities by real-estate risk level. The maps assigned a scale of one (lowest risk) to four (highest risk) where low- income people, who in many cases happened to be African-American, were assigned the color red. Thirty years later, the term "redlining" was coined. What negative impact did redlining have on low-income and minority neighborhoods?
    • Redlining caused some banks to contribute to the decline of some neighborhoods by stifling the flow of credit. The banks would take the deposits from residents of the neighborhoods and invest them outside of the community even though there were creditworthy borrowers and profitable investment opportunities inside the neighborhoods.
  2. How did the Community Reinvestment Act of 1977 address redlining?
    • The CRA tried to end redlining by requiring financial institutions to meet the credit needs of lower-income communities where they collect deposits and lend to creditworthy borrowers. The CRA required that banks must not arbitrarily refuse borrowers because of where they lived.
  3. What are the CRA’s accomplishments?
    • Research has shown that the CRA has brought credit and investment to lower-income communities because the number and dollar amount of prime mortgage loans since the CRA passed has grown.
    • Evidence shows the CRA has increased homeownership and decreased vacancies in lower-income areas.
  4. What are the CRA’s shortcomings?
    • There are signs that the CRA has not kept up with changing times. Assessment areas are defined around banks’ branches because the CRA was designed when banking was strictly local, not taking into account interstate collaborations between banks that may invest in low-income neighborhoods.
    • Many large financial institutions view compliance as akin to paying a regulatory tax.

A Proposal: Using the CRA to Fight Vacancy and Abandonment

In 2009, banks became the reluctant holders of more than 1,500 foreclosed properties in Cuyahoga County, Ohio. Most of these houses are in Cleveland, worth little to nothing, and in danger of remaining vacant for the foreseeable future—destined to define neighborhood decay. Read more (PDF)

  1. Researchers at the Federal Reserve Bank of Cleveland came up with a proposal to modify the Community Reinvestment Act (CRA) rules to give banks incentives to provide credit-worthy community groups with loans, services and investments that support neighborhood recovery efforts. What are some of the incentives to the banks that the proposal outlines?
    • Banks can get some points toward higher CRA ratings by donating properties to community groups and providing loans for rehabbing and demolition.
    • Awarding outstanding ratings to banks that focus on rehabilitation and demolishing of foreclosing properties in certain lower-income census tracts nationwide, as long as their other CRA activities remain satisfactory.
  2. What are the advantages of this proposal for the communities?
    • Banks can take a straight route to an outstanding rating by focusing on activities that reduce the number of vacant houses. Hard hit housing markets also can get the help they need.

Seeing the Forest and the Trees: A Systemic Risk Identification Model

What could we have done differently to spot—and then stop—the impending financial crisis of 2008? Read more (PDF)

  1. The Federal Reserve Bank of Cleveland has been working on a way to identify systemic-risk, which is risk of collapse of the entire financial system. The identification model is called SAFE, Systemic Assessment of the Financial Environment, to help identify early signs of emerging shocks and structural weaknesses in the financial system. In the SAFE model, shock is thought of as a sudden change in investors’ expectations. What are the three factors these expectations are based on?
    • One factor is called return or how much an investor may expect to make on a particular asset; the second factor is risk, the chance that an asset may lose some or all of its value; and the third is liquidity or the ease with which an investor may turn the investment into cash.

Small Businesses: Credit Where Credit is Due?

The story of Torbeck Industries, a Harrison, Ohio, manufacturer of safety equipment, has grown all too familiar. Read more (PDF)

  1. The Federal Reserve has paid attention to the problems of small business owners by keeping near zero interest rates, several emergency programs and forums to hear from small business executives and bankers. Why are small businesses’ problems troublesome for the whole nation?
    • Over the last 15 years, small businesses have been a major employer, creating almost two of every three new jobs, and they have employed nearly half of all workers. They have also created half of GDP. During the current recession, small businesses have lost half of U.S. jobs versus 10 percent in the 2001 recession.
  2. What has the Fed done to help small businesses?
    • The Fed has joined other regulatory agencies in issuing new guidance for small businesses and commercial real estate lending to encourage bankers to work with customers during periods of stress.

Interview with Anil K. Kashyap

Some say that the financial crisis has launched a thousand Ph.D. dissertations and perhaps just as many books. Anil Kashyap was on the case from the very beginning. Read more (PDF)

  1. Anil K. Kashyap, co-author of "Everything You Need to Know about the Financial Crisis," and the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago’s Booth School of Business, said a combination of things were responsible for failure of the financial system including the ratings agencies, the regulators, the politicians and the traders inside financial institutions to name a few. How does the Squam Lake proposal, which he co-authored, address financial reform?
    • The biggest thing is creating a resolution authority to shut down troubled financial institutions, changing capital standards and changing liquidity standards.

View: Neighborhood Stabilization: Early Reports on Policymaking in Action

Many neighborhoods bear visible scars of the housing crisis in the form of vacant and abandoned homes. These properties attract crime, drag down the values of neighboring properties, and erode a neighborhood’s sense of community. Read more (PDF)

  1. The federal Neighborhood Stabilization Program, enacted in July 2008, gave nearly $4 billion in grants to neighborhoods with the highest concentration of vacant and foreclosed properties. What has the Federal Reserve Bank of Cleveland learned in assessing NSP’s use of funding?
    • Communities define "neighborhood stabilization" in different ways, so there must be flexibility in how the NSP funds can be spent. Partnerships, especially long-established ones, are vital in the success of NSP.