The Impact of Credit Easing So Far
Although credit market conditions have improved some in recent weeks, liquidity strains remain. Accordingly, monetary policy continues to focus on restoring financial stability. A recent Economic Trends article describe a framework for understanding the new policy tools that have been created and employed by the Federal Reserve to support credit markets and restore their functioning. These tools, as Chairman Bernanke has pointed out, enable the Fed to respond aggressively to the crisis even though the federal funds rate stands near zero.
One common feature of the new tools is that “They all make use of the asset side of the Federal Reserve’s balance sheet. That is, each involves the Fed’s authorities to extend credit or purchase securities.” In this way, the Fed can supplement its traditional monetary policy tools by changing the mix of the financial assets it holds, stimulating specific troubled markets in the process. Chairman Bernanke calls the approach “credit-easing.” (Our website provides data on each of the new tools.)
While many new, seemingly diverse credit-easing tools have been introduced, Bernanke divides them into three groups: lending to financial institutions, providing liquidity to key credit markets, and purchasing longer-term securities. Most of the tools are an extension of the Fed’s traditional role as lender of last resort, the purpose of which is to ensure that healthy financial institutions have access to sufficient short-term credit, particularly during times of financial stress. The use of each of the new lending facilities is monitored by analysts to assess whether conditions in the corresponding private markets are improving.
Lending to Financial Institutions
Lending to financial institutions represents the largest share of the credit-easing tools, accounting for 58 percent of the Federal Reserve’s portfolio as of March 2009. This class of tools is most closely related to the Federal Reserve’s lender-of-last-resort responsibility. The category includes repurchase agreements, primary credit, foreign currency swaps, the Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF), securities lent to dealers (including the Term Securities Lending Facility or TSLF), and credit extended to AIG.
After peaking in late December, lending to financial institutions dropped substantially, largely as a consequence of a decline foreign currency swaps. Currency swap lines provide foreign central banks with dollars, which they can use to supply liquidity to credit markets in their jurisdictions that are based on dollars. The decline in currency swaps indicates that dollar liquidity conditions abroad have improved.
Providing Liquidity to Key Credit Markets
Providing liquidity to key credit markets, representing the second-largest share of the credit-easing policy tools, currently accounts for 17 percent of the Fed’s balance sheet. Of the different programs in this category, the Asset-Backed Commercial Paper/ Money Market Mutual Fund Facility (ABCP/MMF) is perhaps the furthest along in accomplishing the restoration of a key credit market. This facility was created to help restore confidence in money market funds at the peak of the financial crisis in September. The facility appears to be working well, as money funds are growing—a sign of increased confidence in this instrument.
The net portfolio holdings of the Commercial Paper Funding Facility (CPFF) continue to decline, leaving it well off its peak of $351 billion in late January. After the collapse of Lehman Brothers, the term commercial paper market essentially shut down. Creditworthy issuers could obtain funds only over very short terms and at extremely high rates of interest.
The CPFF was created to allow the Fed to acquire new, private issues of tier-1 (highest quality) commercial paper with maturities of 90 days. The facility thus provided some assurance to potential issuers of commercial paper that the market would remain a reliable source of funding over terms of several months, thereby reducing the risk that issuers would not be able to roll over their debt if funding needs persisted.
The issuance of very short-term paper dropped dramatically with the new source of longer-term funding and stayed low as the longer-term issues held began to roll over in late January. About 60 percent of the paper held by the CPFF was reissued by the CPFF, indicating some continued market impairment. Moreover, some of maturing paper was neither rolled over in the CPFF nor issued to the market. Issuers that did not reissue to the CPFF or place commercial paper in the market employed several alternative funding strategies, including prefunding earlier in the month, issuing Temporary Lending Guarantee Program (TLGP) debt, funding through intercompany loans, or retiring paper as firms reduced their short-term funding needs.
While issuers’ reduced reliance on the facility is a positive signal, money markets have not demonstrated sufficient risk tolerance to absorb a substantial quantity of paper. Numerous challenges to issuers in securing term financing in the commercial paper market indicate that the market remains unreliable. Only the most reputable issuers were able to place paper at desired rates and maturities, while most struggling institutions and the conduits for asset-backed commercial paper could only place in the overnight to two-week range, as investors were reluctant to take on additional credit risk.
Despite concerns of rate spikes due to an oversupply of paper in late January, average rates did not widen. Nevertheless, rate spreads over risk-free term rates like the overnight index swap rate (OIS) seem to indicate the continuing, though lessened, need for support from the CPFF.
Purchasing Longer-Term Securities
In addition to lending to financial institutions and providing liquidity directly to key financial markets, the Federal Reserve employed a third set of policy tools aimed at improving conditions in private credit markets. These tools involve the purchase of long-term securities in these markets.
In January 2009, the Federal Reserve began purchasing mortgage-backed securities. Purchases up to $100 billion in government-sponsored-enterprise (GSE) obligations and $500 billion in non-GSE mortgage-backed securities are expected to take place over several quarters. The mortgage market has responded favorably to the Federal Reserve’s program. Indeed, immediately after the announcement of the intended purchases, mortgage rates fell and have stayed low.
Over the past year or so, the Federal Reserve has introduced a number of new tools for dealing with the financial crisis. Increasing market attention has been given to these instruments, especially after the federal funds rate reached its lower bound. While it is too early to judge the overall effectiveness of credit easing, conditions in many financial markets have improved to near-normal levels. Given the great uncertainty surrounding the state of the economy, it is critical that credit markets be given the support necessary to continue to function.