Credit Easing: A Policy for a Time of Financial Crises
In a lecture at the London School of Economics on January 13, 2009, Federal Reserve Chairman Ben Bernanke added some clarity to the Fed’s policy response to the current financial crisis. Against the backdrop of its traditional policy tools—changes to the federal funds rate target and loans made through the discount window—the chairman described a framework for understanding the new tools that have been created and employed to support credit markets and restore their functioning. These tools, he 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” to distinguish it from the one taken by the Bank of Japan (“quantitative easing”) when it was in a similar, zero-interest-rate environment. Quantitative easing focuses on the quantity of reserves generated by policy actions, rather than the mix of assets.
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 the new lending facilities has dramatically affected both the composition and size of the Fed’s balance sheet.
Initially, as lending to financial institutions expanded in response to the crisis, it merely displaced securities held outright—the traditionally dominant asset in the Fed’s portfolio. With the failure of Lehman Brothers in September 2008, lending to financial institutions rose sharply, increasing the size of the Fed’s portfolio. Soon after, the size of the assets accumulated as the other two groups of policy tools began to increase as well. Since the beginning of December, however, the total size of the portfolio has diminished, as several of the newly created lending facilities have begun to unwind.
Lending to Financial Institutions
Over the course of the financial crisis, innovative approaches have been needed to ensure that financial institutions have access to short-term credit. Traditionally, the Fed has offered short-term loans to banks through its discount window—most typically over a business day. Such loans are usually secured with very high-quality collateral. Loans to depository institutions in pristine financial condition are classified as primary credit, and banks that do not qualify for primary credit or need to resolve severe financial issues must apply for secondary credit. Unfortunately, there is a stigma associated with discount-window borrowing, and as the financial crisis progressed, the Fed grew concerned that banks were reluctant to tap this critical source of liquidity.
To overcome the stigma problem, the Federal Reserve unveiled the Term Auction Facility (TAF) in December 2007. The TAF auctions funds to depository institutions against the same kinds of collateral that can be used to secure funds at the discount window. But because healthy banks are just as likely to participate in the auction as those in trouble, individual banks are not assumed to be under distress just because they use the facility. The facility has promoted an efficient distribution of liquidity.
At the same time it introduced the TAF, the Federal Reserve announced it would extend currency swap lines with the European Central Bank and the Swiss National Bank. The swap lines provide these central banks with dollars, which they can use to supply liquidity to credit markets in their jurisdictions that are based on dollars.
Despite the success of the TAF, financial conditions worsened in early 2008, especially in March when Bear Stearns collapsed. Liquidity became scarce again when a highly leveraged hedge fund defaulted on a loan, making creditors even more cautious. Another problem emerged as a shortage of Treasury securities in the marketplace threatened to interfere with the process of reducing leverage. In more tranquil times, both U.S. Treasury securities and triple-A rated private mortgage-backed securities serve as collateral in private borrowing arrangements. Not so in today’s environment. Many lenders will now accept only Treasury securities as collateral, and shun the triple-A rated mortgage-backed securities. Some creditworthy borrowers are shut off because they do not have Treasury securities. To deal with the shortage of collateral, the Federal Reserve introduced two new policies: the Term Securities Lending Facilities (TSLF) and the Primary Dealer Credit Facility (PDCF).
The TSLF extended the borrowing term and expanded the types of collateral primary dealers could provide in order to borrow Treasury securities from the Fed. Primary dealers can now hold the securities for up to 28 days (extended from overnight) and provide less-liquid securities as collateral, including federal agency debt, federal agency mortgage-backed securities, and non-agency AAA private mortgage-backed securities.
The PDCF authorized the Federal Reserve Bank of New York to create a lending facility for primary dealers. Under the PDCF, credit extended to primary dealers can be collateralized by a broad range of investment-grade debt securities. This facility extended the Fed’s typical liquidity support facilities to the nonbank broker-dealers and investment banks that the Fed and Treasury transact with on a regular basis. In effect, it created a temporary “discount window” for the some of the largest non-depository institutions. Because the new facilities involved lending to institutions not explicitly allowed for under the Federal Reserve Act, the Fed needed to invoke its authority under section 13(3) of the Act which allows such credit under exigent and emergency conditions.
In September of 2008, the Board of Governors expanded the types of collateral that would be accepted at the TSLF and the PDCF. The TSLF now accepts all investment-grade securities and the PDCF accepts any collateral acceptable in tri-party repo systems. The currency swap lines with the ECB and SNB were also increased at that time, and new swap lines with other central banks were authorized, including the Bank of Japan, the Bank of England, and the Bank of Canada.
Under section 13(3) of the Federal Reserve Act, the Federal Reserve was able to extend loans directly to a distressed financial institution, namely AIG. The loan is collateralized by all of AIG’s assets, and the U.S. government received a 77.9 percent equity interest in AIG.
Providing Liquidity to Key Credit Markets
In spite of these creative devices and their success in funneling massive amounts of liquidity to financial institutions, credit markets were still faltering. One problem was that Fed-supplied liquidity was not necessarily being transferred to credit markets by the financial institutions that had obtained it. Another was that lending to financial institutions was not addressing credit strains in nonbank markets. Over the past two decades, financial intermediation has gradually shifted away from bank lending and toward the capital markets. Because of this shift, stabilizing the financial system requires the Federal Reserve to target the specific lending markets that many companies depend on for short- and long-term financing. The Fed introduced a number of tools intended to support the functioning of these credit markets by providing them access to liquidity.
The first of these markets was money market mutual funds. These funds hold trillions of dollars of short-term government and private sector debt, earning a low-but-steady return for investors who favor the preservation of principal over longer-term, higher-return investments. Following the Lehman Brothers failure, some of these funds sustained losses when they found themselves holding nearly-worthless Lehman debt. The news of losses was threatening to freeze the market (most investors choose money market funds to avoid losses of any kind). Four days after Lehman Brothers filed for bankruptcy, the Federal Reserve announced a new lending facility intended to provide a liquidity backstop for these funds. The facility provides a way for banks to finance the purchase of asset-backed commercial paper from the money funds. The effect of the announcement was to permit an orderly management of withdrawals from the money funds, preventing a liquidation of assets at distressed prices, which could have destabilized the funds' net asset values.
The Fed’s Commercial Paper Funding Facility (CPFF) was introduced on October 7 to support the commercial paper market. Commercial paper is short-term (overnight to 270-day maturity) debt issued by corporations, often to manage cash needs in the short run, such as payroll obligations. It is most often unsecured, but in recent years many financial institutions secured their paper (called “asset-backed commercial paper”) with their holdings of long-term assets, most notably mortgage-backed bonds. Uncertain credit markets in the fall of 2008 led to concerns that companies that had issued unsecured paper or asset-backed commercial paper would be unable to roll it over into new debt. At the time the CPFF was announced, the market would only allow paper to be rolled over one night and at very high interest rates. The CPFF is intended to alleviate the rollover risk. The facility purchases 3-month unsecured and asset-backed commercial paper that carries credit ratings in the top tier. Interest rates float at levels intended to make short-term financing costs reasonable for issuing companies, but high enough that the private commercial paper market will be the better economic choice as it returns to normalcy.
The Maiden Lane LLCs are some of the most esoteric components of the Federal Reserve’s balance sheet. All three are tied to pools of assets that the Fed has lent against to stabilize specific companies and asset classes. The Maiden Lane LLC consists of a loan to J.P. Morgan that is backed by a pool of securities that were obtained from the acquisition of Bear Stearns in March 2008. The pool consists primarily of investment-grade residential and commercial mortgage-backed securities. According to the agreement with J.P. Morgan, the first $1 billion of collateral losses will be borne by the acquiring bank.
Maiden Lane III LLC was created after billions were loaned to AIG. The insurer had extended credit protection—in the form of credit default swaps—on billions of dollars’ worth of collateralized debt obligations (CDOs). When AIG’s credit rating was downgraded, the credit default swap holders ordered collateral postings at levels that threatened the company’s solvency. Beginning in late November 2008, the Fed loaned funds to Maiden Lane III so that it could begin to purchase the CDOs upon which the credit default swap contracts had been written (the CDOs also serve as collateral for the Fed loan). The entity could then begin the process of unwinding the swaps—since it held the assets they derived value from—to stabilize both the derivatives market and AIG.
Maiden Lane II LLC’s purpose also traces back to AIG. In previous years, the insurer had lent some of its large securities holdings to other companies in exchange for cash collateral, which it then invested in mortgage-backed debt products. This produced higher yields than more traditional investments like Treasury securities. However, increasing residential delinquencies and defaults caused the mortgage investments to lose both value and liquidity. Many securities borrowers stopped rolling over their loans and instead demanded their cash back, particularly after AIG was downgraded in September 2008. In December, the Federal Reserve extended a loan to AIG to meet cash redemptions and stabilize the value of the mortgage-backed securities. The loan collateral (mortgage bonds) is represented in the Maiden Lane II LLC vehicle.
Finally, the Federal Reserve announced in November 2008 the creation of the Term Asset-Backed Securities Loan Facility (TALF). Though not yet operational, the program will provide both liquidity and capital to the consumer and small business loan asset-backed securities markets. The Fed will lend money against asset-backed securities that are backed by student, auto, credit card, and SBA loans. What’s more, the Treasury Department has agreed to provide $20 billion in credit protection from its Troubled Asset Relief Program (TARP) to the TALF—a cushion against losses on the ABS collateral. This capital will allow the Federal Reserve to revive the market for securitized consumer loans, which has been essentially shut down since last fall.
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 November 2008, the Federal Reserve announced plans to purchase the direct obligations of the housing-related government-sponsored enterprises (GSEs), specifically Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. In principle, the extra demand for these obligations is designed to increase the price of the securities and thereby lower rates paid for mortgages. Additionally, the Fed outlined plans to purchase mortgage-backed securities backed by Fannie Mae, Freddie Mac, and Ginnie Mae. These actions were designed to improve the availability of credit for the purchase of houses, therefore supporting the housing markets and financial markets in general.
In January 2009, the Federal Reserve began purchasing mortgage-backed securities. Purchases up to $100 billion in GSE obligations and $500 billion in mortgage-backed securities are expected to take place over several quarters. The mortgage market has responded favorably to the Federal Reserve’s program.
Each of the Federal Reserve’s “credit easing” strategies—lending to financial institutions, providing liquidity to key credit markets, and purchasing long-term securities—has helped to restore liquidity to impaired markets and to push down lending spreads to more typical levels. Moreover, the Fed has shown that its policy arsenal can be greatly expanded by changing the composition of its balance sheet assets. With the target federal funds rate now near zero, credit easing will undoubtedly play a leading role in promoting the full recovery of the economy and financial markets.