By Robert Stowe England
June 22, 2009
Last week Federal Reserve Board Governor Elizabeth A. Duke took time out, she said, “to look back on the policies that have been implemented throughout the financial crisis and consider how well they have worked to lessen the broader impact of financial market disruptions.”
Duke, who joined the Federal Reserve’s Board of Governors last August on the eve of the financial meltdown in September, gave her early analysis of the impact of Fed policies on credit availability at the annual meeting of Women in Housing and Finance June 15 in Washington, D.C.
For a brief bio of Governor Duke, go to this link:
But, it was not too early, she noted, to look at specific credit markets to see if the Fed’s credit easing policies “have worked to avert a far more severe and detrimental outcome.”
While the Fed’s traditional monetary policy was intended “to strengthen aggregate demand, the ultimate goal of the other policies is to maintain credit availability to households and businesses.”
Duke was careful to point out that the Fed’s policy of expanding its balance sheet through its credit easing policy “is conceptually distinct from quantitative easing, the policy used by the Bank of Japan from 2001 through 2006.”
Despite her reassurances that the Fed’s activities do not amount to quantitative easing, some market analysts continue to view them as such.
Duke offered a brief tutorial. “Quantitative easing can be thought of as an expansion of the central bank’s balance sheet with no intentional change in its composition,” she stated.
“That is, the central bank undertakes more open market operations with the objective of expanding bank reserve balances, which the banking system should then use to make new loans and buy additional securities,” Duke saud.
Duke then explained why quantitative easing is not the appropriate policy to address the crisis that erupted after the failure of Lehman Brothers last September. “[W]hen credit spreads are very wide, as they are at present, and the credit markets are quite dysfunctional, it becomes less likely that new loans and additional securities will result from increasing bank reserve balances” – that is, will result from quantitative easing.
Credit easing is different because it “focuses on the mix of loans and securities that the central bank holds as assets on its balance sheet as a means to reduce credit spreads and improve the functioning of private credit markets,” Duke said.
Note: Figures in this story are taken from the online copy of Governor Duke's speech. See link at the end of story.
As the above figure graphically illustrates, the Fed's balance sheet more than doubled over the past year. More details on the Fed's balance sheet are available in the first monthly report on its credit and liquidity programs released June 10. The report can be found at this link: http://www.federalreserve.gov/newsevents/press/monetary/monthlyclbsreport200906.pdf
According to the June report, as of May 27, 2009, the Fed had $2.082 trillion in assets on its balance sheet, a $1.176 trillion increase over the level on May 28, 2008.
Governor Duke divided the Fed’s credit easing efforts into four categories and provided a color coded chart to show how the Fed’s balance sheet has grown with reference to each category, as shown in Figure 1 above.
1. Red: Targeted actions to prevent the failure or substantial weakening of specific systemically important institutions
2. Blue: Liquidity programs for financial institutions
3. Green: Lending to support the functioning of key financial markets
4. Orange: Large-scale purchases of high-quality assets
(The fifth area at the bottom part of the figure is colored pink and represents other assets held by the Fed that are not part of its credit easing policies.)
The red category includes the first so-called Maiden Lane transaction in March 2008 to extend support to facilitate the merger of Bear Stearns and JPMorgan Chase. It also includes loans and facilities to support American International Group (AIG), first rescued in September 2008.
Duke sees the narrowing of spreads between LIBOR (the London inter bank offered rate) and OIS (overnight indexed swap), shown in the left panel of Figure 2, as a sign that the Fed’s policy in this area has been successful. Another sign is the diminished use of this program, shown to the right. (For a basic description of the LIBOR-OIS spread, see this link:
The blue category includes a number of facilities to provide liquidity to “severely disrupted” interbank funding markets, as well as repurchase (or repo) markets for securities other than Treasuries, according to Duke. In this program the Fed has the Term Auction Facility, which expanded the range of programs through which it can lend to depository institutions.
Two other blue programs -- The Fed’s Term Securities Lending Facilities and the Primary Dealer Credit Facility -- provide liquidity to primary dealers, Duke explained, to enable markets to buy, sell and issue securities. This program is aimed at reducing stress in repo markets for securities other than Treasuries, importantly mortgage-backed securities.
Duke noted that these blue programs have been successful in narrowing of spreads between agency (Fannie Mae and Freddie Mac) and mortgage-backed securities, on the one hand, with Treasury general collateral repo rates, on the other hand. (See Figure 3.) Again, the Fed governor cited diminished use of this program is another mark of its success.
In the green category, credit-easing policies have been targeted at improving conditions in commercial paper, asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS). One money market mutual fund broke the buck in the aftermath of the failure of Lehman Brothers, a well-publicized event that led to a run on money market funds.
(Breaking the buck is a colloquial expression for a decline in the normally constant $1 net asset value of a Money Market Fund. See Wall Street Journal story here: http://online.wsj.com/article/SB122169845959750475.html)
The Fed’s response was to set up three facilities:
1. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility
2. The Commercial Paper Funding Facility
3. The Money Market Investor Funding Facility.
These three facilities sought to improve the functioning of the commercial paper markets and help money market funds navigate through the volatility that was overtaking the markets.
Duke pointed out that commercial paper conditions have improved markedly since the programs were launched and spreads have narrowed sharply. (See Figure 4.) As the spreads narrowed, again use of these facilities also declined.
The Term Auction Lending Facility (TALF), another green program, is a joint effort of the Fed and the Treasury to improve credit availability by providing loans to investors to finance their acquisition of ABS and CMBS.
The program was in response to the shutdown of these markets last fall. The program began with newly-issued ABS backed by consumer and small business loans. Recently, the program was expanded to include newly-issued and legacy CMBS.
Conditions for ABS markets “have improved notably since the beginning of the year,” Duke said. Similarly, CMBS markets have more recently improved.
Spreads on triple-A rated consumer ABS have narrowed 70 to 80 percent since they peaked in December, Duke noted. Spreads on CMBS have also narrowed, but remain “well above” year ago levels, according to the Fed governor.
The “real story of TALF is new issuance,” Duke said. (See Figure 5.) While the program started off slow it has gained momentum in May and June and overall ABS issuance has returned to levels near what they were before the markets collapsed. Furthermore, the Fed governor explained, there have been some ABS issues outside of TALF.
The orange program is the largest of the credit easing efforts at $1.75 trillion of potential new assets on the Fed's balance sheets. The Fed committed to potential purchases of $1.25 trillion in agency MBS, up to $200 billion of agency debt, plus up to $300 billion of Treasury securities by the fall. It is this program that has garnered the most skepticism in some quarters, sparking fears of renewed inflation. The Fed has, in fact, slowed down its purchases in response to market concerns.
Here Governor Duke expressed more caution. “The program appears to be having its intended effect,” she said. Yields on mortgages relative to yields on Treasuries have come down. (See Figure 6.) There has been a decline of about 1.25 percentage points in the spread between 30-year fixed rate mortgages and 5-year constant maturity Treasury rates since the program began in November.
In recent weeks, however, Treasury rates and mortgage rates have risen, a fact that Duke acknowledged but did not explain in her speech.
Duke also summarized other efforts made by Washington regulators, sometimes in conjunction with the Fed. One is the $200 billion Capital Purchase Program that came out of TARP (Toxic Asset Relief Program) funds and which has expanded the capital base of the largest banks and many smaller banks through direct capital injections from the federal government in return for preferred shares.
As well, the Fed Governor itemized the various FDIC programs that also bolstered the financial system: The temporary raising of the deposit insurance limit from $100,000 to $250,000, the temporary full coverage of non-interest-bearing deposit transaction accounts (Temporary Account Guarantee Program), and newly-issued senior unsecured debt of banks, thrifts and certain holding companies (Temporary Liquidity Guarantee Program).
Finally, Duke tossed in the stress tests performed under the Supervisory Capital Assessment Program, a joint program of the Fed and Treasury. That program – which has also garnered a lot of criticism in the way it was handled – will add additional “capital buffers” worth $185 billion once the 10 targeted banks of the largest 19 raise the capital required to assure that they have Tier 1 capital of more than 6 percent and Tier 1 common equity of more than 4 percent under an “adverse scenario.”
Duke compared the “evolution of credit” in home mortgages, commercial mortgages, consumer credit and nonfinancial business credit in the current and past business cycle downturns.
She measured data for four quarters officially designated as recessions by the National Bureau of Economic Research in the period from 1952 to 2008. (See Figure 7).
Using data from the Fed’s Flow of Funds reports, Duke noted that while home mortgage credit expanded in prior recessions, this is the first recession in the post-war period during which home mortgage credit declined.
The current decline in the availability of home mortgage credit is similar to the one for commercial mortgages in the 1990-1991 recession, Duke noted.
Duke made further comparisons in Figure 8 and Figure 9.
Importantly, Duke found that “with the exception of housing, lending over the current downturn does not appear particularly weak or subdued relative to other downturns.”
Further, the current decline in home lending is not as great as the declines in some credit markets in the 1990-1991 recession. In addition, the current path of lending for credit markets other than home mortgages is more benign that in some past recessions.
She also found that if you are looking only at depositories, lending "does not appear particularly weak or subdued relative to other downturns." (See Figure 10.)
“Given the enormity of some of the events of the past year,” Duke told the gathering, “the findings of these business cycle comparisons may seem somewhat surprising.”
Duke argued that the greater decline in credit availability in the commercial mortgage market in the 1990-1991 recession “could be thought of as a possible scenario for lending in the current downturn in the absence of any policy response.” That is to say, without the Fed’s substantial credit-easing policies “the likely path of lending in the current downturn . . . would have been notably more contractionary than the 1990-1991 recession, given that the earlier episode – while characterized by a financial crisis – did not face as extreme an episode as the one experienced last September,” Duke stated.
Duke’s conclusion: the Fed’s credit easing programs “have been broadly successful in relieving stresses in the key markets.” Given the severity of the crisis, the result is “a surprising but reassuring early indication that the combined policies have been successful at shoring up credit despite these events."
For the full text of Governor Duke’s remarks, go to this link: http://www.federalreserve.gov/newsevents/speech/duke20090616a.htm
Note: In the online text of Governor Duke's speech, the part of Figure 1 that represents Large Scale Purchases of High-Quality Assets is described as being "pink." It clearly is not. The area that is actually pink is the area at the bottom, which is part of the figure that represents "Other Assets." In this story, the writer has refrained from using the word "pink" to describe the category identified as Large Scale Purchases of High-Quality Assets in order to avoid confusion to the reader. He has, instead, described the color for Large Scale Purchases of High-Quality Assets as orange even though it is not exactly orange, but is close enough for the average viewer to identify that part of the figure.
Copyright 2009© by Robert Stowe England