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Current Events in the Economy and Financial Markets :: March 27, 2008 :: Federal Reserve Bank of Cleveland home | news & media | careers | site map FEDERAL RESERVE BANK o f CLEVELAND A bout U Tours For the Public News & Media Com munit y D e velopm ent S tream ing Media Forefront M agazine Speakers Bureau I Our IRegion I Research I Ban kin g I Learning Center Savings Bonds Home > For th e Public > News and Media > Speeches > 2 0 08 > C urrent Events in th e Economy and Financial... SH RRE ^ f ... Current Events in the Economy and Financial Markets Additional Information Sandra Pianalto Introduction As you all know , fin a n c ia l m a rk e ts h av e b e e n u n d e rg o in g a g r e a t d e a l o f s tr e s s th e s e p a s t s e v e ra l m o n th s . It has in d e e d b e e n a ch a lle n g in g an d in te r e s tin g tim e to b e a p o lic y m a k e r, a n d I w e lc o m e th is o p p o rtu n ity to s h a re my p e rs p e c tiv e s on w h a t h as b e e n h a p p e n in g in fin a n c ia l m a rk e ts . T h e F e d e ra l R e serv e S ystem w as c r e a te d in 1 9 1 3 , n o t long a f t e r a s e v e r e ban k in g crisis, to a d d re s s o u r c o u n tr y ’s n e e d fo r fin a n c ia l s ta b ility . T h e F e d e ra l R e serv e h as th e a u th o rity — a n d I m ig h t a d d th e re sp o n sib ility — to p ro v id e th e ban k in g sy ste m w ith a re a d y s o u rc e o f fu n d s in tim e s o f m a rk e t s tre s s . P resident and CEO, Federal Reserve Bank o f Cleveland R.I.S.E. Global Student Investment Forum U n iv ersity o f D ayton March 27, 2008 T o d ay, I w ill p ro v id e so m e c o n te x t fo r th e c u r r e n t fin a n c ia l m a rk e t tu rm o il, d e s c r ib e its p ro g re ssio n , an d th e n e x p la in w h y a n d ho w th e F e d e ra l R eserv e h as b e e n re sp o n d in g to th e s itu a tio n . T h e v iew s I e x p re ss to d a y a r e m in e a lo n e an d do n o t n e c e s sa rily r e f le c t th e v iew s o f m y c o lle a g u e s in th e F e d e ra l R e serv e S ystem . I. A C o n te x t fo r th e C u rre n t F in an c ial T urm oil To a p p r e c ia te th e u n iq u e n a tu r e o f th e c u r r e n t fin a n c ia l m a rk e t tu rm o il a n d policy re sp o n se s, I w o u ld like to beg in by s e ttin g th e c o n te x t b e h in d it. I w ill d e s c rib e th r e e key c o n trib u tin g e le m e n ts — th e housing boom a n d b u st, c h a n g e s in th e s tr u c tu r e o f m o rtg a g e m a rk e ts , an d th e ro le o f highly le v e ra g e d fin a n c ia l in s titu tio n s . T h e f ir s t e le m e n t, o f c o u rs e , is th e unw in d in g o f th e r e c e n t housing b o o m . H ousing boom s a n d b u sts a r e n o t all t h a t u n u su a l a t a lo c a l o r e v e n re g io n a l le v e l. For e x a m p le , w e sa w th e s e b o o m -b u s t p a tte r n s in T ex as in th e m id -1 9 8 0 s a n d in M a ssa c h u se tts a n d C a lifo rn ia in th e e a rly 1 9 9 0 s . F o re c lo su re r a te s in th o s e reg io n s ro se a n d re m a in e d high fo r y e a rs as housing p ric e s fe ll. W h a t is u n u su a l a b o u t th e c u r r e n t s itu a tio n is how b r o a d -b a s e d a n d p e r s is te n t h o u sin g p ric e d e c lin e s h a v e b e e n . O nly a fe w reg io n s o f th e c o u n try h a v e b e e n s p a re d , an d u n fo rtu n a te ly , Ohio is n o t o n e o f th e m . A s e c o n d key e le m e n t r e la te s to c h a n g e s in th e s tr u c tu r e o f m o rtg a g e m a rk e ts . Y ears ag o , p e o p le p u rc h a se d ho m es by b o rro w in g fro m local b an ks a n d th r if t in s titu tio n s , w h ich k e p t th e loan s on th e ir books. Banks an d th r if ts b o re th e risk o f loss if a loan w e n t b a d , so th e y had a c le a r in c e n tiv e to ap p ly high s ta n d a r d s fo r ap p ro v in g m o rtg a g e lo an s. B ut m o rtg a g e le n d in g h as c h a n g e d d r a m a tic a lly o v e r th e p a s t d e c a d e o r so w ith th e in c re a sin g m ove to an “o r ig in a te to d is tr ib u te ” m o d el o f le n d in g . In th is m o d e l, m o rtg a g e b ro k e rs o r ig in a te th e lo an s, b u t http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20080327.cfm[4/29/2014 2:02:46 PM] Current Events in the Economy and Financial Markets :: March 27, 2008 :: Federal Reserve Bank of Cleveland do n o t ow n th e m . O th e r fin a n c ia l c o m p a n ie s, su ch as in v e s tm e n t b an k s, buy th e s e lo an s, pool th e m , a n d r e p a c k a g e th e m fo r s a le as m o rtg a g e -b a c k e d s e c u r itie s . T h e se s e c u r itie s a r e so ld to in v e sto rs a ro u n d th e w o rld . M o rtg ag e b ro k e rs a n d in v e s tm e n t b a n k e rs e a r n f e e s fo r th e ir ro le s, an d th e y h av e s tro n g in c e n tiv e s to g e n e r a te la rg e v o lu m e s o f b u sin e ss. In d e e d , h u g e sum s o f m o n e y h av e flo w e d in to th e U.S. ho u sing m a rk e t. At th e e n d o f 1 9 9 5 , in v e sto rs o w n e d $ 1 9 4 billion w o rth o f h o m e m o rtg a g e s p a c k a g e d as m o rtg a g e -b a c k e d s e c u ritie s . T en y e a rs la te r , t h a t n u m b e r h ad sk y ro c k e te d by a b o u t te n fo ld , to $ 1 .6 trillio n . To s a tis fy in v e s to r s ’ a p p e tit e fo r e v e r -h ig h e r y ie ld s, in v e s tm e n t banks o f fe re d th e ir c u s to m e rs pools t h a t c o n ta in e d m o rtg a g e -b a c k e d s e c u r itie s alo n g w ith s e c u r itie s b a c k e d by o th e r kinds o f lo a n s, such as s tu d e n t, a u to , an d c o m m e rc ia l re a l e s t a t e lo an s. M any o f th e s e n e w fin a n c ia l in s tru m e n ts w e r e c o m p le x b le n d s o f s e c u r itie s , e a c h w ith v ary in g d e g r e e s o f risk. O fte n , th e r e w a s a la ck o f tr a n s p a r e n c y a b o u t e x a c tly w h a t a s s e ts w e r e in th e pools. T h e th ird key e l e m e n t to th e s to ry involves th e g row ing ro le o f highly le v e ra g e d fin a n c ia l in s titu tio n s , su ch as h e d g e fu n d s a n d in v e s tm e n t b an k s. T ak e h e d g e fu n d s, fo r in s ta n c e . H edge fu n d s p ool la rg e sum s o f m o n e y fro m v e ry w e a lth y in d iv id u al an d in s titu tio n a l in v e sto rs, su ch as p en sio n fu n d s, an d u se th e m o n e y to buy a v a r ie ty o f a s s e ts , in c lu d in g c o m p le x a s s e t- b a c k e d s e c u r itie s . B e ca u se th e y a r e n o t le g ally re q u ire d to hold an y cu sh io n a g a in s t losses in th e ir p o rtfo lio s, h e d g e fu n d s c a n e a r n m o re fo r th e ir in v e sto rs by ta k in g on a d d itio n a l risk. O ne w ay th e y do th is is to re ly h ea v ily on b o rro w e d fu n d s. T h e b asic s tr a te g y is to b o rro w fo r th e s h o r t te rm a t a re la tiv e ly low, fix e d r a te o f in te r e s t an d u se th e fu n d s to p u rc h a se re la tiv e ly lo n g e rte rm an d h ig h -y ield in g a s s e ts . This s tr a te g y e n a b le s th e h e d g e fu n d to b o o st th e r a t e o f re tu r n fo r its in v e sto rs. T h e u se o f b o rro w ed m o n e y in th is w a y is c a lle d le v e ra g e . A lthough highly le v e ra g e d in v e s tm e n ts c a n in c re a s e th e in v e s to rs ’ r e tu rn s , th e y also in c re a s e th e ir risk. T he risk is t h a t th e y w ill n o t b e a b le to c o n tin u e to a t t r a c t le n d e rs a n d w ill h a v e to s e ll o ff th e ir a s s e ts to p ay b a c k th e lo an s. H edge fu n d in v e sto rs an d th e ir le n d e rs c a n lo se c o n fid e n c e in p erio d s o f fin a n c ia l s tr e s s — b eh a v in g m uch like d e p o s ito rs d id a t banks b e fo re th e a d v e n t o f d e p o s it in su ra n c e . In th e te rm in o lo g y o f th e n ew fin a n c ia l e n v iro n m e n t, w e c a ll th is b a n k -ru n -lik e b e h a v io r a “ liq u id ity s q u e e z e .” T h e se th r e e e le m e n ts — th e h o using m a rk e t c o r r e c tio n , c h a n g e s in th e s tr u c tu r e o f m o rtg a g e m a rk e ts , a n d th e ro le o f highly le v e ra g e d fin a n c ia l in s titu tio n s — all s e t th e s ta g e fo r th e fin a n c ia l tu rm o il w e h av e s e e n o v e r th e p a s t fe w m o n th s. II. The Turmoil Unfolds W ith t h a t b ac k g ro u n d in m ind, le t m e d e s c rib e th e p ro g re ssio n o f th e fin a n c ia l tu rm o il. Rising in te r e s t r a te s h a d b e e n d riving up m o n th ly m o rtg a g e p a y m e n ts fo r so m e b o rro w e rs. H om e p ric e s h ad b eg u n to w e a k e n , an d an in c re a sin g n u m b e r o f h o m e o w n e rs fo u n d th e y had n e g a tiv e e q u ity — t h a t is, th e ir o u ts ta n d in g m o rtg a g e s e x c e e d e d th e v a lu e o f th e ir h o m e s. T h e se a n d o th e r c irc u m s ta n c e s le d m any h o m e o w n e rs to d e f a u lt on th e ir m o rtg a g e lo a n s an d c a u s e d m any p r o p e r tie s to go in to fo re c lo s u re . H igher m o rtg a g e d e f a u lt r a te s an d fo re c lo s u re s tr a n s la te d in to lo w e r re tu r n s on m o rtg a g e -b a c k e d a s se ts an d th e p o rtfo lio s holding th e m . T h e f ir s t signs o f a liq u id ity s q u e e z e e m e rg e d la s t A ugust, w h en le n d e rs to highly le v e ra g e d fin a n c ia l in s titu tio n s b e c a m e f e a rf u l o f th e p o te n tia l lo sses. To s a tisfy th e ir le n d e rs , th e s e highly le v e ra g e d http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20080327.cfm[4/29/2014 2:02:46 PM] Current Events in the Economy and Financial Markets :: March 27, 2008 :: Federal Reserve Bank of Cleveland in s titu tio n s w e r e fo rc e d to se ll so m e o f th e ir a s s e ts . W hen a la rg e n u m b e r o f a s s e ts c a m e on th e m a rk e t fo r s a le , th e r e w e r e fe w b u y ers. P rices fo r th e s e risky a s s e ts f e ll f u r th e r , an d le n d e rs b e c a m e r e lu c ta n t to f in a n c e th e ir tr a d itio n a l c u s to m e rs . T h e fin a n c ia l sy stem t h a t h a d w o rk e d so w e ll w h e n a s s e t v a lu e s w e r e a p p r e c ia tin g w as n o w stru g g lin g . P e o p le w ho h ad b e e n w illing to h old c o m p le x fin a n c ia l a s s e ts now w a n te d s a fe U.S. T re a s u ry s e c u r itie s o r ca sh . As th e n a tio n ’s c e n tr a l b an k , th e F e d e ra l R e serv e has th e a b ility to c r e a t e an a s s e t t h a t e v e ry o th e r p a r tic ip a n t in th e fin a n c ia l sy stem alw ay s a c c e p ts a t f a c e v a lu e . W e p ro v id e c a sh to th e b an k in g sy stem e le c tro n ic a lly , in o n e o f tw o b asic w ay s. Banks c a n b o rro w s h o r t-te r m fu n d s d ir e c tly fro m R e serv e Banks a t th e d is c o u n t w in d o w , an d w e re q u ire th e m to p o s t c o lla te r a l fo r th e te rm o f th e lo a n . W e le n d a t a r a te c a lle d th e d is c o u n t r a te on p rim a ry c r e d it. W e also p ro v id e ca sh to th e ban k in g sy ste m by buying U.S. T re a s u ry s e c u r itie s on th e o p en m a rk e t an d p aying fo r th e m by c re d itin g th e b a n k a c c o u n t o f th e p rim a ry s e c u r itie s d e a le r w ho se lls th e m to us. W e c a ll th e s e tr a n s a c tio n s o p e n m a rk e t o p e ra tio n s . In n o rm a l tim e s , th e F e d e ra l R e serv e re lie s o v erw h elm in g ly on o p en m a rk e t o p e ra tio n s to su p p ly m o n e y to th e fin a n c ia l sy ste m . Lending a t th e d is c o u n t w in d o w c o m e s in to p lay o c c a sio n a lly to h elp in d iv id u al b an k s w ith v e ry s h o r t- te r m liq u id ity n e e d s. B e tw e e n A ugust a n d N o v em b er, w e u se d th e tr a d itio n a l to o ls of m o n e ta ry policy a n d d is c o u n t w in d o w le n d in g , a n d th e y a p p e a r e d to b e w o rk in g . In d ic a to rs o f risk s e e m e d to s ta b iliz e . B ut m a rk e ts re m a in e d fra g ile , a n d th e y r e a c te d stro n g ly to n ew s a b o u t th e h e a lth o f v ario u s fin a n c ia l c o m p a n ie s. By m id -D e c e m b e r, th e s itu a tio n e n t e r e d a n ew , m o re d isc o n c e rtin g p h a s e . T h e housing d o w n tu rn a p p e a r e d to b e spilling o v e r in to o th e r s e c to r s o f th e e c o n o m y , as c o n s u m e r s p e n d in g a n d b u sin ess in v e s tm e n t slo w e d . S om e o f th e la rg e c o m p a n ie s t h a t sto o d a t th e c ro ssro a d s o f th e fin a n c ia l m a rk e ts w e r e s till having liq u id ity p ro b le m s. And, p e rh a p s m o re im p o r ta n t, m an y c r e d itw o rth y b o rro w e rs w h o w e r e f a r re m o v e d fro m th e m o rtg a g e m a rk e ts co u ld n o t fin d c r e d it. III. Unusual Circumstances Call for Creative Policy Responses L et m e d e s c rib e how th e F e d e ra l R e serv e has re s p o n d e d to th e s e u n u su a l c irc u m s ta n c e s . As liq u id ity p re s s u re s in te n s ifie d in D ec em b e r, it b e c a m e c le a r t h a t th e F e d e ra l R e serv e w o u ld n e e d to ta k e a d d itio n a l s te p s to a d d re s s th e s e p ro b le m s. O ne sh o rtc o m in g o f using d is c o u n t w in d o w le n d in g , e s p e c ia lly in p e rio d s w h e n m a rk e ts a r e s tr a in e d , is t h a t m an y fin a n c ia l in s titu tio n s an d m a rk e t p a r tic ip a n ts in fe r t h a t a b a n k t h a t b o rro w s fro m th e d is c o u n t w in d o w m ay b e in tr o u b le . This stig m a , w h ich e x ists re g a rd le ss o f th e a c tu a l re a so n s fo r b o rro w in g o r th e so u n d n e ss of th e b o rro w e r, o f te n m a k es b an k s r e lu c ta n t to ta k e a d is c o u n t w in d o w lo a n , e s p e c ia lly in tim e s o f m a rk e t s tr e s s . T hus, e v e n th o u g h th e F e d e ra l R eserv e a n n o u n c e d its w illin g n ess to le n d a t th e d isc o u n t w in d o w , c r e d itw o rth y banks w e r e r e lu c ta n t to ta k e u p th e o ffe r. To a d d re s s th e stig m a p ro b le m , in D e c e m b e r th e F e d e ra l R eserv e c r e a te d th e T erm A uction F acility , o r TAF, as i t is c a lle d . This n e w su p p le m e n ta r y to o l a d d re s s e s liq u id ity d e m a n d s by p ro v id in g an o p p o rtu n ity fo r h e a lth y banks to bid in an a u c tio n fo r d isc o u n t w in d o w loans w ith a 2 8 - d a y m a tu r ity an d to u se a b ro a d a r r a y of in s tru m e n ts fo r c o lla te r a l. D esp ite th e su c c e ss o f th e TAF, fin a n c ia l c o n d itio n s w o rs e n e d in e a rly 2 0 0 8 . L iquidity b e c a m e s c a r c e ag ain w h e n a highly le v e ra g e d h e d g e http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20080327.cfm[4/29/2014 2:02:46 PM] Current Events in the Economy and Financial Markets :: March 27, 2008 :: Federal Reserve Bank of Cleveland fu n d d e f a u lte d on a lo a n , m aking c r e d ito r s e v e n m o re c a u tio u s . A n o th e r p ro b le m e m e r g e d , as a s h o r ta g e o f T re a s u ry s e c u r itie s in th e m a rk e tp la c e th r e a te n e d to in te r f e r e w ith th e p ro c e ss o f re d u c in g le v e ra g e . In m o re tra n q u il tim e s , b o th U.S. T re a s u ry s e c u r itie s an d trip le -A r a te d p riv a te m o rtg a g e -b a c k e d s e c u r itie s s e rv e as c o lla te r a l in p riv a te b o rro w in g a r r a n g e m e n ts . N ot so in to d a y ’s e n v iro n m e n t. M any le n d e rs w ill now a c c e p t on ly T re a s u ry s e c u r itie s as c o lla te r a l, an d sh u n th e trip le -A r a te d m o rtg a g e -b a c k e d s e c u r itie s . Som e c r e d itw o rth y b o rro w e rs a r e s h u t o ff b e c a u s e th e y do n o t h av e T re a s u ry s e c u ritie s . On M arch 1 1 , th e F e d e ra l R e serv e c r e a te d a n e w to o l to a d d re s s th is p ro b le m . S p ecifically , to a lle v ia te th e T re a s u ry s e c u r itie s s h o r ta g e , th e F e d e ra l R eserv e in tro d u c e d th e T erm S e c u ritie s L ending F acility , o r TSLF. This fa c ility allow s p rim a ry s e c u r itie s d e a le rs to u se highly ra te d p riv a te s e c u r itie s as c o lla te r a l fo r th e T re a s u rie s th e y b o rro w from us. On M arch 1 6 , th e F e d e ra l R e serv e a n n o u n c e d a n o th e r fa c ility . In p e rh a p s its m o st ag g re ssiv e a c tio n , th e B oard o f G o v ern o rs a u th o riz e d th e P rim ary D e a le r C re d it F acility , o r PDCF. This in n o v a tio n gives th e F e d e ra l R eserv e Bank o f N ew York a u th o rity to le n d d ire c tly to p rim a ry d e a le rs to p ro v id e fin a n c in g to p a r tic ip a n ts in s e c u ritiz a tio n m a rk e ts . C o llec tiv e ly , th e s e in n o v a tio n s p ro v id e fo r m uch lo n g e r te rm s of le n d in g , b r o a d e r ty p e s o f c o lla te r a l, a w id e r cla ss o f c o u n te r p a r tie s , an d a tig h te r s p re a d b e tw e e n th e p rim a ry c r e d it r a t e an d th e ta r g e t f e d e r a l fu n d s r a te . All o f th e s e in n o v a tio n s a r e d e s ig n e d to b o ls te r m a rk e t liq u id ity a n d p ro m o te o rd e rly m a rk e t fu n c tio n in g . Liquid, w e ll-fu n c tio n in g m a rk e ts a r e e s s e n tia l fo r p ro m o tin g fin a n c ia l s ta b ility a n d e c o n o m ic g ro w th . Conclusion T h e se a r e c h a lle n g in g tim e s fo r o u r e c o n o m y a n d fin a n c ia l m a rk e ts. W e know fro m stu d y in g e c o n o m ic h isto ry t h a t bo o m s a r e o fte n fo llo w e d by b u sts , an d th is p a tte r n h as r e p e a te d its e lf in o u r housing m a rk e ts la te ly . H o w ev er, w e also know t h a t th e s e s tre s s fu l p e rio d s w ill a b a te an d t h a t o u r e c o n o m y w ill im p ro v e o v e r tim e . T h e F e d e ra l R e serv e w a s c r e a te d to s u p p o rt lo n g -te rm e c o n o m ic g ro w th by p ro m o tin g low an d s ta b le in fla tio n an d by p roviding fin a n c ia l s ta b ility . I h o p e t h a t my re m a rk s to d a y h e lp you b e t t e r u n d e rs ta n d th e fo rc e s t h a t h a v e s h a p e d o u r c u r r e n t fin a n c ia l s itu a tio n a n d how th e F e d e ra l R e serv e has b e e n re sp o n d in g w ith tim e ly a c tio n s . Careers | Diversity | Privacy | Terms of Use | Contact Us | Feedback | RSS Feeds http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20080327.cfm[4/29/2014 2:02:46 PM]
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