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Crisis and Response: Central Banks and the Financial Crisis

Stephen Cecchetti*Economic Adviser and Head, Monetary and Economic Department Bank for International Settlements

* Views expressed are those of the author and not necessarily those of the BIS

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Outline

Prelude to a Crisis Central Bank Tools The Crisis Hits Policy Response

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Ratio of Home Prices to Rents

Source: Ratio of Federal Reserve Board flow of funds value of residential real estate, Table B. 100 line 4 to Bureau of Economic Analysis national income and product accounts housing service consumption, table 2.3.5 line 14.

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US Mortgage Market

Increase in leverage Increase in securitization Shift away from Traditional lending

Note: GSE is “Government Sponsored Enterprise” and refers primarily to Fannie Mae and Freddie Mac.

Value Residential

Housing Stock

Owner’s Equity Share

GSE Mortgages

Pools

Non-GSE ABS Issues

1986 $5032 68.0% $458 (29%) $58 (4%) 1996 $8219 57.9% $1659 (48%) $737 (21%) 2006 $19,488 51.0% $3725 (39%) $3746 (39%) Dollar values are all in USD billions. Numbers in parentheses are the fraction of mortgage debt accounted for by the various ABS issues.

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Leverage Ratios and VaRs

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Subprime mortgage loans

Subprime mortgage bonds

2%BB-unrated

3%BBB

4%A

11%AA

80%AAA

High-Grade Structured CDO

Mezzanine Structured CDO

1%Unrated

1%BBB

2%A

3%AA

5%Junior AAA

88%Senior AAA

4%Unrated

6%BBB

6%A

8%AA

14%Junior AAA

62%Senior AAA

Representative Pool:$1 billion par value4000 mortgages

2%Unrated

3%BBB

4%A

4%AA

27%Junior AAA

60%Senior AAA

CDO-squared

CDO: Collateralized Debt Obligation

Subprime mortgage loans

Subprime mortgage bonds

2%BB-unrated

3%BBB

4%A

11%AA

80%AAA

High-Grade Structured CDO

Mezzanine Structured CDO

1%Unrated

1%BBB

2%A

3%AA

5%Junior AAA

88%Senior AAA

4%Unrated

6%BBB

6%A

8%AA

14%Junior AAA

62%Senior AAA

Representative Pool:$1 billion par value4000 mortgages

2%Unrated

3%BBB

4%A

4%AA

27%Junior AAA

60%Senior AAA

2%Unrated

3%BBB

4%A

4%AA

27%Junior AAA

60%Senior AAA

CDO-squared

CDO: Collateralized Debt Obligation

Securitization

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A Few Details

Subprime ABS

• Often financed by commercial paper (SIVs)

• Banks provided back up lines of credit So long as house prices rise

• Refinancing is straightforward

• Estimation of default rates is unimportant

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Prelude to the Crisis

Home prices at unprecedented levels Home owners had substantial leverage Mortgage quality had declined Asset-backed Securitization had spread Created opaque instruments used as collateral

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The Central Bank Toolbox

Balance Sheet Traditional Monetary Policy Tools

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The Balance Sheet of the Federal Reserve, July 2007 (in billions of dollars)

Assets Liabilities Securities Held Outright Repurchase Agreements Loans Primary Lending Foreign Exchange Reserves Gold Other assets Total Assets

$790.6 $ 30.3

$ 0.19

$ 20.8 $ 11.0

$27.5

$880.4

Federal Reserve Notes Commercial Bank Reserve Balances US Treasury, General Account Liabilities related to Foreign Official Other Liabilities Total Liabilities Capital

$781.4

$ 16.8

$ 4.1

$ 28.3

$ 5.7

$846.3

$ 34.1

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The Balance Sheet of the Federal Reserve, July 2007 (in billions of dollars)

Assets Liabilities Securities Held Outright Repurchase Agreements Loans Primary Lending Foreign Exchange Reserves Gold Other assets Total Assets

$790.6 $ 30.3

$ 0.19

$ 20.8 $ 11.0

$27.5

$880.4

Federal Reserve Notes Commercial Bank Reserve Balances US Treasury, General Account Liabilities related to Foreign Official Other Liabilities Total Liabilities Capital

$781.4

$ 16.8

$ 4.1

$ 28.3

$ 5.7

$846.3

$ 34.1

Large

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The Balance Sheet of the Federal Reserve, July 2007 (in billions of dollars)

Assets Liabilities Securities Held Outright Repurchase Agreements Loans Primary Lending Foreign Exchange Reserves Gold Other assets Total Assets

$790.6 $ 30.3

$ 0.19

$ 20.8 $ 11.0

$27.5

$880.4

Federal Reserve Notes Commercial Bank Reserve Balances US Treasury, General Account Liabilities related to Foreign Official Other Liabilities Total Liabilities Capital

$781.4

$ 16.8

$ 4.1

$ 28.3

$ 5.7

$846.3

$ 34.1

small

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The Balance Sheet of the Federal Reserve, July 2007 (in billions of dollars)

Assets Liabilities Securities Held Outright Repurchase Agreements Loans Primary Lending Foreign Exchange Reserves Gold Other assets Total Assets

$790.6 $ 30.3

$ 0.19

$ 20.8 $ 11.0

$27.5

$880.4

Federal Reserve Notes Commercial Bank Reserve Balances US Treasury, General Account Liabilities related to Foreign Official Other Liabilities Total Liabilities Capital

$781.4

$ 16.8

$ 4.1

$ 28.3

$ 5.7

$846.3

$ 34.1

small

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The Balance Sheet of the Federal Reserve, July 2007 (in billions of dollars)

Assets Liabilities Securities Held Outright Repurchase Agreements Loans Primary Lending Foreign Exchange Reserves Gold Other assets Total Assets

$790.6 $ 30.3

$ 0.19

$ 20.8 $ 11.0

$27.5

$880.4

Federal Reserve Notes Commercial Bank Reserve Balances US Treasury, General Account Liabilities related to Foreign Official Other Liabilities Total Liabilities Capital

$781.4

$ 16.8

$ 4.1

$ 28.3

$ 5.7

$846.3

$ 34.1

Large

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The Balance Sheet of the Federal Reserve, July 2007 (in billions of dollars)

Assets Liabilities Securities Held Outright Repurchase Agreements Loans Primary Lending Foreign Exchange Reserves Gold Other assets Total Assets

$790.6 $ 30.3

$ 0.19

$ 20.8 $ 11.0

$27.5

$880.4

Federal Reserve Notes Commercial Bank Reserve Balances US Treasury, General Account Liabilities related to Foreign Official Other Liabilities Total Liabilities Capital

$781.4

$ 16.8

$ 4.1

$ 28.3

$ 5.7

$846.3

$ 34.1

Very Small

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The Balance Sheet of the Federal Reserve, July 2007 (in billions of dollars)

Assets Liabilities Securities Held Outright Repurchase Agreements Loans Primary Lending Foreign Exchange Reserves Gold Other assets Total Assets

$790.6 $ 30.3

$ 0.19

$ 20.8 $ 11.0

$27.5

$880.4

Federal Reserve Notes Commercial Bank Reserve Balances US Treasury, General Account Liabilities related to Foreign Official Other Liabilities Total Liabilities Capital

$781.4

$ 16.8

$ 4.1

$ 28.3

$ 5.7

$846.3

$ 34.1

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Balance Sheet Management

Control the size Control asset composition

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Traditional Monetary Policy Tool Box

Overnight/Short-term Interest Rate Lending and Deposit Facility Rate

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The Crisis Hits

Thursday August 9, 2007

• ECB injected €94.8 billion overnight

• Fed injected $24 billion overnight Reserves supplied in response to bank demand Symptoms

• LIBOR

• Commercial Paper

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Spread between 3-month LIBOR and 3-month Expected Federal Funds rate

July 2007 to Present, daily

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US dollar LIBOR rates, in per cent

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3 Month Treasury Bill

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US Commercial Bank Credit, billions of USD

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Commercial Paper

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The Crisis Hits

Risk premia increased Increased reliance on bank financing Difficult to value assets could not be used as collateral

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The Crisis

House prices decline• Default rates become difficult to estimate• Value of MBS and CDO becomes impossible to compute• Sub-prime collateral unacceptable

Banks • Lines of credit are drawn down• Loss in asset value reduces capital• Uncertainty about future write downs• Balance sheet capacity falls

Lenders • Face Increased Risk

• Liquidity: Don’t know own capacity• Credit: Counterparty ability to repay

• Capital Impairment• Reduce Lending• Raise Capital

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Two Types of Liquidity

Market Liquidity: Asset Specific Ability to sell without moving price

Funding Liquidity: Institution SpecificAbility of solvent institution to borrow

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Market Volatility

Risk-based Capital & Margin

Financial Institution Leverage

Asset Sales Drive Prices

Market Liquidity

Funding Liquidity

Liquidity Spirals: Modern Bank Runs

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Two types of actions

Balance sheet size: Fed funds target Asset composition: Influence spreads

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Unconventional Federal Policy actions (cont.)

Pricing: Discount Rate Method: Auctions Term: Longer-term loans and repos Swaps: Dollars to banks based outside the US Securities Lending: US Treasurys for ABS Counterparties: Primary Dealers, Money Market Funds New Legal Entities: Maiden Lane LLC Market making: Commercial Paper

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Federal Reserve Assets (in billions of dollars)

4 July 07 26 Nov 08 Securities Held Outright Uncommitted Committed to TSLF Repurchase Agreements Loans Primary Credit Term Auction Credit Primary Dealer Credit Portfolio of Maiden Lane LLC† Portfolio of Maiden Lane III LLC++ ABCP Money Market Liquidity Facility Credit to American International Group Other credit extensions

Commercial Paper Funding Facility Foreign Exchange Reserves+ FX Swaps Gold* Other assets Total Assets

$790.6

$ 30.3

$ 0.19

$ 20.8

$ 11.0 $27.5

$880.4

$295.4 $193.2 $ 80.0

$ 91.7

$406.5 $57.9 $27.0 $21.1 $53.3 $55.9 $0.0

$294.1

$24.8 $476.7‡

$ 11.0 $ 20.5

$2,109.1

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Federal Reserve Liabilities (in billions of dollars)

4 July 07 26 Nov 08 Federal Reserve Notes Commercial Bank Reserve Balances Reverse Repos w/ Dealers U.S. Treasury Supplementary Financing Account Liabilities related to Foreign Official and US Treasury Deposits Other Liabilities Total Liabilities Capital

$781.4

$ 16.8

$ 42.4

$ 5.7

$846.3

$ 34.1

$835.1

$582.7

$25.0

$479.1

$136.8

$5.8

$2,065.5

$49.4

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Contrast with the ECB

Eurosystem assets are largely repo Regular Open Market Operations:

• Up to 1700 counterparties (US has 19)• Broad collateral (US only Treasury & Agency)

European banks willing to borrow Investment & commercial banks combined.

No need to • Reduce maturity of portfolio• Broaden collateral • Widen access

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Summary:

Boom and bust in price of leveraged assets Change in financing patterns Opaque & difficult to value instruments Lack of transparency exacerbated

principal-agent problem Decline in asset prices led to liquidity spiral

• Market illiquidity

• Funding illiquidity

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Do Central Bankers Have the Tools?

Crisis management: Asset Composition

• Sphere of influence: To whom do you lend?

• Credit Risk: What do you accept as collateral?

• Asset Holdings: What do you buy?

Crisis prevention: Traditional Tools

• Regulation and Supervision

• Lean against booms in prices of leverage asset

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Do Central Bankers Have the Tools?

Short-run: Yes

• Emergency liquidity assistance buys time.

• Financial Institutions must either

• Reduce size of balance sheet (de-leverage)

• Raise Capital

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Do Central Bankers Have the Tools?

Short-run: Yes

• Emergency liquidity assistance buys time.

• Financial Institutions must either

• Reduce size of balance sheet (de-leverage)

• Raise Capital Long-run: No

• Cannot de-leverage by borrowing!

• Fiscal policy needs to step in.

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Broader Lessons

Need for Data on balance sheets and quantities Role of Deposit Insurance Organization of regulation & supervisions Standardisation and trading in organized markets

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