Crisis Credit Conditions and Federal Reserve Intervention

Following the abrupt collapse of Bear Stearns, the Federal Reserve stepped in as a major provider of liquidity to the markets. The primary issue, starting in March 2008, was that banks had started to scale back their funding to other banks. This was evidenced through internal changes, like less allotment of funds to the Repo (Repurchase Agreements) trading desks for Reverse Repos, and often in more cases – actively conducting repos. For those unfamiliar to the Repurchase Agreement it is in all practicality a short term loan in which the investor/lender purchases the asset and the borrower agrees to buy that asset back at a fixed price and date. When referring to a “repo,“ the term is based from the side of the borrower while a “reverse repo” is from the lenders perspective. The markets took Bear Stearns in relative stride compared to the future bankruptcy of Lehman Brothers in September, which is where the Fed was really forced to show its hand.

Leading up the bankruptcy – then fire sale – of Lehman Brothers, interest rates remained relatively stable, as tracked by libor rates. However, the currency markets were showing another picture of the economic situation. In June the dollar began to see some incredible strength as now a large majority of foreign banks started tapping the spot market for dollars. Continued asset price deflation and poor performance of US assets (like Mortgage Backed Securities, CDO’s, CMO’s) had caused massive unanticipated shortfalls in dollar accounts for international banks. In order to cover their exposure they immediately began to sell their own (Euro, Pound, etc.) currency and create long dollar positions. Over the next two months there was a massive repatriation of funds and signs that were showing the stock and credit markets were ready for another down leg.  However, amidst this period the Federal Reserve was providing ample liquidity -- they thought -- through a variety of new programs; the two major ones were the Primary Dealer Credit Facility and the Commercial Paper Funding Facility.

Established in March 2008, the Primary Dealer Credit Facility was initiated by the Fed in order to provide support for the repo market. Essentially they became a massive lender of money to its primary dealers in a matter of days by offering to accept “investment grade collateral” in exchange for overnight funding. This was an alternative to the discount window, which normally carries a negative stigma with it, as it serves as a last effort for funding. After reaching a peak of about $40 billion in April 2008, the total amount issued returned to zero, yet following the Lehman collapse it surged to an all time high of around $150 billion. Meanwhile the discount window was extended to non-financial institutions, and similarly in October 2008 reached an all time high of around $110 billion of credit extensions. A net change in $150 billion was unheard of and would have been impossible had the Federal Reserve not amended its collateral acceptance policy. Notably on the 13^th of September they issued a statement saying that they had expanded the type of collateral they would accept so that it would previously meet the standards for a standard Tri-Party Repurchase Agreement.  Essentially, and what did occur, was that the primary collateral, which was at one time the Treasury's, changed now to equities, and in some cases shares of stocks in the bankruptcy process.

What is extremely important to note is that essentially the Federal Reserve was purchasing stocks; and dependent on the borrower’s intention, allowing more equity purchases. No one should have been buying stocks in that period as time would soon show, but in a matter of days the Government and intrinsically the U.S. taxpayer had just assumed an immediate liability of over 200 billion dollars- interestingly that equates to 667 dollars per citizen. Also, at this time LIBOR spiked to new relative highs (approximately 4%), indicating that the credit market was in serious disarray. Yet once the immediate panic stopped, disbursements retreated to new lows; and although the market didn’t bottom until March of 2009 the repo market and interbank lending resumed to stable levels.

Also, but with less of an impact was the Fed’s purchase of short term commercial paper so that short term cash flow demands would be met. They acted again, as a primary lender to the system while purchasing through their primary dealers. For those unfamiliar short-term paper is simply an unsecured note (which can be thought of as a bond) with a maturity less than 9 months.

Lastly, the key point to take away from the implementation of both programs is that the Fed stopped a major destruction of the financial system which would have had a massive impact on the real economy. However, although the Fed was a savior, it is easy to ask the question: has the recent stabilization been merely as a result of its actions? One look at the current balance sheet is incredibly scary, as it has it has expanded to more than 2 trillion of assets. If they do not control the disposition of those assets in a proper way, say in a market that cannot absorb them, we could see just the opposite of what took place in 2008.