Subprime Crisis: Did Bernanke Go Too Far, or Did He Not Go Far Enough?Published: June 20, 2008 in Knowledge@Wharton
The Federal Reserve wanted to rekindle the flame.
Lenders, engulfed in fear as the subprime mortgage crisis swept the credit markets last summer, were refusing to lend, endangering the economy. The Fed's response under chairman Ben Bernanke: a series of moves from August 2007 through this June creating new channels of central-bank lending, much of it to investment banks that previously had been left to solve their own problems.
Was it innovation and creativity, as supporters claimed? Or has the Fed overstepped its bounds, putting taxpayers' money on the line and encouraging more high-risk behavior among the financial institutions at the heart of the subprime mess? Many experts have concerns, but the reviews are mostly good.
"The Fed has been very innovative and very appropriate -- and very timely," says Wharton finance professor Jeremy Siegel.
Though Siegel worries that another Fed response, a string of interest rate cuts, may have been too much at a time when inflation is picking up, he believes the new lending programs have worked.
"I think Bernanke will look good [to historians]," he says, adding: "I think that we're going to get through this with a mild recession or less. Think about what happened 70 years ago with the Great Depression, when a similar set of circumstances hit. The Fed didn't come to the rescue. The whole banking system went belly-up and unemployment went up to 25% and [gross domestic product] contracted by one-third. I mean, these are magnitudes that we can't even imagine today, but it shows you how bad things can be."
Fed Moved Quickly
The Fed's prompt action has done more than just help the markets recover from a short-term liquidity problem -- it has made them healthy enough to attract new capital to replace the enormous losses that grew out of the subprime collapse, says Wharton finance professor Richard J. Herring.
"One thing... that I applaud and think has worked very well is [that] the prompt corrective-action solutions that we have put in place in the United States have encouraged banks to recapitalize very, very quickly," he says. "Sovereign wealth funds [and] to some extent private equity, [and] to some extent shareholders... have been recapitalizing these banks in massive amounts, which will... give them some time to restructure and find new and more profitable business models."
While Siegel and Herring appear to reflect widespread views among economists and financial-market experts, some do worry about unintended consequences. Former Fed chairman Paul Volker has warned, for example, that by taking as loan collateral securities backed by mortgages, student loans and other risky assets, and by lending to a new class of institutions, the Fed has stepped outside its traditional role of focusing on interest-rate control and other monetary issues. Volker warns that could make it difficult for the Fed to maintain its independence.
Wharton finance professor Franklin Allen also has worries. He shares Siegel's concern that the rate cuts could stimulate inflation, and he is concerned that the Fed's role in the March sale of the collapsing Bear Stearns to J.P. Morgan Chase amounted to a safety net that will encourage other investment banks to take excessive risk. Investment banks primarily deal with companies and other financial institutions on matters like issuing new stocks and bonds, organizing and funding mergers and acquisitions. Many were involved in the process of bundling subprime loans into securities that could be sold to investors, and they suffered enormous losses as a result.
As for the new lending programs, Allen says: "I think... we are in the unknown. We haven't done this before. On the face of it, it looks as though it helps the markets. But I think we have to wait and see."
Among the Fed's moves, the headline grabbers were its string of interest-rate cuts, reducing the fed funds rate from 5.25% in September to 2% at the end of April, and its role in the Bear Stearns sale in March, which put $29 billion of tax money at risk.
But the Fed also dramatically expanded its role in assuring the financial markets have enough cash to operate smoothly. It has made hundreds of billions of dollars available for short-term loans, taking mortgage-backed securities and other risky instruments as collateral in ways it has not in the past.
Much of the Fed's efforts have been to help investment banks. Traditionally, Fed help focused on commercial banks, which primarily deal with ordinary deposits and loans to consumers and businesses. The health of commercial banks is essential to ordinary people, and since the 1930s the Fed's role has been to protect innocent bystanders when a commercial bank falters. Investment banks include firms like Merrill Lynch, J.P. Morgan Chase and Goldman Sachs, while Bank of America, Wachovia and similar institutions are commercial banks. Some companies appear on both lists.
The new moves are meant to assure a free flow of credit, which is essential to the financial markets and the economy. Lending allows money to go where it is needed most. For businesses, not having credit would be the same as ordinary people being deprived of mortgages, car loans and credit cards, and in many cases it would be even worse. If business activity slows because of a lack of credit, the whole economy slows. People lose their jobs and stocks and other assets can fall in value.
The subprime crisis gathered speed in the first half of 2007, as homeowners saw their monthly payments jump during the first interest-rate resets on adjustable-rate loans taken out a year or two earlier. Growing numbers of borrowers fell behind in payments and entered the foreclosure process. Mortgage-backed securities, whose earnings came from homeowners' monthly mortgage payments, fell in value as fewer payments were made.
According the Fed, one result was that lenders would no longer accept as collateral any asset whose value was suspect -- and that list was growing. The problem spread to other types of debt securities because of worries that firms losing money on mortgage securities would dump other assets to raise cash, causing their prices to drop. Big banks cut back on lending for fear that borrowers would not be able to repay their loans. The financial system was freezing up.
"What we're learning is that this financial market of ours is very interconnected," says Wharton finance professor Richard Marston. "When you see a reassessment of risk on one security, the market then very quickly reassesses risks on other securities.... What we had was a reassessment of risk, and it affected a lot of securities that had nothing to do with mortgages."
The rising fear can be seen in the spread, or difference, between yields of safe U.S. Treasury bonds compared to other securities, Marston says. Wider gaps mean investors think risks are greater.
Early in 2007, yields on corporate "junk" bonds and bonds issued by emerging-market countries were only slightly above Treasury yields, indicating little concern about risk. By August, that had changed. The London Interbank Offer Rate, which normally hovered about 0.5 percentage points above the Treasury yield, had quintupled the spread to 2.5 points, Marston says. LIBOR is the rate at which banks offer to lend money to one another.
"And that's basically setting off alarm bells, saying the banks are in distress, they don't trust each other," Marston asserted. "The system needs more liquidity. So the Fed stepped in to provide liquidity."
In a May 13, 2008, speech at a Fed conference in Atlanta, Bernanke explained the Fed's reasoning, pointing to research by Wharton's Allen and New York University economist Douglas Gale, authors of Understanding Financial Crises. Their work, Bernanke says, "confirms that... 'fire sales' forced by sharp increases in investors' [demand for cash] can drive asset prices below their fundamental value, at significant cost to the financial system and the economy."
The central bank's role, says Bernanke is to counteract this process "by making cash loans secured by borrowers' illiquid but sound assets." In other words, the Fed could make loans, taking as collateral mortgage-backed securities and other assets that other lenders would not accept. "Thus, borrowers can avoid selling securities into an illiquid market, and the potential for economic damage -- arising, for example, from the unavailability of credit for productive purposes or from the inefficient liquidation of long-term investments -- is substantially reduced," says Bernanke.
The Fed's first step, in August 2007, was to open the discount window wider. Since January 2003, this facility had provided overnight loans to eligible institutions, primarily "depository institutions" such as commercial banks that accept savers' deposits and make loans. The discount window is meant to help with short-term cash shortages, such as when an institution must pay for an unexpected securities transaction.
On August 17, 2007, the Fed lengthened the maximum loan term to 30 days from overnight, and it reduced the interest rate it charged to half a percentage point above the Fed funds rate from one percentage point. The 30-day limit could be renewed at the borrower's request. On March 16, 2008, the term was extended to 90 days and the interest rate was cut to a quarter-point over the Fed funds rate.
On December 12, 2007, the Fed established the Term Auction Facility (TAF), to loan money to the depository institutions for up to 28 days in return for a broad range of collateral that borrowers might have trouble selling or using as collateral elsewhere, such as mortgage-backed securities. Since the loans are not delivered immediately, as they are through the discount window, the TAF is designed to serve somewhat longer-term needs. The Fed sets a limit on the amount available for these loans, but has gradually raised it from $20 billion per auction to $75 billion. It provides them to the institutions offering to pay the highest interest in an auction process. On March 7, 2008, the Fed says it would keep the TAF operating for at least another six months.
Aside from the depositary institutions, the Fed has long done business with "primary dealers" such as brokerages and investment banks. Though it does not closely regulate these institutions, the Fed uses them to move money in and out of the banking system to adjust short-term interest rates to stimulate the economy or curb inflation. The Fed buys and sells securities, lends money and even borrows it on occasion.
On March 7, 2008, the Fed says it would lend up to $100 billion to primary dealers, accepting a range of securities as collateral, including those backed by mortgages. Then, on March 11, the Fed set up the Term Securities Lending Facility which allows primary dealers to borrow safe, easily traded U.S. Treasuries, using risky, illiquid assets like mortgage-backed securities as collateral. On May 2, the list of acceptable collateral was expanded to include securities backed by student loans, car loans, home equity loans and highly rated credit card debt. A week later -- March 16 -- the Fed established the Primary Dealer Credit Facility to loan money overnight to primary dealers. Again, the chief innovation was to let those institutions use a broader range of collateral than they can in ordinary dealings with the Fed.
In a series of steps from September 2007 to the end of April 2008, the Fed also reduced the Fed funds rate from 5.25% to 2%. Reducing rates encourages borrowing, giving individuals and companies more money to spend. That stimulates the economy, which fell from an annual growth rate of 4.9% in the thirdquarter of 2007 to 0.6% in each of the following two quarters.
Bear Stearns' Meltdown
The Bear Stearns sale was the highest profile move. In March 2008, the investment bank was nearing bankruptcy after suffering enormous losses on mortgage securities. The Fed's goal was to prevent a domino effect as Bear Stearns and firms it did business with dumped securities on the market. Bernanke says: "A bankruptcy filing would have forced Bear's secured creditors and counterparties to liquidate the underlying collateral and, given the illiquidity of the markets, those creditors and counterparties might well have sustained losses. If they responded to losses or the unexpected illiquidity of their holdings by pulling back from providing secured financing to other firms, a much broader liquidity crisis would have ensued."
The $29 billion loaned by the Fed protects J.P. Morgan against losses on risky assets held by Bear Stearns. The Fed took control of those assets as collateral. In his May 13 speech, Bernanke argued that the measures were working, noting that spreads between mortgage-backed securities and Treasuries had slightly narrowed since mid-March. He conceded, though, that "conditions in the financial markets are still far from normal."
In another sign the credit markets are improving, the issuance of new high-yield corporate bonds has picked up slightly. Early this year, that process had all but ground to a halt. The modest recovery has opened the door to some high-profile corporate deals financed with debt or loans, such as the Cablevision Systems Corp. $650 million purchase of the newspaper Newsday and, possibly, Hewlett-'s $13.25 billion purchase of Electronic Data Systems. In addition, stock-market investors appear to think the worst is over. The Standard & Poor's 500 rose about 5% from March 17 to mid-June.
The Fed's initial actions also restored enough confidence that investors were willing to pour money into the troubled banks, Herring says. Sovereign wealth funds controlled by the governments of Abu Dhabi, Singapore, Kuwait and Saudi Arabia pumped $22 billion into Citigroup, for example. Merrill Lynch & Co. attracted $12.8 billion in sovereign wealth funds, while UBS received $11.8 billion and Morgan Stanley $5 billion.
"Ultimately," Bernanke says, "market participants themselves must address the fundamental sources of financial strains -- through de-leveraging [cutting back on borrowing], raising new capital and improving risk management -- and this process is likely to take some time."
But the Fed's moves do carry risks. Allen worries they could backfire by creating "moral hazard" -- encouraging risky behavior by signaling the Fed will rescue institutions that run into trouble. Preventing Bear from collapsing was probably a good move, given the risk of falling dominos affecting other firms, he says. But he worries about the Fed's $29 billion guarantee, which assured the shareholders would get $2 a share in the sale rather than nothing in a bankruptcy. The company's executives and employees were major shareholders. The company's shares traded around $30 just before the deal was announced. "If people think they are going to be able to walk away with some money as opposed to nothing, that will make a big difference in the way they behave," he says.
Despite the risk of moral hazard, Marston believes the Fed had to step in to avert a bankruptcy by Bear Stearns, noting it had laid the groundwork for such a move by orchestrating the 1998 response to the collapse of the hedge fund Long-Term Capital Management. In that case, the Fed did not put taxpayers' money at risk but convinced big financial institutions to do so to prevent their own holdings from plummeting in value in a fire sale.
"A lot of this situation was very similar in the sense that Bear Stearns was holding securities in a highly leveraged portfolio which were also being held by Citigroup, by Merrill Lynch, by Goldman Sachs, by UBS, by many banks in the world -- investment banks...," Marston says. "And the great thing is that the head of the Federal Reserve, Ben Bernanke, has actually done a study of what happened the last time the federal government let the banking system go down in a domino effect. And his study of the Depression was, of course, one of the major studies of that period. And I think that informed him a great deal about what to do in this crisis, because the worry is that if you allow Bear Stearns to go under, you allow them to dump all their securities on the market. Remember, this is a very highly leveraged firm. What happens is an awful lot of other firms in the United States as well as in Europe and elsewhere in the world are at risk."
The Fed's long focus on the health of commercial banks rather than investment banks blurred following the 1999 repeal of the Depression-era Glass-Steagall Act, which had kept the two banking functions distinct. In recent years, each type of bank has entered lines of business previously reserved for the other. In addition, the recent rise of securitization -- the bundling of mortgages and other debts into securities that can be traded widely -- allows both types of banks to invest in the same things. That puts them in the same boat when the markets are in turmoil.
"The Fed had to go in to provide funding to an investment bank, which has traditionally been outside the purview of the Fed," Marston says. "It's not like trying to rescue a commercial bank in 1980 because they're having a funding problem. This is very different. It's going in because you know that the portfolio of securities of this investment bank is being held by commercial banks as well as by other investment banks, and the financial sector as a whole is in danger."
Although the Fed has expanded its role in the subprime crisis, Bernanke pointed out that central banks in other countries have long had broader powers than the Fed's, dealing with all types of banks and accepting a much wider range of collateral.
Still, says Allen, the Fed's new lending programs may have unintended consequences. Allowing financial institutions to borrow Treasuries by using risky securities as collateral, for example, could help those borrowers issue deceptive financial statements, he says. Statements, like those made to mutual fund investors, are snapshots of assets held at the close of business on the reporting day, and those holdings can be unrepresentative of assets held between reports.
"By the Fed providing Treasuries in exchange for low-quality securities, what they are doing is essentially helping financial institutions to make their books look better than they in fact are," he says. "So they hold high-quality securities provided by the Fed for a day or two, then the rest of the time they are holding lower-quality securities. Investors don't know about that because the Fed is helping this lack of transparency."
Judgment about the Fed's recent moves may well hinge on whether it loses money -- taxpayers' money -- on the risky assets it has taken as collateral. Because those assets were taken on at deeply discounted values, the Fed could actually make money if the market for those securities improves. "I suspect they only have an upside on these securities," Marston says.
In the subprime crisis, the Fed stretched its mandate to help investment banks after the damage was done, but the crisis points to a need for the next president, new Congress and oversight agencies to make sure the regulatory system can prevent a recurrence, Marston says.
"After the election, I think people are going to have to sit down in Washington and really think through what would be the minimal amount of regulation which would make this system of ours safer," he says.