THE FEDERAL RESERVE BANK OF ST. LOUIS | ANNUAL REPORT 2002

PART 1

FINANCIAL STABILITY: WELL-ROOTED IN U.S.

A Message from Our President

The St. Louis Fed traditionally anchors its annual report with an essay on a topic that’s important to those who care about our nation’s economy. This year is no exception. The subject is financial stability—always worth talking about but particularly timely now, what with the shocks that we’ve endured of late: terrorist attacks, war, accounting scandals and volatile markets, to name a few.

Although our financial system has weathered these storms—and many more before them—we’d be wise to keep in mind the oft-stated warning: Past performance is no guarantee of future results. The steps we took to protect our credit and payment mechanisms during the latest wave of crises may not apply in the future. Different problems require different solutions. We should start thinking about these problems and solutions now—before some vulnerability surfaces out of the blue and bites us. A few of the threats to our financial system are very well-known, such as the funding shortages facing Social Security and Medicare. Others are beginning to catch the public’s eye, such as the troubling dominance of the home mortgage market by Fannie Mae and Freddie Mac. If either of these giants were to stumble, the entire housing market would fall into disarray. Other possible threats may be harder to get a handle on, but we must still try.

For those who think the protectors of our financial system will always prevail, this essay will provide a reminder of when the United States had a reputation for financial instability. Looking today at Japan, one can see that such instability can recur, even in a country that has a long-term track record of stability like ours.

We hope that this essay spurs discussion about the vital need for vigilance on the subject of financial stability.

Elsewhere in this report, we summarize our year—a good one for the St. Louis Fed, in almost all regards. This book also contains a new section, called “By the Numbers.” Through important, unusual or just interesting numbers, we will tell you a bit more about who we are at the St. Louis Fed and what we do. I hope you enjoy it.

William Poole

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2002 marked the third consecutive year of financial turbulence in the United States. In early 2000, investors lost faith in technology stocks and later in other stocks, ushering in what has turned out to be a long bear market in equities. In March 2001, the economy entered its first recession in a decade. Then, in September 2001, terrorists attacked New York City and Washington, D.C. After these shocks, one might have expected a calmer 2002. Instead, last year brought new challenges in the form of sensational accounting and investment-banking scandals, large corporate bankruptcies, and historically high levels of stock- and bond-market volatility.

Yet, three consecutive years of turbulence have not damaged the roots of the U.S. financial system—the banking sector. Commercial banks and thrifts have proven financially robust—indeed, quite profitable—during this period. Creditworthy households and businesses continue to enjoy uninterrupted access to credit, while the payments system functions as smoothly as ever. Steady performance is important because access to credit and to a functioning payments system are the twin hallmarks of financial stability.

Although financial market turbulence did spread to the banking system in the 19th and early 20th centuries in the United States and sometimes still does in other economies around the globe, our financial system has stood immune and stable for decades.

Why?

The Seeds of Stability

Financial stability rarely comes up in daily conversation precisely because the U.S. financial system has proven so stable since the 1930s. Stability implies widespread reliance on the financial system and its parts to function smoothly—as, for example, when we expect a 24-hour ATM machine to dispense cash on demand, when we assume a gas pump will accept a debit card without fail, when we anticipate that online lenders will refinance mortgages without a hassle or when we trust our money to an unfamiliar bank without a second thought.

To the Federal Reserve, the term has a more precise meaning: Financial stability refers to the smooth, uninterrupted operation of both credit and payment mechanisms. In practice, financial stability means that all credit-worthy borrowers can obtain funds at reasonable rates and that all monetary payments and securities transactions will settle accurately and promptly. Because extending credit and executing payments are two core commercial banking functions, it should come as no surprise that the Fed’s mandate to promote financial stability is carried out largely through policies designed to preserve the health of individual banks and the integrity of interbank networks.

The Fed plays an important role in maintaining both economic and financial stability. Using monetary policy, the Fed exerts a stabilizing influence on the economy as a whole, working primarily through interest-rate channels that influence borrowing and lending decisions. The Fed also relies on lender-of-last-resort (discount window) and payments-systems policies to calm financial markets after a shock. Finally, the Fed monitors many U.S. financial institutions to make sure that they are run in a safe-and-sound manner. All of these responsibilities interact to stabilize the banking system, thereby preserving its ability to extend credit and to serve as the backbone of the payments system.1

Uprooting Stability

Historically, financial instability—a temporary but potentially severe disruption of credit and payment mechanisms—has occurred from time to time despite the best efforts of market participants and policy-makers. To be sure, the U.S. financial system was perhaps most notable among advanced economies for its instability as late as the 1930s. Caveat emptor was the operative rule because banks failed as frequently as any other kind of business. System-wide collapses, albeit temporary, were not unknown.

Business and financial cycles did not originate in the United States, of course. Adam Smith, the Scotsman who is now known as the father of modern economics, long ago distilled the essential dynamics of a modern economy as an inevitable, recurring sequence of “overtrading,” followed by “negligence and profusion,” culminating in “revulsion and discredit.”2 What was unusual about the U.S. financial system is how long it took to temper the “overtrading-negligence-revulsion” cycle. England experienced only one banking crisis after 1866—when the Bank of England first intervened successfully as a lender of last resort. Meanwhile, serious banking disruptions struck the United States in 1873, 1884, 1890, 1893, 1907, 1914, and most tragically, 1930-33.3 Crashes of the stock market and collapses of major financial institutions were even more frequent. These episodes contributed to a widespread belief that the U.S. financial system—and particularly the banking system—was inherently unstable.

The remarkable 19th- and early 20th-century instability of the U.S. banking system was, in many ways, homegrown. Because the U.S. Constitution prohibited states from taxing interstate commerce or printing money, they turned in large part to taxes on state-chartered banks to cover their expenditures.4 Many of the restrictions on geographical and product expansion in banking date from this period. To maximize tax revenues from banks, states restricted competition.

As a result, the United States ended up with a very large number of small, undiversified institutions that were vulnerable to local economic as well as national financial shocks. Depositors, aware of this vulnerability, rationally responded to such shocks by “running” their banks. Bank panics, in turn, depressed the real economy by reducing the available supply of credit to business firms and preventing businesses and households from making payments.

Financial instability amplified economic instability to create a self-reinforcing downward spiral. Before 1914, no central bank existed in the United States to help break the vicious cycle. A demand for the government to provide deposit insurance arose as a means to keep small banks competitive with larger banks that could offer greater safety. Many states responded with programs for local banks. Typically, the insurance was voluntary, and its price did not rise much with bank risk. These design flaws ultimately bankrupted the states’ reserve funds and, more importantly, kept the state-run programs from exerting a stabilizing influence on the financial system.5

What forced fundamental change on the U.S. financial system, of course, was the Great Depression. Between 1930 and 1933, roughly 9,000 U.S. banks failed—some 30 percent of the nation’s total. Today, many economists believe that the collapse of the banking system transformed a garden-variety recession into an economic calamity. Bank failures destroyed deposits in droves (or froze them as the failed banks were resolved), causing the available money supply to drop by one-third. Bank failures also destroyed valuable lending relationships, further contributing to the depth and length of the Depression. Between 1929 and 1933, the unemployment rate soared to 25 percent from 3 percent, not falling back into the single digits until the 1940s. Sadly, the Federal Reserve—created in 1914 in part to ensure that financial shocks would not spark financial instability—made things worse in the early 1930s by tightening monetary policy to defend the gold standard rather than injecting liquidity to contain the banking panic. This financial, economic and social catastrophe convinced a sufficient majority of business and political leaders of the day that the hitherto lightly regulated financial system was inherently and intolerably unstable.

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Root-and-Branch Reform

The New Deal was a massive policy response to the economic calamity. In the financial sector, the response took the form of strict bank chartering requirements, narrowly drawn activity restrictions across all types of financial institutions, price controls (such as interest-rate ceilings), federal deposit insurance, new government financial institutions (such as the Reconstruction Finance Corp. and the Federal National Mortgage Association, or “Fannie Mae”) and a restructured Federal Reserve System. Although many warned of the inhibiting effects of government intervention, the risk of not attempting root-and-branch reform of the financial system appeared even greater. And while a revisionist school of thought today questions the wisdom of many New Deal financial reforms, the circumstantial evidence suggests that these reforms have contributed to our success in avoiding bouts of financial instability during the past seven decades.

The United States has suffered no instances of generalized financial instability since the 1930s despite the fact that shocks to financial markets have been no less frequent than in earlier eras. A partial list of shocks since the Depression includes World War II and the Korean War, the Cuban missile crisis, the Penn Central commercial-paper crisis, two OPEC oil shocks, the 1974 and 1987 stock market crashes, and the regionally devastating energy and real estate lending cycles of the 1980s, culminating in the failure of thousands of bank and thrift institutions. Most recently, corporate accounting scandals, large corporate bankruptcies and stock market volatility have shaken investor and consumer confidence. Yet, none of these events produced economy-wide financial instability. Why?

Federal deposit insurance—the keystone of the New Deal reforms—largely explains the disappearance of financial instability. When designing the program, Congress sought to avoid the problems that brought down the state systems. For example, Congress insisted that all national banks and members of the Federal Reserve System accept coverage—thereby preventing larger, and typically stronger, banks from opting out. The nationwide scope of the program reduced the likelihood that a geographic or industry shock would bankrupt the reserve fund. In the worst case, the federal treasury could be called upon to bolster the fund. These improvements over the state-run programs kept financial turbulence from provoking banking panics. No longer did a financial shock—such as the failure of a major financial institution—spell trouble for a small depositor. Nationwide bank panics became the stuff of newsreels, not CNN.

Other Weaknesses Surface

Although federal deposit insurance did much to stabilize the U.S. banking system, it contained structural flaws that would later come back to haunt policy-makers and, ironically, test the robustness of the post-Depression financial system. Specifically, the flat-rate premium structure—a design flaw in the state-run systems as well—
promoted imprudent risk-taking, thereby contributing to the savings and loan debacle of the 1980s. With flat-rate premiums, troubled thrifts could take on risky activities, knowing that deposit insurance would cost no more than before and that the government would bear most of any resulting losses. These perverse incentives resulted in billions of dollars of loans to support projects of dubious value and, ultimately, in thousands of failures with enormous cost to taxpayers.

To be sure, flat-rate premiums were not the only cause of the thrift debacle. Policy-induced incentives to take on interest-rate risk, inadequate supervision of risk-taking and poorly designed legislative responses contributed as well.8 New Deal programs that were aimed at stabilizing the mortgage market encouraged thrifts to lengthen the maturity of their assets, while deposit insurance allowed thrifts to shorten their liabilities. The resulting mismatch increased the interest rate risk exposure of the industry and ate away capital during the period of higher and more volatile interest rates in the late 1960s, 1970s and early 1980s.

Congress responded to the developing crisis by deregulating thrift asset portfolios—a sensible move for a strongly capitalized industry, but an ill-advised policy for a weakly capitalized one. With little of their own wealth to lose, some undercapitalized thrift owners gladly took on risky investments. Congress also raised the deposit insurance ceiling, thereby shielding thrifts from market discipline because a greater portion of their funding became insensitive to risk. Underfunded thrift supervisors, who operated under intense political and lobbying pressure, sanctioned the use of accounting gimmicks to give thrifts more leeway to avoid recognizing losses, presumably so that they could grow out of their problems. In many cases, however, these gimmicks simply gave thrift managers more time to experiment with new, even riskier investments, thereby compounding the cost of the eventual cleanup. Despite an ultimate loss to taxpayers of roughly $150 billion, the federal deposit insurance system—and what is more important, the banking system—did not break. Through it all, the public never lost confidence in depository institutions because the insurance was fully backed by the federal government. Because the credit and payment mechanisms remained intact, the thrift crisis did not degenerate into a vicious cycle of financial and economic instability. The role of federal insurance cannot be overemphasized: In the mid-1980s and early 1990s, state-insured depository institutions in Maryland, Ohio and Rhode Island were destroyed by panicked deposit withdrawals. Such panics could have become national rather than localized phenomena if no federal deposit insurance system had existed.

No doubt, other factors help account for the financial stability of the 1980s and 1990s. Unlike the early 1930s, monetary policy during and after the S&L crisis took explicit account of the condition of the banking system. Government-sponsored enterprises—Fannie Mae, Freddie Mac and the Federal Home Loan Banks—stepped in with commercial banks to replace thrift institutions as the primary conduits for channeling funds to households desiring mortgages.

A New Season

Even though the New Deal reforms helped us survive the thrift debacle, the high price paid to protect the financial system, in terms of taxpayer funds and resource misallocation, dictated a re-evaluation. This re-evaluation pointed to five important lessons. First, it became clear that mechanisms should be in place to encourage faithful and timely disclosure of financial condition. Second, a new method was needed for pricing deposit insurance, whereby the explicit price of deposit insurance plus the implicit price imposed by bank supervisors would mimic the private sector’s risk-sensitive approach to pricing. Third, wherever possible, market discipline must reinforce pressure from deposit-insurance premiums and bank supervisors to contain risk. Fourth, financial firms must maintain adequate capital to promote market discipline and to provide a cushion against mistakes and unforeseen portfolio losses. Finally, bank supervisors must receive adequate funding and remain shielded from political pressures.

The Federal Deposit Insurance Corp. Improvement Act of 1991 (FDICIA) constituted a significant step in the right direction. The act beefed up supervision by mandating safety-and-soundness exams at least every 18 months, prompt corrective action, risk-based deposit insurance premiums and least-cost failure resolution. Frequent exams improved the flow of information between bankers and supervisors so that emerging problems could be addressed quickly and decisively. Prompt corrective action, which mandates specific supervisory responses to deteriorating bank capital, guaranteed that emerging problems would be addressed quickly and decisively—thereby keeping supervision insulated from politically motivated tampering. Risk-based premiums, which currently range from 0 to 27 cents annually per $100 of deposits, increased the cost of deposit insurance coverage as bank risk rises, thereby making deposit insurance more like private insurance. Finally, least-cost resolution, which forces the FDIC to clean up failures in the least costly way for the deposit insurance fund, shifted more of the losses to uninsured depositors. Greater loss exposure increases investors’ incentive to demand higher interest rates from riskier institutions—an illustration of market discipline. The consensus view so far seems to be that FDICIA has reduced the chances of another thrift-type deposit-insurance meltdown.

FDICIA brought one more important change—it scaled back the so-called “too big to fail” protection for large banks. In May 1984, concerns about “systemic risk” (another term for financial instability) led regulators to shield all creditors of Continental Illinois from losses when the bank became insolvent. That September, the Comptroller of the Currency formalized the policy in congressional testimony by announcing that the 11 largest national banks were too big to fail. The equity markets immediately priced a reduction in risk into the publicly traded securities of all large banking organizations. That is, market participants came to believe that the failure of a large bank was unlikely; so, the potential damage one bank’s failure might cause for other banks also diminished. As a consequence of implied federal protection, of course, market pressure on all large banks to contain risk was reduced.

FDICIA curbed too-big-to-fail protection by requiring the consent of the Secretary of the Treasury, along with two-thirds majorities of the Board of Governors of the Federal Reserve and the directors of the FDIC, before an institution could be given an exemption from normal procedures for resolution. To be sure, regulatory resolve has yet to be tested in a crisis; so, we do not know if the claim by regulators that no bank is too big to fail is, indeed, true. The consensus view among market participants appears to be that uninsured creditors of large banks now face greater default risk than before FDICIA, which is the intent of the law. Genuine risk exposure ensures that market discipline will reinforce supervisory efforts to maintain the safety and soundness of large banks.

Why the banking sector has fared so well during the recent economic slowdown can be explained in part by the retooling of policy following the thrift crisis, along with:
• other changes in regulation that permitted greater bank diversification across product lines and geographic markets,
• the strengthening of capital requirements under the Basel Capital Accord,
• technological advances in risk management, such as asset securitization, and
• better risk management by banks.

For the banking sector as a whole, return on assets remains comfortably above the traditional 1 percent benchmark for strong earnings. Bank failures numbered more than 100 every year between 1985 and 1991, but since 1995, they have not exceeded 11 in any year. The average commercial bank’s equity capital ratio stood at 6.4 percent of assets at the end of 1990, but had risen to 9.2 percent of assets by the end of 2002.

One other stabilizing aspect of the supervisory framework is worth mentioning. The Federal Reserve’s role as supervisor of all financial holding companies, bank holding companies and some state-chartered banks contributes to financial stability in two ways. First and foremost, the Fed’s supervisory role yields critical feedback about ongoing developments in the financial sector and in the non-financial economy. This feedback puts the Fed in a better position to carry out its function as lender of last resort. Second, and somewhat under-appreciated, the Fed’s status as being “independent inside the government” puts some distance between the political process and bank supervision. The Fed shares supervisory responsibility at the federal level with the Office of the Comptroller and the FDIC; each state also has a supervision department.

The Fed’s independence helps guarantee that competition among state and federal regulators, which can do much to improve efficiency and reduce regulatory burden, does not compromise the integrity of the supervisory process.

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Threats on the Horizon

We have learned from long and painful experience that the best safeguard against financial instability is a carefully designed private-public partnership. Yet, as a result of rapid financial innovation as well as profit-driven incentives to avoid regulation, a thriving set of non-bank financial entities has emerged in the United States and many other nations. These lightly regulated entities are not allowed to offer deposits, but compete with banks on other fronts. Prominent non-bank financial entities today include investment banks, mutual funds, finance companies, the “financial conglomerates” permitted by the Gramm-Leach-Bliley Act of 1999 and financially oriented government sponsored enterprises (GSEs). Because these institutions have grown rapidly, they have become important players in the financial system. Yet, because we do not have many centuries of experience with non-bank financial institutions as we do for banks, we do not really know what risks they potentially pose to the financial system. As important, they are not federally insured and do not have access to the Federal Reserve discount window.

Two of these entities—Fannie Mae and Freddie Mac—merit special attention because of their size and dominance in the housing finance market in the United States. These two housing GSEs are so massive in size and are growing so fast that any significant disruption at one or both of the enterprises necessarily would impact a large number of other financial institutions and non-financial entities.9 The securities issued and guaranteed by the housing GSEs are widely held in the United States and abroad, notably by commercial banks.10 U.S. households depend on Fannie and Freddie to obtain capital-market rates for home mortgage borrowing. A large number of players in the interest-rate derivatives market (including commercial banks) count one or both enterprises among their most important counterparties. Illiquidity caused by concerns about enterprise viability, not to mention outright default, could disrupt commercial banks’ liquidity management and other financial institutions and markets in unpredictable ways. The collapse of the hedge fund Long-Term Capital Management (LTCM) in 1998 illustrates how disruptive a single large player’s demise can be, especially in the global derivatives markets. Federal Reserve intervention, which encouraged a capital infusion and an orderly winding-up of LTCM’s business, prevented much greater financial turbulence.

Housing GSEs also operate with an ambiguous status in the market. Participants in capital markets clearly perceive a significant credit-quality benefit attached to GSE status, as reflected in the very tight interest-rate spreads that GSE obligations enjoy over Treasury securities. Yet, the housing GSEs have no legal right to call upon the federal government to provide financial support beyond a trivial line of credit. If market participants were to abruptly downgrade the credit quality of GSE-issued or GSE-guaranteed securities, the resulting repricing and loss of wealth by securities holders could unleash substantial portfolio reallocations and widespread market volatility.

The potential threat to financial stability posed by the housing GSEs has not gone unnoticed. The housing GSEs’ federal regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), recently published an extensive study analyzing the systemic-risk implications posed by Fannie Mae and Freddie Mac.13 The report concluded that the immediate risks of financial-solvency issues at either Fannie or Freddie—and hence, the risk they pose for financial stability—were quite small because these enterprises are very strong financially and are well-regulated by OFHEO. The agency also believes it likely that other financial institutions, such as large banks, could quickly fill any void created by the pullback of Fannie or Freddie from the mortgage market due to financial problems they might encounter.

Nevertheless, OFHEO concluded that the chance of such a systemic disruption could not be ruled out and that further research is warranted. For, though a Fannie or Freddie insolvency is unlikely, the ramifications for financial markets and some financial institutions should insolvency occur—particularly if it occurred abruptly, say, as a result of uncovering an accounting fraud—would be profound, to say the least. A more likely event is not outright insolvency of one or both of the enterprises, but some disruption to the liquidity of the markets in which their fixed-income securities trade—the agency market or the mortgage-backed security (MBS) market. Such a “liquidity event” could stress the banking system because banks are relying more and more on agency securities and MBS as secondary liquidity reserves.

As Unpredictable as the Weather

Sudden shocks—including dramatic revaluations of currencies, stock market corrections or terrorist events—are facts of life in modern economies. Economic disturbances such as recessions and lending cycles appear to be unavoidable as well. Without prudent policy, these shocks and disturbances, if severe or concentrated enough in time, could translate into a financial crisis that critically damages the banking sector. This, in turn, could severely disrupt credit and payment mechanisms—that is, create financial instability.

Extensive government intervention into the financial sector of the U.S. economy—federal deposit insurance, the Federal Reserve System’s multifaceted role as promoter of macroeconomic and financial stability, and other financial regulations—has short-circuited this damaging feedback loop since the 1930s. To be sure, private-sector risk management practices have improved, but it is no accident that the New Deal financial reforms described in this essay have coincided with the longest uninterrupted stretch of financial stability in U.S. history.

Even though no bouts of financial instability have occurred in the United States since the 1930s, we know its reappearance is not outside the realm of possibility. The bursting of Japan’s “bubble economy” of the 1980s has crippled its banking sector. Indeed, Japan has avoided profound financial instability only by massive ad hoc government interventions that well may bring long-lasting negative consequences, such as an unsustainable amount of government debt issued to support the banks. Moreover, many less-developed economies have succumbed to macroeconomic and financial instability of the type that bedeviled the U.S. economy during the 19th and early 20th centuries.

As we move into the 21st century, we must build on our successes and learn from our own and other countries’ mistakes. In practice, this means paying careful attention to the incentives created by our banking policies. The fact that we have avoided financial instability for 70 years is, unfortunately, no guarantee that we will be as lucky during the next seven decades. In addition to continuous updating of financial supervisory practice and regulation, constant vigilance by government regulators—the public’swatchdogs—will be required.

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SIDEBAR 1

The Fed and Financial Stability

Casual observers may think the Federal Reserve’s role in the economy is exclusively to promote macroeconomic stability—including price stability, maximum sustainable economic growth and low long-term interest rates. While certainly an important and challenging task, the Fed’s mandate actually is broader and includes the goal of promoting financial stability of the banking system. This dual mandate makes sense because macroeconomic and financial stability are mutually reinforcing—for better and for worse.

The 12 Federal Reserve banks serve as the banking system’s lender of last resort, the safety valve that depressurizes sudden spikes in the demand for liquidity, such as occurred in the aftermath of Sept. 11. This episode showed clearly that, when commercial banks and thrifts have emergency access to liquidity at the central bank’s discount window, disruptions to the credit and payment mechanisms can be avoided even under the direst circumstances. The Federal Reserve also serves as lead supervisor for thousands of financial holding companies, bank holding companies and many state-chartered banks in the United States. This front-line contact with financial institutions equips the Fed to play a role in financial policy-making and provides a source of timely information for monetary policy deliberations.

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SIDEBAR 2

Potential Sources of Financial Instability in the 21st Century

Is a return to financial instability likely? In 1984, Charles Kindleberger, an eminent economic historian, suggested that financial turbulence was unavoidable: “Financial crises have appeared at roughly 10-year intervals for the last 400 years or so.”6 The years after 1984 have witnessed, if anything, even more financial crises around the world. Yet, the United States has successfully avoided disruptions of credit and payments mechanisms. Will our record hold? What threats to financial stability exist today?

To answer these questions, it pays to think about the type of economic or financial crisis that could cause an outbreak of financial instability. The International Monetary Fund provides a quarterly update on trouble spots in the global economy and in the financial systems of major countries.7 The report summarizing risks to global economic and financial stability entering 2003 pointed to a long list of problems:
• An excessive amount of corporate leverage and excess production capacity in some sectors.
• Deterioration in the financial condition of households, posing a risk that consumer spending could slow sharply.
• Heightened risk aversion among investors in financial markets, depressing asset prices.
• High levels of volatility in major equity and credit markets.
• Bank losses—both financial losses on loans and losses of reputation from questionable business practices.
• Diminished access to international capital markets by borrowers in emerging markets.

The March 2003 report also pointed to the huge size and ambiguous legal status of Fannie Mae and Freddie Mac, two government sponsored enterprises (GSEs), as discussed elsewhere in this essay.

Any one or a combination of these risk factors could strike an undercapitalized, poorly regulated banking system and precipitate financial instability somewhere in the world during 2003. But given the resilience of our banking system in the last three years, it appears unlikely that financial instability will visit the United States any time soon.

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SIDEBAR 3

Fannie and Freddie: Troubling Dominance

Fannie Mae (formerly known as the Federal National Mortgage Association, or FNMA) and Freddie Mac (formerly known as the Federal Home Loan Mortgage Corp., or FHLMC) together own or guarantee about 45 percent of all residential mortgage debt, up from about 25 percent in 1990.11 In their primary market niche of so-called “conforming mortgages”—prime quality fixed-rate single-family mortgages—Fannie and Freddie enjoy a market share of about 75 percent, up from about 50 percent a decade ago. The U.S. housing market has been strong throughout the 1990s and into the 2000s, in part due to the ability of these housing GSEs to provide uninterrupted access by households to the competitive interest rates available in international capital markets.

As the secondary mortgage market has grown, so have the direct debt obligations of Fannie and Freddie. Direct debt obligations of the two enterprises (i.e., excluding mortgage-backed securities) presently exceed $1.5 trillion, roughly 40 percent as much as the publicly held debt of the U.S. Treasury. Mortgage-backed securities issued and guaranteed by Fannie and Freddie of about the same amount are held by investors of many types. U.S. commercial banks held about $900 billion of housing-GSE securities (13 percent of banks’ total assets) on Sept. 30, 2002, up from about $400 billion at the end of 1993 (11 percent of total assets). Meanwhile, community banks alone (those banks with less than $500 million of assets) held $130 billion of housing-GSE securities on Sept. 30, 2002 (16 percent of total assets), a bit more than at the end of 1993 (15 percent of total assets).12 To manage interest-rate risk, Fannie and Freddie together have become the largest end-users of interest-rate derivatives in the world.

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TIMELINE

Cross Section of U.S. Financial Crises and Reforms

• 1863-64: The National Banking Acts of 1863 and 1864. Created a national bank charter and the Office of the Comptroller of the Currency to regulate nationally chartered banks. These acts tried unsuccessfully to drive state-chartered banks out of business.
  
• 1873, 1884, 1890, 1893, 1907, 1914, 1930-33: Major banking disruptions.
  
• 1913: The Federal Reserve Act of 1913 was signed by President Woodrow Wilson. Created the Federal Reserve System. This was the first central bank in the United States, although its structure and functioning were quite decentralized.
  
• 1927: The McFadden Act of 1927. In effect, barred interstate banking and branching by requiring national banks to follow the same laws that applied to state banks.
  
• 1929-39: The Great Depression 1929-1939. Nearly 30 percent of banks fail. Unemployment hits 25 percent.
  
• 1930s: Early 1930s: Fed tightens monetary policy to defend gold standard rather than injecting liquidity to contain banking panic.
  
• 1933: The Banking Acts of 1933 (Glass-Steagall) and 1935 (part of FDR’s New Deal reforms, which stretched out throughout the 1930s). Created federal deposit insurance for commercial banks (FDIC) and savings institutions (FSLIC). Separated commercial banking from investment banking and insurance underwriting. Restructured the Federal Reserve System, focusing more authority in Washington. Created the Federal Open Market Committee (FOMC). Created a true central bank with a unified decision-making structure.
  
• 1956, 1970: The Bank Holding Company Acts of 1956 and 1970. Defined and created regulation for bank holding companies, an organizational form with little economic rationale other than to arbitrage regulation. The Federal Reserve was given authority to regulate bank holding companies, regardless of the charter(s) held by banks owned by the holding companies.
  
• 1970: Penn Central commercial-paper crisis, which threatened to draw the Fed (via the discount window) into a non-banking financial crisis. The Fed refused a request by the Nixon administration to lend money to a non-bank.
  
• 1974: When Franklin National Bank of Long Island, N.Y., failed in October 1974, it was the largest bank failure to date. Franklin had $5 billion in assets. Federal Reserve discount-window lending to Franklin peaked at $1.8 billion just six days before the bank’s failure. Noting “the severe deterioration of confidence at home and abroad that would have resulted from an abrupt failure,” the Fed was inadvertently laying the groundwork for a “too-big-to-fail” policy, which later would hamper efforts to instill market discipline in banking.
  
• 1973-74: Worst bear market since the Great Depression.
  
• 1970s, 1980s: The S&L crisis of the late 1970s and 1980s. By the time all the doors were closed and depositors paid off, the crisis cost U.S. taxpayers at least $150 billion.
  
• 1980: The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980. Abolished Regulation Q, which put ceilings on deposit interest rates. Broadened access by banks to the Federal Reserve’s discount window and extended reserve requirements to all depository institutions.
  
• 1984: “Too big to fail” is inadvertently acknowledged as policy by the Comptroller of the Currency when it says Continental Illinois and 10 other major banks cannot be allowed to fail for fear of bringing the entire financial system down.
  
• 1987: Stock market crashes.
  
• 1989: The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. Tightened regulation of commercial banks and savings institutions. Appropriated funds and created government-sponsored entities to administer the resolution (bailout) of the savings and loans’ insolvent deposit-insurance corporation (FSLIC). Moved deposit insurance of savings institutions to the FDIC.
  
• 1991: The Federal Deposit Insurance Corp. Improvement Act (FDICIA) of 1991. Made changes to the FDIC and to the deposit insurance provided to depository institutions. Addressed the “too-big-to-fail” problem by specifying how systemically important depository institutions could be treated when insolvent.
  
• 1994: The Riegle-Neal Interstate Bank Branching Act of 1994. Permitted interstate branching by all commercial banks. States subsequently passed laws to permit state-chartered banks to branch across state lines.
  
• 1998: Long-Term Capital Management, a hedge fund, collapses, pushing the world’s financial system to the brink of collapse.
  
• 1999: The Financial Modernization Act (Gramm-Leach-Bliley) of 1999. Repealed much, but not all, of the Glass-Steagall Act that had separated commercial banking from investment banking and insurance underwriting. Created the financial holding company designation to permit financial organizations to engage in different financial activities within the same corporate entity. Reaffirmed the role of the Federal Reserve as the lead (or “umbrella”) supervisor of complex financial institutions (both bank holding companies and financial holding companies). Preserved the role of functional supervisors at the subsidiary level to oversee each line of financial business separately.
  
• 2000: Stock market meltdown begins.
  
• 2001: Sept. 11, 2001: Terrorists attack New York City and Washington, D.C. New York Stock Exchange closes for four days, the longest interruption of trading since 1914. Federal Reserve undertakes extraordinary measures to protect the payments system. Financial stability is maintained.
  
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ENDNOTES

1. The Federal Reserve served as a stabilizing force on several fronts in the unsettled post-Sept. 11 environment. The Federal Reserve Bank of St. Louis 2001 Annual Report described in detail the Fed’s contributions to maintaining financial stability. http://www.stlouisfed.org/publications/ar/2001/default.html.Back to the text.
   
2. Smith, Adam. An Inquiry into the Nature and the Causes of the Wealth of Nations. New York: Modern Library, 1776 (1937 edition), p. 700. Back to the text.
   
3. Gorton, Gary. “Banking Panics.” The New Palgrave Dictionary of Money and Finance, p. 147. New York: The Stockton Press, 1992. Back to the text.
   
4. Sylla, Richard; Legler, John B.; and Wallis, John J. “Banks and State Public Finance in the New Republic: The United States, 1790-1860.” Journal of Economic History, 1987, Vol. 47, pp. 391-403. Back to the text.
   
5. For a brief history of the state-chartered deposit insurance systems, see Mark D. Vaughan and David C. Wheelock, “Deposit Insurance Reform…Is It Déjà Vu All over Again?” Federal Reserve Bank of St. Louis, The Regional Economist, October 2002, pp. 5-9. Back to the text.
   
6. Kindleberger, Charles P. “Financial Crises.” A Financial History of Western Europe, p. 269. London: George Allen & Unwin, 1984. Back to the text.
   
7. International Monetary Fund. Global Financial Stability Report: Market Developments and Issues. Washington, D.C.: IMF, December 2002 and
   March 2003. www.imf.org/external/pubs/ft/GFSR. Back to the text.
   
8. For an overview of the thrift crisis, see David H. Pyle, “The U.S. Savings and Loan Crisis,” in Handbooks in Operations Research and Management Science, Vol. 9, edited by R.A. Jarrow, et al., Amsterdam, North Holland, 1995. Back to the text.
   
9. The third housing GSE is the Federal Home Loan Bank System. Because
   its structure and operations are quite different, we do not discuss it here. Back to the text.
   
10. Direct debt obligations of Fannie, Freddie or the Federal Home Loan Bank System are termed “agency securities.” Securitized pools of mortgages guaranteed against default by Fannie or Freddie are termed “mortgage-backed securities,” or MBS. Back to the text.
    
11. Falcon Jr., Armando. Statement before the Bond Market Association, New York, Feb. 4, 2003. http://www.ofheo.gov/docs/speeches/bmspeech2403.pdf. Back to the text.
    
12. Banks increasingly view securities issued by the housing GSEs as near-perfect substitutes for Treasury securities to serve as secondary liquidity reserves. The share of banks’ total securities holdings accounted for by housing-GSE securities increased from 49 to 72 percent between the end of 1993 and late 2002. Substitution of GSE for Treasury securities raises banks’ interest earnings slightly, at the risk of some illiquidity if GSE securities markets were to become unsettled and illiquid for some reason. Back to the text.
    
13. Office of Federal Housing Enterprise Oversight. “Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO,” a report transmitted to the Congress pursuant to 12 U.S.C. 4513, Sec. 1313 (e), February 2003, http://www.ofheo.gov/docs/reports/sysrisk.pdf. Back to the text.
    
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PART 2

YEAR IN REVIEW: OUR PEOPLE, OUR WORK

A Message from Management

2002 was a year of which all of us at the St. Louis Fed can be truly proud. We accomplished our goals—and, in many cases, did more than we set out to do—in helping the Federal Reserve System fulfill its primary responsibilities: setting and carrying out monetary policy, regulating and supervising member financial institutions, and providing financial services to banks and to the federal government.

However, the Federal Reserve’s success in converting paper payments to electronics will result in consolidated operations and a significant change in the way we operate. Recently, the Federal Reserve System announced that it would eliminate jobs because of the decline in the nation’s check usage. For decades, processing checks has been one of our main businesses. At the same time, we’ve been encouraging check writers to switch to electronic forms of payment. Why? Electronic payments make for a more-efficient payments system—one of our primary responsibilities. Because the public has now begun a fundamental shift to electronic payments, we need fewer locations and people to process checks. System-wide, 1,300 positions will be eliminated; in the Eighth District, about 170 jobs will be cut by year-end 2004—more than 10 percent of our staff—as the Little Rock and Louisville branches stop processing checks. Never before has the Fed reduced staff to this extent, and we’re saddened that we’ll lose such dedicated employees. Yet we know these reductions are an unavoidable consequence of a move that will improve the nation’s economy in the long run.

Despite the sobering news of staff reductions, we must recognize the many successes we’ve had over the past year. These can be measured in a variety of ways: from the numbers on the ledger sheets to the number of outreach efforts, from the quality of our financial services to the valuable research and advice that we provide to our nation’s monetary policy-makers.

Looking at the most basic barometer of success, our expenses last year came in under budget and our financial services local net revenue exceeded expectations. Not many businesses can say that for 2002.

In the financial services arena, we’re working hard to keep up with our customers’ demands. For example, we’ve modernized all check-related systems as the Fed has moved to a single system for the entire nation; the Eighth District was the first Reserve bank in the System to complete this effort. Our cash operations—counting, sorting and storing currency, along with replacing the worn-out bills—have also become more efficient. As a result, we ended 2002 as No. 2 in productivity among the 12 Fed districts in cash operations. The Federal Reserve System has also recognized our track record in processing food coupons at our Memphis Branch—Memphis now has responsibility for processing food coupons for the western half of the United States.

Even as we picked up additional System responsibilities, we gave up some financial services work to other Feds to create common practices, to produce economies of scale and to reduce expenses. For example, our electronic access support was shifted in 2002 to the Minneapolis Fed. We also pursued joint ventures with other Feds; the business development departments of the St. Louis and Cleveland Feds were recently merged—a first for the System—to save money and provide better service to customers across the two districts.

Our previous experience and expertise in financial services have been carried over into the jobs we perform for the U.S. Treasury. For the last two years, the St. Louis Fed has had oversight responsibility for the work done by other Federal Reserve banks for the Treasury. In addition, our District provided some of these Treasury services. For example, we handled more than $2 trillion in transactions for the Treasury last year, mainly in federal tax payments and investments of available Treasury funds in banks around the country. With our help, these investments earned $280 million in interest for the U.S. Treasury in 2002. We also helped in 2002 to devise a new investment program that in the pilot phase alone netted the Treasury an additional $3 million.

In bank supervision, our staff carried out 91 on-site safety and soundness examinations and inspections last year and continued to use off-site monitoring capabilities to improve our own productivity and to be less intrusive in our examinations. Reports on examinations were processed faster than ever. The department’s newly established Center for Online Learning is the System’s leader in web-based training for examiners. The center’s online courses save time and money for all involved and allow trainees to learn at their own pace.

The economists in our Research Department continue to provide valuable policy advice, which is shared with the Federal Open Market Committee when it meets to set monetary policy. The economists also share their research and expertise with broader District audiences—everyone from students to teachers to business executives to government officials. In the past year, the economists have seen more of their work published and have increased the number of speeches they give to outside audiences. They also regularly criss-cross the district to meet our constituents and customers, swap ideas and gather information on local and regional economies.

It’s not just the economists who are reaching out to the public with expertise and services. Our Community Affairs staff travels the District and beyond, bringing together bankers and those who need credit to help redevelop their communities. The office also shines the spotlight on issues that deserve attention, issues such as predatory lending and financial literacy. Of particular note is the conference we sponsored in fall 2002 on the subject of revitalizing distressed urban areas. Instead of holding such an affair in a destination city at a fancy hotel, the office took the bold move of holding the conference in East St. Louis, Ill., the exact location that needs and deserves our attention. Meanwhile, our economic education department is at the forefront in the Fed in training teachers and laymen about the economy, having doubled its goal in attendance at such events last year.

As good stewards of our limited resources, we are always trying to do more with less. One of our new initiatives in 2002 for saving money was ED—Electronic Distribution. Instead of printing and mailing regulatory and financial services information to banks, we now send them via e-mail and the Internet. This move reduced our mailing costs by more than half.

Another major savings will come in the future as a result of our decision not to build a new headquarters building. Instead, we will renovate the building that we’ve called home for more than 75 years. This decision will require some creativity on the architects’ part—to give us the added security precautions necessitated by Sept. 11 in our current location. But we won’t sacrifice on employee security, as we’ve already demonstrated. In the past year, we’ve added protection officers at all four offices, and each of them has now been trained and certified as a federal law enforcement officer.

Next year at this time, we hope that we can report a similar level of success. And we wish the same for you.

William Poole
President and Chief Executive Officer

W. LeGrande Rives
First Vice President and Chief Operating Officer

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St. Louis Fed: By the Numbers

At any bank, success is measured through numbers. But not all the important numbers can be found in accountants’ financial statements. What follows is a collection of numbers that speak on many different levels about the St. Louis Fed’s work and about the people involved with the Bank, whether they are customers, employees or outside parties who are just curious about the Federal Reserve System. You don’t have to be an accountant—or auditor—to understand why these numbers are meaningful to us.

• 1,994 depository institutions—banks, savings & loans, credit unions and holding companies—are located in the Eighth District. These include 75 Fed-supervised state member banks and 624 Fed-supervised holding companies. Last year, four banks and 16 holding companies were started in the District, and there were two failures (one bank and one credit union, neither supervised by the Fed).
  
• 171 citations in professional journals and elsewhere to the work of Research Division economists.
  
• 396 loans to depository institutions for a total dollar value of $974 million.
  
• 46,120,000 Treasury checks processed, an increase of 64 percent from the previous year.
  
• 4 is average number of suspected counterfeit bills found a day in money turned over to the St. Louis office by banks for processing and storing. The bills are turned over to the Secret Service.
  
• 28 percent of all notes sent to the Bank are destroyed because they are worn out.
  
• 1,323 employees in four locations: the home office in St. Louis and the branches in Little Rock, Louisville and Memphis. Of these, 76 were part-time. Total turnover was 8.25 percent.
  
• $37,611,399,000 the total dollar value of all currency handled by the St. Louis Fed and paid out. In all, almost 2.4 billion notes were processed. When the cash is received from banks, lightning-quick machines count, validate and bundle notes at the rate of 88,500 an hour.
  
• Approximately $1.6 trillion in federal taxes on businesses processed through the Treasury Tax & Loan program for the U.S. Treasury.
  
• $280 million in interest earned for the U.S. Treasury through TT&L investments at qualified financial institutions.
  
• 216,487,000 postal money orders processed.
  
• 5,500 calls a month handled by Treasury Relations and Systems Support staff members. They deal with more than 10,000 financial institutions nationwide.
  
• 25 workshops on risk management were facilitated by the Bank’s Risk Management Consulting department.
  
• 34,189 statistical reports from financial institutions and other respondents were processed.
  
• 102,843 cans of food donated by St. Louis employees to charity. The annual food drive is now providing half of the food collected by Operation Food Search, the area’s largest food bank.
  
• 5,435,469 hits to the newly designed web site from the time it went live in the middle of August until the end of the year.
  
• 1,165,805,000 commercial checks processed (down 0.7 percent from 2001),
  with a total dollar value of $696 billion (up 12 percent).
  
• 106,549 subscriptions to our periodicals. In addition to these publications sent out in the mail, we have 3,617 online subscriptions from people who want to do their reading on the computer.
  
• 520 depository institutions had a total balance of $478,795,726 in Fed accounts at year’s end. The money represents required reserves and discretionary funds needed for settling transactions.
  
• 26,949,000 food coupons destroyed. That’s 28 percent more than the previous year, thanks, in large part, to consolidation of this work in Memphis and Richmond, Va.
  
• 1,603 people who attended 29 economic education events held across the District. These included seven high-school students from St. Louis who made it
  to the Fed Challenge’s “final four” in Washington, the highest level attained by any team from our district, and 35 teachers who participated in the weeklong Money and Banking course during the summer for college credit.
  
• 8 million hits for the year to the FRED (Federal Reserve Economic Data) database, the Internet’s most popular noncommercial web site for U.S. economic data. The Research Division implemented a new, enhanced version of FRED in 2002. Hits rose 23 percent from 2001.
  
• The Bank had net income of $877 million, with $816 million of that profit turnedover to the U.S. Treasury, $11 million paid out to member banks and $50 million kept as surplus. Income totaled $1.04 billion and included $897 million from interest on U.S. government and federal agency securities, $53 million from services, $42 million from foreign currency gains and $38 million from reimbursable services to government agencies. Expenses totaled $163 million and included $84 million for salaries and other benefits, $42 million for “other (includes everything from software to travel to some pension costs),” and $19 million for assessments by the Board of Governors.

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Board of Directors

We would like to express our deepest gratitude to those members of our Eighth District boards of directors who retired in 2002. Our appreciation and best wishes go out to: Joseph E. Gliessner Jr. from the St. Louis Board, Cynthia J. Brinkley from the Little Rock Board and Mike P. Sturdivant Jr. from the Memphis Board.

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Little Rock Board of Directors

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Louisville Board of Directors

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Memphis Board of Directors

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St. Louis Board of Directors

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CREDITS

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