Lessons Learned from the Financial Crisis: The Fed as a "First Responder" to the Crisis

As housing prices began to fall, financial market panic started in September 2008. Julie Stackhouse explores how the Federal Reserve provided liquidity to both stem the panic and prevent an economic collapse, in addition to actions taken by the U.S. government and the FDIC.

Presentation (PDF)

• Part 1: Welcoming Remarks | James Bullard (8:40)
• Part 2: Responses to the Pre-Event Survey | Julie Stackhouse (2:41)
• Part 3: A Brief History of the Federal Reserve and the Fed's Responses to Past Crises (7:25)
• Part 4: The Beginnings of the Most Severe Financial Crisis since the Great Depression (10:07)
• Part 5: The Housing Bubble and Its Ramifications (9:53)
• Part 6: The Federal Reserve as a "First Responder" to the Crisis (9:37)
• Part 7: Avoiding a Financial Collapse, but not the Great Recession (8:18)
• Part 8: Lessons Learned from the Crisis (7:21)
• Part 9: Question-and-Answer Session (26:26)

Transcript:

Julie Stackhouse: So this is where we were in September of 2008. And you might remember some of this. It was a 19-day stretch of time, and many, many things happened. First of all, I mentioned Fannie Mae and Freddie Mac, the mortgage giants. It was discovered that those mortgage giants were out of capital. That the mortgages they had on their books, because they actually bought some of these bad mortgages, these Alt-A mortgages, exceeded the capital that they had on their books. The former president of this Reserve Bank, Jim's predecessor, a guy named Bill Poole, was one of the first to say those mortgage giants do not have enough capital. Of course, you know, by that point the capital was so thin and the crisis so big.

So these two mortgage giants that make up the bulk of the mortgage market, except for FHA today, were put into government conservatorship. What does that mean? It means that you, the taxpayer, are essentially funding them. And their losses have been significant since they were put into conservatorship.

The second thing occurred is that a large investment bank, one of the companies that took these mortgages and formed them into securities, they had a lot of them on their books. And this investment bank had more mortgages than it had capital. Anybody remember what one it was?

Lehman Brothers? Yeah. Bear Stearns was actually earlier. This one in September was Lehman Brothers. But very similar.

And then one of the world's largest insurance giants was bailed out. Anybody remember that?

Collectively: AIG.

Julie Stackhouse: AIG, yeah. A lot of questions out there about, well, why AIG and why not Lehman? You know, hindsight is 20/20. At the time that Lehman Brothers went into bankruptcy it was quite evident that its losses would exceed its capital. It was not so evident with AIG on whether its issue was one of solvency or one of a run that investors wanted their money out. And so a different tact was taken.

And finally, a large financial institution, $300 billion was allowed to fail and was transferred ownership. And that was Washington Mutual. Now I mention that, because here in St. Louis the largest banking organization headquartered here, we don't have any really big ones headquartered here, but headquartered here is about $8 billion in asset size. Certainly we have banks like Regents that have operations here, but of the banks headquartered here, our largest is about $8 billion. So compare that to $300 billion. That's absolutely amazing.

Now what I didn't cover in this are all of the organizations that had marriage partners, be it Countrywide Mortgage. Be it other organizations, investment banks that found marriage partners very quickly. And so none of those hit the ranks of failures, but, again, all of that occurred during this period of time where the financial market erupted.

So this is what it looked like. There are lots of different ways to look at financial market disruption. You can pick your favorite. I've picked the one that I use most often because we can go back for a long period of time and see what it looked like before and what it looks like now.

What this line says is it takes a look at two interest rates. What the intent of it is to do is to say what sort of panic is there in financial markets? So the difference between the lines or between the zero and where the line goes to is just simply symbolic of panic in financial markets. I can get into a much more technical explanation, but that's panic. That's when those that participate in financial markets aren't sure what to do the next day.

And as we worked through the financial crisis, the beginnings of it, we saw that there was concern in financial markets. In fact, that's why the FOMC took steps to rapidly lower interest rates. It's why the Federal Reserve began making more loans to financial institutions, to try and calm the jitters.

As we worked through the period of roughly a year or so though, there were peaks, there were valleys. But it was only in September of 2008 that the financial markets realized that the issue in the mortgage market has well exceeded expectations and they were no longer sure who to do business with. And that's really a very, very frightening situation, because when a corporation cannot go out and finance its payroll, if that's how it finances it through the commercial paper market, or when investors are no longer sure, or they're pulling their money rapidly out of money market mutual funds, because they have no idea what those funds are invested in, very quickly the financial system can verge toward collapse. And clearly that would be in—it would have serious, serious repercussions for the economy.

In this case we hit the height of the financial market panic in the fall of 2008. So that's where you got, you saw the headlines outside? That's where many of the government organizations or quasi government organizations began to step in.

The Federal Reserve, our job is to provide the liquidity to stem the panic. I showed you the picture of Sept. 11, 2001. I'll show you another picture of what that looked like visually in just a minute. The government, if there is going to be a bailout, that is the job of the U.S. government. The U.S. government had several programs, one called The Troubled Asset Relief Program or TARP. It was commonly referred to as the bank bailout. That is a little bit—that's not totally wrong. Banking organizations received about $240 billion in funds. That amount though has been largely repaid. It's down to $19 billion in funds. And the banking piece of it, the interest collected on the investments of the U.S. government will cover the losses of the program.

So in hindsight it's not entirely clear that the bank piece of this was a gift to banks. It certainly was a cost and most of those banks have repaid their TARP funds. There are still sizable TARP investments outstanding related to the automotive industry and to AIG.

The U.S. government also had a very sizable economic stimulus. And then there was the Cash for Clunkers Program, the extended insurance benefits, others that were also very important in terms of reinvigorating the economy.

And the third first responder, the Federal Deposit Insurance Corporation. The FDIC was there to give you confidence that your deposits were insured. It was really an amazing time, because investors for so long, or depositors for so long hadn't thought about deposit insurance. When I spent at the Kansas City Fed down in Oklahoma during the energy crisis, we saw runs on banks. We saw lines at banks when there was uncertainty about whether or not that bank was going to be closed. And that lasted until people discovered they would be insured. And once they understood that, the lines stopped.

Indeed we saw some of that in this crisis as well, although most of the runs were the runs that were occurring through electronic means and not through lines in banking organizations.

So those were the three first responders.

Okay, so this is a picture of the Fed’s balance sheet. Really easy to understand, right?

Okay. What I do want to show you a little bit though at least to help visualize this, I'm almost afraid to push this clicker. Yep. Okay, so I'm not going to push the clicker. I'm going to point. Is the middle part of the chart. And what you can see there is the Federal Reserve with a balance sheet that's largely about one size for a long period of time. And then as we move into the financial crisis, the Fed changes the composition of its balance sheet, as it starts to stimulate the economy, but keeping the balance sheet fairly level.

Then we hit the financial crisis, then you see the run up. And most of that is related to the lending programs of the Fed, as well as other actions it took to provide U.S. dollars to other foreign central banks.

What's very interesting about this, and I think probably not well understood, is that although that got very large and peaked at a very high level, it has largely gone down to zero on those programs. There’s very, very little left on the Federal Reserve balance sheet from the financial crisis.

What is on the balance sheet is something that we could spend another hour talking about called Quantitative Easing 1 and Quantitative Easing 2. In order to effectively bring interest rates below zero, at least this is how I have to think about it, when interest rates are at zero, the way you influence that is by buying bonds. And the Federal Reserve and Quantitative Easing 1 bought mortgage bonds, and in the second round bought U.S. Treasury securities. Indeed, there's a great economics lesson there and we certainly could take questions on that in just a few minutes.

So that's what the Fed's balance sheet looks like today as it has done its work to first of all resolve panic, and second, to stimulate the economy.