Revisiting the Financial Crisis: Meeting of the Federal Open Market Committee on September 16, 2008 Part 1
The Federal Reserve has finally released the minutes of the Federal Open Market Committee after Lehman Brothers filed for bankruptcy. William Dudley opened with a briefing on the current economic status. The Fed did an overnight repo (repurchase agreement) to put money back in the market. The stock market ended up losing half its value during the following five months. Dudley was too optimistic about the repos.
To try to have more effect on this issue, this morning we came in much earlier than we normally do—around 8:00 a.m. We did a $50 billion overnight repo. The funds rate at the time was trading at 3¼ percent. I think this means that we are obviously adding way too many reserves for the current maintenance period; but the good news is that, when this maintenance period is over a week from tomorrow, we get a fresh start. So at the current time I think we will see essentially a lot of firmness in the funds rate in the morning and then the funds rate trading down to zero late in the day. Where the funds rate averages relative to the target is going to be somewhat difficult to say. Yesterday, despite the collapse in the funds rate to essentially zero at the end of the day, the funds rate was quite firm relative to the target. I don’t remember the numbers, but it was in the 2½ percent range. We are going to try to hit the target on average, but it is going to be very difficult. In the current circumstances, it probably is more sensible—at least my advice would be—to err on the side of providing enough liquidity to the market rather than trying to be cute and worrying just about the target federal funds rate.The Fed was buying the repos to give a quick fix to cash strapped financial institutions. The banks would agree to buy to repos back at a greater interest. According to Bloomberg News, Lehman Brothers used repos to hide the true worth of the investment bank. Lehman was essentially lending money to itself through Hudson Castle Group Inc. This was legal under the law. Lehman pledged the notes to Hudson Castle as collateral to JPMorgan Chase & Co. The notes were essentially worth nothing. Dudley told the Committee that Goldman Sachs and Morgan Stanley were at risk. Investors feared that Goldman Sachs and Morgan Stanley could go under like Lehman Brothers.
Now, the Lehman filing has also intensified the pressure on Morgan Stanley and Goldman Sachs in a number of respects. The Lehman failure means that investors now view the debt of Morgan Stanley and Goldman Sachs as having much more risk than it did on Sunday. This means that these firms need bigger liquidity buffers than they had before, and it does have implications for long-term profitability. As a consequence, their share prices fell very sharply yesterday. Morgan Stanley was down about $5 a share, to $32, and Goldman Sachs’s stock was off 18 points, to $135. Morgan Stanley experienced a modest, but not insignificant, pulling back of their counterparties and ate into their liquidity buffer by a measurable degree.If no one wants to do business with Goldman Sachs or Morgan Stanley than they will quickly run out of money. Banks only keep about ten perfect of their revenue. The rest of the money loaned or invested out. Banks make their money from collecting interest from their various deals. THe problem is this creates a problem for the banks if there is an economic crisis. Dudley correctly told the committee that AIG presented a bigger crisis to the financial institutions. People that bought to collect on credit default swaps they bought in the event of Lehman Brothers assets failing. Dudley told the Committee that AIG doesn't have the money to repay the on the swaps their clients bought.
Of course, we also have the issue of AIG. The AIG problem is at least starting as a liquidity crisis. The problem with AIG is that the parent company doesn’t have a lot of liquidity resources and doesn’t have easy ability to funnel liquidity up from their subsidiaries because most of the subsidiaries are regulated entities. So AIG is running into two problems: One, they are unable to roll their commercial paper and, two, as their ratings are downgraded—they were downgraded by Moody’s yesterday, I think from AA minus to A minus, but don’t quote me on that—they have to post a lot more collateral against their derivatives exposures and also with respect to their GIC (guaranteed investment contract) business. So AIG is in a situation in which the parent is basically going to run out of money—today, tomorrow, Thursday, or very, very soon. Now we say it’s a liquidity thing, but a lot of times when people look closer at the books they find out that the liquidity crisis may also be a solvency issue. I think it is still a little unclear whether AIG’s problems are confined just to liquidity. It also may be an issue of how much this company is really worth.What Dudley is actually saying here is that Eurupean banks were freezing out the major American investment banks.
This would reassure people that dollar liquidity was available in Europe throughout the European day. My advice to you is that this is probably a good idea in this environment because we are seeing that the lack of dollar liquidity in Europe is really having a feedback effect on people’s willingness to do business with one other in the broader markets.The Committee agreed to swap dollars for Euros with the European Central Bank and other parties. Donald Kohn did not want this recorded in the minutes. Ben Bernanke agreed with Kohn.
CHAIRMAN BERNANKE. Why don’t we have discussions with our counterparties—we won’t announce anything today, I would assume? MR. DUDLEY. No, I think they have to take it up the chain of command, just as we do here. So it’s going to take probably a day. MR. KOHN. This would come out in the minutes for this meeting. CHAIRMAN BERNANKE. Right. We’ll announce something. MR. STERN. But I assume there will be an announcement at some point. CHAIRMAN BERNANKE. Of course. When would we announce this measure? MR. DUDLEY. I think it would be after we’ve had a chance—I mean, I think we have a lot of work to do with our foreign counterparties. This was basically raised to me this morning.Dudley was concerned that the dollar would not be available in Europe. Jeffrey M. Lacker felt that the ECB was attempting to hoard dollars because of the economic crisis. I think both Dudley and Lacker are right.
MR. LACKER. Note here a sense of discomfort with our lending them dollars that they already have and so our serving as a substitute for their mobilizing their own dollar reserves for this purpose. Obviously, the demand could swamp their own reserves, and at that point I would feel differently about this. But my understanding is that the distribution within the European system of central banks is uneven, and in some sense this just provides them with a way to circumvent negotiating how those dollars would be distributed from different central banks to different private-sector banks within their own system. Broadly, I’m uncomfortable with our playing that role.The short answer is banks all over the world were going to the Federal Reserve for a line of credit. Bernanke signed off on the Euro swap deal with Europe because he was concerned about the dollar weakening in Europe.
There is another action item I would like to add, given what is happening, which is that there are very significant problems with dollar funding in other jurisdictions—in Europe and elsewhere.Later in the meeting, Lacker was talking about raising interest rates. On what planet was he living on.
I can support standing pat with the funds rate today. I think that’s a good idea. I think, looking forward, that we will want to raise rates sooner rather than later if core inflation doesn’t moderate.The Federal Reserve ended up keeping interest rates near zero in response to the great recession. The Federal Reserve ended up dropping interest rates to 1 percent on October 29, 2009. The labor market was already weak when Lehman filed for bankruptcy. Economist Dave Stockman provides a bleak picture to the Committee. Unfortunately, Stockman thought the unemployment numbers might get better.
The other notable development over the intermeeting period has been the weakness in the labor markets—now not principally in the payroll employment figures. Private payroll employment has been falling pretty sharply but not any faster than we would have thought. But the rise in the unemployment rate is remarkable. Now, some of the 0.4 percentage point increase in the unemployment rate last month could be statistical noise. It wouldn’t be entirely surprising to see it fall back some. But the more than 1 percentage point rise that we’ve had since April is not going to be statistical noise. Some of that increase probably reflects a bigger response to the emergency unemployment compensation program than we previously thought, and we’ve upped our estimates for that to a little less than 0.3 percentage point on the level of the unemployment rate. But even putting that aside, we have experienced a more significant rise in the unemployment rate, and I think that’s consistent with other things that we’re seeing in terms of the labor market data. We’ve seen another appreciable jump in initial claims. Announced job cuts are up. Job openings are down. Survey hiring plans have softened.Stockman thought there was a chance for the housing market to recover in 2009. Boy, was he wrong.
The three things that are absolutely central to producing that outcome are our projection that we’re going to get a stabilization in housing in 2009—and early in 2009; that there will be some diminishment of the drag on growth from the financial turbulence; and that oil prices flatten out. Of those three, to my mind, the component that probably is most central and most important would be seeing some stabilization in the housing market, not only because this has been a big drag on growth and will also have consequences for household wealth but also because if there’s going to be some clarity and reassurance to financial market participants, it seems as though some end to the housing debacle has to be in sight. We think we are seeing a few glimmers of hope there—however, we thought that on occasion in the past and have been proven wrong. But sales of existing homes have been flat since the turn of the year. Sales of new homes have been flat for several months now. We’ve had a drop in mortgage interest rates that followed the takeover of Fannie and Freddie. Starts have fallen so much now that, in fact, builders are making significant progress in working down the inventory of unsold new homes and even months’ supply has tipped down of late. So we think that some things are looking a little better for us there. As a consequence, we’re expecting to see some bottoming-out near the end of this year or the beginning of next year—but not a sharp recovery. Overall residential investment actually is still a negative for 2009 but less of a negative than it has been this year.This chart by Business Insider show foreclosures increased in 2009. Banks went into overdrive on foreclosing on homeowners. JPMorgan Chase was forced to pay $13 billion for the illegal mortgage practices of Washington Mutual.