Extra Credit (Fall 2008)

Economically Speaking

Striving for stability: Federal Reserve actions address financial turmoil

Photo of Wall Street MarketFinancial system turbulence has been in the news a lot lately. The Federal Reserve and other agencies have been working together to address financial market unease and return the economy to sustainable growth while maintaining stable prices.

Developments leading to credit troubles
What's behind the recent turbulence? After several years of significant increases in home prices, rapidly expanding home building, and major subprime lending growth, by 2006 the housing market began to weaken and home prices began to decline in many areas.

Atlanta Fed President and CEO Dennis Lockhart described how credit markets began to feel the impact of the weakening housing market in the summer of 2007. That July, the rating agency Standard & Poor's downgraded some classes of residential mortgage-backed securities, precipitating a generalized repricing of risk in the financial system.

Institutions were caught holding large inventories of residential mortgage-backed securities and other investments. The value of these assets fell significantly as market trading for them faltered. Also, the institutions holding these securities came under increasing suspicion related to their liquidity and, in some cases, solvency. With significant losses from debt backed by mortgages and without reasonably free-flowing credit, many companies could not adequately finance their operations.

Related Links
Information regarding recent Federal Reserve actions off-site image

Addressing liquidity issues
A stable and properly functioning financial system is vital to economic growth and therefore a key concern of the Federal Reserve. When dislocations in financial markets threaten the economic well-being of the country, the Fed must weigh all aspects of market conditions to help mitigate systemic risk to the economy.

As conditions worsened starting in August 2007, the Fed began to use various tools to combat the financial crisis. First, the Fed immediately began to address liquidity issues by reducing the discount rate to encourage banks to borrow from the Fed as needed. Through a number of reductions, the Fed has lowered the discount rate from 6.25 percent in August 2007 to 1.25 percent today.

Next, in September 2007, the Fed began lowering the federal funds rate, the rate at which banks borrow from each other on an overnight basis. From September 2007 to October 2008, the Fed lowered its federal funds target rate from 5.25 percent to 1.0 percent.

As credit market turmoil continued in 2007, Federal Reserve policymakers realized that traditional Fed monetary policy tools alone were not sufficient to address the problems. The Fed thus began to use different tools—some of them new—to increase liquidity in the financial markets.

One existing but little-used tool has been currency swap lines with foreign central banks to provide dollar liquidity to institutions overseas. Since December 2007, the dollar amounts of these swap lines have been increased and expanded to include additional central banks.

Last December the Fed began to provide additional liquidity to different types of financial institutions through a variety of lending facilities. These facilities have increased the length of time for loans from the Fed, expanded the types of collateral accepted for loans, and opened up the Fed's discount window to different types of institutions.

Further global deterioration in credit markets—particularly in September of this year—occurred despite these actions and began to affect credit availability for businesses and individuals. As credit continued to tighten, the Fed and other government organizations decided that further action was needed.

Other actions from the U.S. government
In recent months, the U.S. Treasury, in coordination with the Fed, has taken several actions. The Treasury placed the two housing government-sponsored enterprises, Fannie Mae and Freddie Mac, in conservatorship and provided them financial support. In a separate action, the Fed provided American International Group (AIG), a large insurance and financial services corporation, an emergency credit line of $85 billion (since that time the Fed provided $37 billion in additional funds to AIG through another lending agreement).

Fed Chairman Ben Bernanke described the AIG action to Congress in testimony in September. The Fed took this action, he said, "because it judged that, in light of the prevailing market conditions and the size and composition of AIG's obligations, a disorderly failure of AIG would have severely threatened global financial stability and, consequently, the performance of the U.S. economy."

While the Treasury and Fed have offered assistance to individual firms with targeted financial support, this assistance has come with penalties to these firms in the form of "significant costs and constraints on the [firms'] owners," according to Bernanke, to try to prevent moral hazard.

A comprehensive approach
Despite significant actions by the Fed and Treasury to combat financial issues, credit markets have remained under stress, and the Treasury, with the Fed's support, presented a more comprehensive approach to Congress in September of this year.

Congress held hearings on the Treasury proposal, made some significant changes to it, and then passed a rescue package (the Emergency Economic Stabilization Act) in early October. A significant part of the act centers on the Treasury's purchase of certain types of assets deemed to be blocking up the credit markets and gives the Treasury the ability to purchase capital in financial institutions.

The same bill changed the law to allow the Fed to begin paying interest on reserves it requires banks to hold (required reserves) and on reserves in excess of this amount (excess reserves). This change was already planned for 2011, but implementation was moved up to help the Fed better manage the federal funds rate.

An additional change in the law increased FDIC bank deposit insurance coverage limits (see FAQs in Related Links).

The coordinated but separate actions of the Federal Reserve, Treasury, and other government agencies have been working toward the same goal of a stable financial system and economy. And the Treasury and Fed have been collaborating with foreign governments and central banks to address global credit issues.

Despite all these measures, credit markets are continuing to undergo significant transitions. Visit the Federal Reserve Board's Web site (see Related Links) for the latest updates.