Fed Functions, Responsibilities, and Independence

The Fed’s functions:

• Issuing currency

  • Federal Reserve Banks issue Federal Reserve Notes (paper currency)

  • The bank that issued a particular bill is identified in black in the upper left of the front of the newly designed bills.

    • “A1” identifies the Boston bank, “B2” the New York bank, etc

• Setting reserve requirements and holding reserves

  • reserve requirements::

    • fractions of checking account balances that banks must maintain as currency reserves.

  • The central banks accept any portion of banks and thrifts’ mandated reserves not held as vault cash.

• Lending to financial institutions and serving as an emergency lender of last resort

  • The Fed makes routine short term loans to banks and thrifts and charges them an interest rate called the discount rate

  • occasionally auctions off loans to banks and thrifts through its Term Auction Facility

  • lender of last resort to critical parts of the U.S. financial industry in emergencies

• Providing for check collection

  • if a check is written on one bank/thrift and the receiver deposits the check in a different bank/thrift

    • Fed adjusts the reserves (deposits) of the two banks.

• Acting as fiscal agent

  • The Fed acts as the fiscal agent (provider of financial services) for the federal government

  • government uses the Fed’s facilities to collect taxes, spend money, and sell and redeem bonds

• Supervising banks

  • makes periodic examinations to assess bank profitability, make sure they follow regulations, and uncover questionable practices or fraud.

  • Following the financial crisis of 2007–2008, Congress expanded the Fed’s supervisory powers over banks.

• Controlling the money supply

  • manage the money supply (and thus interest rates) according to the needs of the economy

  • making an amount of money available consistent with high and rising levels of output and employment and a relatively stable price level

Federal Reserve Independence

• congress made the Fed an independent agency of government

  • protects the Fed from political pressures

    • Political pressures may result in inflationary fiscal policies, including tax cuts and special-interest spending.

    • b/c of its independence, Fed can increase interest rates to reduce aggregate demand and stem inflation

    • on average, countries that have independent central banks like the Fed have lower rates of inflation

• If Congress and the executive branch also controlled the nation’s monetary policy, citizens and lobbying groups would pressure elected officials to keep interest rates low

What Caused The Financial Crisis of 2007 and 2008?

• a properly functioning monetary system supports the continuous circular flows of income and expenditures in the economy.

• a malfunctioning one causes major problems in credit markets and can cause severe fluctuations in the economy’s levels of output, employment, and prices.

• In late 2007-2008, the U.S. financial system faced its most serious crisis since the Great Depression

  • it soon spread to the entire economy, culminating in the severe recession of 2007–2009

The Mortgage Default Crisis

• In 2007 there was a major wave of defaults on home mortgage loans

  • threatened original mortgage lenders and any financial institutions that made such loans or invested in such loans

  • defaulting is when a borrower fails to make their mortgage payment, breaching the mortgage contract

• A majority of these mortgage defaults were on subprime mortgage loans

  • subprime mortgage loans::

    • high-interest-rate loans to home buyers with higher-than-average credit risk.

• several of the biggest indirect investors in these subprime loans had been banks.

  • banks lent money to investment companies that purchased many of these loans from mortgage lenders.

  • When the mortgages went bad, many investment funds “blew up” and could not repay the loans to the banks.

  • The banks thus had to “write off” (declare unrecoverable) the loans they made to the investment companies, but doing that meant reducing the banks’ reserves and ability to generate new loans

• threatened the economy because both consumers and businesses rely on loans to finance consumption and investment expenditures

Before the Crisis

• banks and government regulators wrongly thought the “mortgage-backed security” eliminated most of the bank exposure to mortgage defaults

  • mortgage-backed security::

    • bonds backed by mortgage payments

    • To create them, banks and other mortgage lenders first made mortgage loans.

      • instead of holding the loans as assets on their balance sheets and collecting the monthly mortgage payments, the banks and other mortgage lenders bundled hundreds or thousands of them together and sold them off as bonds

      • banks obtained a single, up-front cash payment for the bond

      • the bond buyer started to collect the mortgage payments as the return on the investment

• banks thought it was smart because it transferred any future default risk on those mortgages to the buyer of the bond

  • but they lent a big portion of the money they received from selling the bonds to investment funds that invested in mortgage-backed bonds

  • They also purchased large amounts of mortgage-backed securities as financial investments to meet bank capital requirements set by bank regulators.

  • though not directly exposed, banks were still indirectly exposed to mortgage-default risk

• When homebuyers defaulted their mortgages, banks lost money on the mortgages they still held.

  • They also lost money on the loans they had made to the investors who purchased mortgage-backed securities, and on the mortgage-backed securities the banks had purchased from investment firms.

What caused the skyrocketing mortgage default rates in the first place?

• government programs that greatly encouraged and subsidized home ownership for former renters

• declining real estate values at the end of a long housing boom where house prices had greatly increased

• bad incentives provided by mortgage-backed bonds.

  • banks and other mortgage lenders thought they were no longer exposed to much of their mortgage default risk so they became lax in their lending practices

    • people were granted subprime mortgage loans that they were unlikely able to repay.

    • some mortgage companies stopped running credit checks and even allowed applicants to claim higher incomes than they were actually earning so they could qualify for bigger loans

• many people took on “too much mortgage” and failed to make their monthly payments

  • people were lured into buying houses they couldn’t afford

Securitization

• these problems relate to…

• securitization::

  • the process of slicing up and bundling groups of loans, mortgages, corporate bonds, or other financial debts into distinct new securities.

• To reduce the risk for holders of these loan-backed securities, a few large insurance companies developed other securities that the holders of loan-backed securities could purchase to insure against losses from defaults.

  • American International Group (AIG) issued billions of dollars of collateralized default swaps:

    • insurance policies that were designed to compensate the holders of loan-backed securities if the loans underlying these investments went into default and did not pay off.

    • They became another category of investment security that was highly exposed to mortgage-loan risk

• Securitization is so widespread and critical to the modern financial system that economists sometimes call it the shadow banking system.

• securities backed by loans or other securities are issued, bought, sold, and resold each day which keeps credit flowing to households and firms that rely on it for their needs.

  • In general, securitization is a positive financial innovation.

  • But mortgage-backed securities turned out to be much riskier than most people thought.

3 questions investors and government regulators failed to ask

1. What would happen if the value of one of the types of loans (ex. mortgages) that underlies part of the securitization process unexpectedly plunged?

2. What would happen if some of the largest holders of the securities based on these mortgages were major U.S. financial institutions that are vital to the US economy?

3. What would happen if the main insurer of these securities was the largest insurance company in the United States AND in the world?

• all 3 of these came true

  • interest rates on adjustable-rate mortgages increased and house prices fell.

  • Borrowers who made small down payments on home purchases or previously cashed out home equity discovered that they owed more on their mortgages than their properties were worth.

  • As interest rates adjusted upward and the economy slowed, borrowers fell behind on mortgage payments.

  • Lenders began to foreclose houses while other borrowers literally handed in their house keys and walked away

Failures and Near-Failures of Financial Firms

• When the mortgage loan “card” underpinning mortgage-based securitization fell, the securitization layers above it collapsed

• big mortgage lenders failed because they still held large amounts of the bad debt. Three huge mortgage lenders collapsed or nearly collapsed.

  • the second largest mortgage lender, was saved from bankruptcy by Bank of America.

  • Regulators seized Washington Mutual bank, the nation’s largest mortgage lender, and arranged a takeover by JPMorgan Chase.

  • Wachovia bank’s heavy exposure to mortgages through its Golden West subsidiary resulted in near bankruptcy and was rescued through acquisition by Wells Fargo

• growing problem of loan defaults quickly jumped from direct mortgage lenders to other financial institutions.

• Securities firms and investment banks that held large amounts of loan-backed securities suffered huge losses.

  • Goldman Sachs and Morgan Stanley rushed to become bank holding companies so they could qualify for the massive emergency loans that the Federal Reserve was making available to banks and bank holding companies.

  • AIG suffered enormous losses because it had not set aside sufficient reserves to pay off the losses that accrued on the insurance policies sold to holders of mortgage-backed securities.