The unprecedented government response to the financial crisis began even before the contagion triggered by Lehman Brothers. On December 12, 2007, the Federal Reserve announced the term auction facility (“TAF”), which auctioned funds to all banks, to avoid the reluctance of banks in trouble to get conventional loans for fear knowledge of their borrowings would exacerbate their problems.72 On March 7, 2008, the Fed initiated a series of single-tranche 28-day term repurchase agreements (“ST OMO”), to provide
funds to primary dealers in exchange for Treasury securities, agency debt, or agency MBS (collateral accepted in conventional open market operations).73 On March 11, 2008, the Federal Reserve launched the Term Securities Lending Facility in which primary dealers
could temporarily exchange program-eligible collateral, which included nonagency AAA/Aaa-rated private-label residential MBS in addition to agency MBS, for Treasury securities.74 On March 16, 2008, the Fed then extended access to the discount window to primary dealers including investment banks through the Primary Dealer Credit Facility (“PDCF”) in connection with the acquisition of Bear Stearns by JPMorgan.75
Following the September 15, 2008 bankruptcy of Lehman Brothers, the number and scale of government programs grew. On September 16, 2008, the Federal Reserve
approved an $85 billion secured revolving credit facility for AIG under Section 13(3) of the Federal Reserve Act.76 According to Secretary Paulson, this was like a temporary
“bridge loan,”77 which can be likened to the Japanese authority to provide bridge financing to insolvent financial institutions, as described in part V of this book. On
September 22, 2008, the Federal Reserve launched the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (“AMLF”), which lent to banks so they could purchase asset-backed commercial paper from money market funds.78 On
September 29, 2008, the Treasury launched the Temporary Guarantee Program (“TGP”), which was funded by the Exchange Stabilization Fund, and provided approximately $3.2 trillion in guarantees for “liabilities” of money market funds to “address temporary
dislocations in credit markets.”79 The Emergency Economic Stabilization Act was enacted on October 3, 2008, and permitted the Treasury, under the Troubled Asset Relief Program (“TARP”), to inject equity into failing financial institutions.80 It also permited the
Treasury, through the Capital Purchase Program (“CPP”) to restructure the Federal Reserve’s emergency support for AIG.81 On October 14, 2008, the FDIC instituted the TLGP, which consisted of (1) the Transaction Account Guarantee Program (“TAGP”) to provide unlimited guarantees to domestic noninterest-bearing transaction deposits and (2) the Debt Guarantee Program (“DGP”) to provide limited guarantees of new senior unsecured debt issued by banks and thrifts.82 On October 3, 2008, the limit on federal deposit insurance coverage was raised temporarily from $100,000 to $250,000.83 On October 27, 2008, the Federal Reserve launched the Commercial Paper Funding Facility (“CPFF”), which authorized the New York Federal Reserve Bank to purchase highly rated unsecured and asset-backed commercial paper.84 On November 25, 2008, the Federal Reserve launched the Term Asset-Backed Securities Loan Facility (“TALF”), which authorized the New York Federal Reserve Bank to lend up to $200 billion to holders of certain ABS, and was intended to encourage lending by promoting the issuance of new ABS.85
Finally, the Federal Reserve Bank acted as international lender of last resort through swap lines in which the Fed loaned US dollars to foreign central banks, which were then lent to foreign institutions.86 Four foreign central banks had unlimited access to these swap lines during the crisis—the Bank of England, the Bank of Japan, the ECB, and the Swiss National Bank.87 The swap lines reached an aggregate amount of $583 billion in December 2008.88
Table 7.2 Government responses to contagion
Date Agency Program name 12/12/2007 Federal
Reserve
Term Auction Facility 3/11/2008 Federal
Reserve
Term Securities Lending Facility 3/16/2008 Federal
Reserve
Primary Dealer Credit Facility 9/16/2008 Federal
Reserve
§13(3) Lending to AIG 9/22/2008 Federal
Reserve
Asset-Backed Commercial Paper Money Market Fund Liquidity Facility
9/29/2008 Treasury Temporary Guarantee Program of Money Market Funds 10/3/2008 Congress Emergency Economic Stabilization Act (enabled TARP
programs)
10/3/2014 FDIC Raise deposit insurance limit to $250,000 10/14/2008 FDIC Transaction Account Guarantee Program 10/14/2008 FDIC Debt Guarantee Program
10/27/2008 Federal Reserve
Commercial Paper Funding Facility 11/25/2008 Federal
Reserve
Term Asset-Backed Securities Loan Facility
Less well known than the actions of the Fed, FDIC, and the Treasury was the role of the Federal Home Loan Bank system (“FHLBank system”) in providing liquidity to depository institutions—commercial banks as well as thrift institutions. The FHLBank System is a government-sponsored enterprise established in 1932 whose public purpose is to provide US thrifts and commercial banks, “with financial products and services, most notably advances i to assist and enhance financing of housing and community lending … by providing a readily available, competitively priced source of funds for housing and community lenders.”89
The FHLBank system consists of twelve regional Federal Home Loan banks and a central body that coordinates the issuance of public debt obligations, which funds
FHLBank advances.90 As a government-sponsored enterprise, the FHLBank system can typically issue debt at favorable interest rates due to their implicit government guarantee.
Contrary to popular understanding, recipients of FHLBanks are not required to use loans just for housing. Indeed empirical evidence provided by Frame, Hancock, and Passmore (2007) suggests that FHLB advances are just as likely to fund other types of bank credit as to fund residential mortgages.91 However, there are several important restrictions on FHLBank advances. First, FHLBanks can only lend to banks that meet
minimum capital requirements, as prescribed by their prudential regulator.92 For example, in order to qualify for an FHLBank advance a commercial bank must have a CAMELS rating of 3 or higher. Additionally FHLBank advances must be fully
collateralized by US Treasury and GSE debt or residential mortgage-related assets (whole loans and mortgage-backed securities).93 As part of each advance, a borrower must also purchase FHLB stock in an amount ranging from 2 to 6 percent of the advance (as
dictated by the individual FHLB’s capital plan).94
Between the third and fourth quarters of 2007, FHLBank advances outstanding grew by
$235 billion, a 36.7 percent increase, and continued to grow through most of 2008, peaking at over $1 trillion by the end of the third quarter of 2008.95 Shockingly, during this time, US commercial banks and thrifts received more in cash from FHLBank
advances than from the Fed in discount window loans. This is because from the
perspective of US thrifts and commercial banks, there were distinct advantages of using FHLBank advances instead of the discount window, as interest rates on FHLBank
advances were lower than the rates on discount window loans and the terms of the FHLBank advances were longer.96 According to a Federal Reserve study, the cost of an advance from the New York FHLB was between 30 and 80 basis points lower than a comparable discount window loan.97 Of the $235 billion increase in FHLB advances during the second half of 2007, $205 billion carried an original maturity of greater than one year (87.4 percent).
However, by late 2008 US commercial banks and thrifts demand for FHLB advances waned, as FHLB advances had become more expensive than the Federal Reserve discount window.98 This occurred for two reasons. First, the Federal Reserve had repeatedly
reduced the discount rate in 2008, and implemented liquidity facilities, like the TAF, that lent at market rates instead of penalty rates. Second, there was a negative change in
investor attitudes toward FHLB debt issuances, which increased the FHLBank’s funding costs thereby requiring the FHLBanks to increase the interest rates on FHLBank
advances. As recognized in the Federal Reserve study on the FHLBank’s role during the financial crisis, “events in 2008 revealed … [that] relying on market funding using an implicit government guarantee is unlikely to be sufficient for a lender of last resort to be entirely effective during a financial crisis—exactly when you need one most.”99
Notes
1. See George Kaufman, Bank contagion: Theory and evidence (Fed. Res. Bank of Chicago, June Working Paper Series, WP-92–13, Jun. 1992), available at
http://www.chicagofed.org/digital_assets/publications/working_papers/1992/WP-92- 12.pdf.
2. See Ted Temzelides, Are bank runs contagious? Fed. Res. Bank of Philadelphia Bus.
Rev. 3, 3–14 (Nov./Dec. 1997), available at http://www.philadelphiafed.org/research- and-data/publications/business-review/1997/november-december/brnd97tt.pdf.
3. Id. at 4–6.
4. Jean-Claude Trichet, Pres., Eur. Cent. Bank, Text of the Clare Distinguished Lecture in Economics and Public Policy (Dec. 10, 2009), available at
http://www.ecb.int/press/key/date/2009/html/sp091210_1.en.html (analyzing the linkage between systemic risk and contagion).
5. Morgan Ricks, Shadow banking and financial regulation, 1, 3, Columbia Law and Economics, Working Paper No. 370 (Aug. 30, 2010).
6. For discussion of the increasing complexity in the contemporary financial system and its role in the financial crisis of 2007–2009, see, for example, Hal S. Scott and Anna Gelpern, International Finance, Transactions, Policy, and Regulation, University Casebook Series 1, 778–873 (20th ed. 2014).
7. Gary Gorton, Slapped in the face by the invisible hand: Banking and the panic of 2007, 1, 43 (Yale and NBER, May 2009), available at
http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf (concluding that
“[r]eforms to the current system must address the reality of [the] shadow banking system as a banking system”).
8. The term “shadow banking system” is attributed to Paul A. McCulley, managing director at PIMCO. It has since been widely adopted by the financial press. Paul McCulley, Teton Reflections, PIMCO (Sep. 2007); see also Zoltan Pozsar, Tobias
Adrian, Adam Ashcraft, and Hayley Boesky, Shadow banking 11–14 (Fed. Res. Bank of New York, Staff Report No. 458, Jul. 2010), available at
http://www.newyorkfed.org/research/staff_reports/sr458.pdf.
9. Gary Gorton and Andrew Metrick, Securitized lending and the run on the repo, 104 J.
Fin. Econ. 425 (2012).
10. Hal S. Scott, How to improve five important areas of financial regulation, Kaufman Task Force on Law, Innovation, and Growth 113, 117, available at
http://www.kauffman.org/~/media/kauffman_org/research%20reports%20and%20covers/2011/02/rulesforgrowth.pdf The FSB has defined “shadow banking” as “credit intermediation involving entities and
activities outside the regular banking system.” FSB, Global Shadow Banking
Monitoring Report 2012 (Nov. 18, 2012). The FSB has recognized a distinction between
“entity-focused” shadow banking, which involves nonbank entities, and “activity- based” shadow banking, in which banks may also participate. Id.
11. See also Zoltan Pozsar , Shadow banking, 1, 11–14 (Fed. Res. Bank of New York, Staff Report No. 458, Feb. 2012), available at
http://www.ny.frb.org/research/staff_reports/sr458.pdf.
12. Hyun Song Shin, Macroprudential Policies beyond Basel III, 1, 8 (2010).
13. Zoltan Pozsar et al., Shadow banking 1, 10–11 (Fed. Res. Bank of New York, Staff Report No. 458, Feb. 2012), available at
http://www.ny.frb.org/research/staff_reports/sr458.pdf.
14. Id. at 12.
15. Id. at 12.
16. Id. at 12.
17. Id. at 13; see also Hal S. Scott and Anna Gelpern, International Finance, Transactions, Policy, and Regulation, University Casebook Series 1, 789–92 (20th ed. 2014)
(describing the steps in the process of creating of a CDO).
18. Zoltan Pozsar et al., Shadow banking, 1, 13 (Fed. Res. Bank of New York, Staff Report No. 458, Feb. 2012), available at
http://www.ny.frb.org/research/staff_reports/sr458.pdf.
19. Id. at 13.
20. Id. at 14.
21. Richard Anderson and Charles Gascon, The commercial paper market, the Fed, and the 2007–2009 financial crisis, Fed. Res. Bank of St. Louis Rev. 589, 590 (Nov./Dec.
2009), available at
http://research.stlouisfed.org/publications/review/09/11/Anderson.pdf.
22. Russ Wermers, Money fund runs, 1 (Sep. 2010) (noting that “[i]n the eyes of some investors, money market funds have become a substitute for bank deposits”); see also Morgan Ricks, Shadow banking and financial regulation, 3, 4 (Columbia Law and Econ., Working Paper No. 370, Aug. 30, 2010) (noting that “the short-term financing sources on which [the system of money market funds and other credit intermediaries]
relies are the functional equivalent of bank deposits”); see also Gary Gorton, Slapped in the face by the invisible hand: Banking and the panic of 2007, 1, 30 (Yale and NBER, May 2009)(arguing that “[r]epo is essentially depository banking, built around
informationally-insentive debt”).
23. Morgan Ricks, Shadow banking and financial regulation, 3, 6, 9–11 (Columbia Law and Econ., Working Paper No. 370, Aug. 30, 2010); see, for example, Brooke Masters and Jeremy Grant, Finance: Shadow boxes, Fin. Times (Feb. 2, 2011) (defining and describing “shadow banking” and noting that “[s]ome non-banks … engage in what is known as ‘maturity transformation’ … [s]ometimes … within a single institution but … also … in long chains that encompass everything from mortgage brokers and packagers of loans into securities, to the money market funds and special-purpose vehicles that hold them”).
24. Morgan Ricks, Shadow banking and financial regulation, 3, 11 (Columbia Law and Economics, Working Paper No. 370, Aug. 30, 2010).
25. Zoltan Pozsar et al., Shadow banking, 1, 5 (Fed. Res. Bank of New York, Staff Report No. 458, Feb. 2012), available at
http://www.ny.frb.org/research/staff_reports/sr458.pdf.
26. Naohiko Baba, Robert N. McCauley, and Srichander Ramaswamy, U.S. dollar money market funds and non-U.S. banks, BIS Q. Rev. 65, 68 (Mar. 2009).
27. Fed. Deposit Ins. Corp., 2008 Annual Report 12, 53 (Jun. 2009), available at http://www.fdic.gov/about/strategic/report/2008annualreport/index_pdf.html.
28. Ben Bernanke, Remarks at the Fed. Res. Bank of Kansas City’s Annual Economic Symposium, Jackson Hole, WY (Aug. 21, 2009).
29. Inv. Co. Inst., Report of the Money Market Working Group 59 (Mar. 17, 2009).
30. Id. at 59.
31. Naohiko Baba et al., U.S. dollar money market funds and non-U.S. banks, BIS Q. Rev.
65, 72 (Mar. 2009).
32. See id.
33. Eleanor Laise, “Breaking the buck” was close for many money funds, Wall St. J. (Aug.
10, 2010).
34. Hugh Hoikwang Kim, Contagious runs in money market funds and the impact of a government guarantee (Pension Research Council, Wharton School of the University of Pennsylvania, Working Paper 2013-31, Sep. 19, 2012).
35. Naohiko Baba et al., U.S. dollar money market funds and non-U.S. banks, BIS Q. Rev.
65, 72 (Mar. 2009).
36. David Serchuk, Another run on money market funds? Forbes (Sep. 25, 2009).
37. Id.
38. Naohiko Baba, et al., U.S. dollar money market funds and non-U.S. banks, BIS Q. Rev.
65, 70–72 (Mar. 2009).
39. Federal Reserve Release, Volume Statistics for Commercial Paper Issuance (2015), http://www.federalreserve.gov/releases/CP/volumestats.htm; Bryan Keogh and Christopher Condon, Commercial paper falls most ever as ConEd sells bonds, Bloomberg (Jul. 16, 2009).
40. Marcin Kacperczyk and Philipp Schnabl, When safety proved risky: Commercial paper
during the financial crisis of 2007–2009, 24 J. Econ. Persp. 29, 41 (Winter 2010), available at https://www.aeaweb.org/articles.php?doi=10.1257/jep.24.1.29; Chris Reese, US asset-backed commercial paper shrinks markedly, Reuters (Sep. 18, 2008).
41. Marcin Kacperczyk and Philipp Schnabl, When safety proved risky: Commercial paper during the financial crisis of 2007–2009, 24 J. Econ. Persp. 29, 40 (Winter 2010),
available at https://www.aeaweb.org/articles.php?doi=10.1257/jep.24.1.29. For
example, when Lehman filed for bankruptcy, the spread between overnight ABCP and the federal funds rate ballooned to over 300 basis points, up dramatically from already steep spreads of 25 to 30 basis points over the previous weeks.
42. Id. at 30; Press Release, US Dep’t of the Treasury, Treasury announces temporary guarantee program for money market funds (Sep. 29, 2008).
43. Marcin Kacperczyk and Philipp Schnabl, When safety proved risky: Commercial paper During the Financial Crisis of 2007–2009, 24 J. Econ. Persp. 29, 46 (Winter 2010), available at https://www.aeaweb.org/articles.php?doi=10.1257/jep.24.1.29.
44. Financial Crisis Inquiry Comission, The Financial Crisis Inquiry Report ix, 394 (2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
45. Id. at 355. For discussion of the wider impact of the financial crisis of 2007–2009 on the real (nonfinancial) economy, see id. at 389–410; Thomas Russo and Aaron Katzel, The 2008 financial crisis and its aftermath: Addressing the next debt challenge, 7, 61–
62 (Working Draft, Oct. 25, 2010).
46. Gavin Finch and Kim-Mai Cutler, Libor jumps as banks seek cash to shore up finances, Bloomberg (Sep. 24, 2008).
47. Id.
48. LIBOR-OIS Spread [Functions: LOIS], Bloomberg Terminal, Bloomberg LP (2015).
The LIBOR-OIS spread measures the difference between the London Interbank
Offered Rate (LIBOR) and the overnight indexed swap (OIS) rate. The 3-month LIBOR is the rate at which banks borrow unsecured funds from other banks in the London wholesale money market for a 3-month period. An OIS allows a bank to exchange a fixed rate of interest on a notional amount for a reference floating rate (typically the federal funds rate) on that notional amount. The OIS rate is generally viewed as a measure of investor expectations of the effective federal funds rate, whereas LIBOR reflects credit risk and expectations of future overnight rates. The LIBOR-OIS spread can therefore be viewed as the premium banks are willing to pay to avoid the need to roll over the funds on a daily basis at changing overnight rates. Rajdeep Sengupta and Yu Man Tam, The LIBOR-OIS spread as a summary indicator, Fed. Res. Bank of St.
Louis (2008), available at
http://research.stlouisfed.org/publications/es/08/ES0825.pdf. See also Financial Crisis Inquiry Comission, The Financial Crisis Inquiry Report ix, 355 (2011), available
at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
49. See Markus Brunnermeier, Deciphering the liquidity and credit crunch 2007–2008, 23 J. Econ. Persp. 77, 85 (Winter 2009) (noting the utility of the TED spread as a measure of liquidity in the financial system).
50. Bloomberg.com Ted Spread Index, Bloomberg (depicting historical data).
51. Gavin Finch and Kim-Mai Cutler, Libor jumps as banks seek cash to shore up finances, Bloomberg (Sep. 24, 2008).
52. Financial Crisis Inquiry Comission, The Financial Crisis Inquiry Report ix, 355 (2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
53. See figures 2.3 and 2.4.
54. Rick Rothacker and Kerry Hall, Wachovia faced a “silent” bank run, Charlotte
Observer (Oct. 2, 2008); Markus Brunnermeier, Deciphering the liquidity and credit crunch 2007–2008, 23 J. Econ. Persp. 77, 90 (Winter 2009) (noting silent run on Washington Mutual prior to its being placed in receivership and sold to JPMorgan Chase).
55. News Release, Wells Fargo & Company, Wells Fargo and Wachovia merger completed (Jan. 1, 2009); News Release, Wells Fargo & Company, Wells Fargo’s merger with Wachovia to proceed as whole company transaction with all of Wachovia’s banking operations (Oct. 9, 2008).
56. Press Release, Fed. Deposit Ins. Corp., JPMorgan Chase acquires banking operations of Washington Mutual (Sep. 25, 2008), available at
http://www.fdic.gov/news/news/press/2008/pr08085.html.
57. See Gary Gorton and Andrew Metrick, Securitized lending and the run on the repo, 104 J. Fin. Econ. 425 (2012) (finding that increases in repo spreads and repo haircuts
during the financial crisis of 2007–2009 were correlated with uncertainty concerning counterparty risk and collateral values, respectively).
58. Id.
59. Id. The authors’ data set focuses on interdealer repo markets and excludes the tri- party repo market.
60. Financial Crisis Inquiry Comission, The Financial Crisis Inquiry Report ix, 355 (2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
(noting effect of hedge fund withdrawals of assets held by Merrill Lynch prior to the closing of its merger with Bank of America and flows to “large commercial banks with
… more diverse sources of liquidity”); Allan Sloan, A year after Lehman, Wall Street acting like Wall Street again, Wash. Post (Sep. 8, 2009).
61. The run on Morgan Stanley, FT.com/Alphaville (Sep. 18, 2008); Saijel Kishan and Katherine Burton, Morgan Stanley loses hedge-fund clients on stock drop, Bloomberg (Sep. 18, 2008).
62. Financial Crisis Inquiry Comission, The Financial Crisis Inquiry Report ix, 361 (2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
63. Id. at 361 n.34.
64. Manmohan Singh and James Aitken, Counterparty risk, impact on collateral flows, and role for central counterparties, 1, 7–8 (IMF, Working Paper No. 09/173, Aug.
2009), http://www.imf.org/external/pubs/ft/wp/2009/wp09173.pdf.
65. Id.
66. Christine Harper, Morgan Stanley said to weigh deal with Wachovia as shares sink, Bloomberg (Sep. 17, 2008); Tiernan Ray, Goldman shares off 33% for week as CDS fears spread, Barron’s (Sep. 17, 2008), available at
http://blogs.barrons.com/stockstowatchtoday/2008/09/17/goldman-shares-33-off- this-week-as-cds-fears-spread/.
67. Financial Crisis Inquiry Comission, The Financial Crisis Inquiry Report ix, 361 (2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf. This
increase in CDS spreads affected both dealers and end clients. See Or Shachar,
Exposing the exposed: Intermediation capacity in the credit default swap market (Stern School of Business, New York University, Working Paper, Mar. 2012). Shachar
examined sample CDS contracts among the top dealers from 2007 to mid-2009, and found that after Lehman’s bankruptcy, dealers found it more difficult to offset their positions, so the interdealer market was “congested” and dealers’ ability to provide liquidity to their clients also decreased.
68. Christine Harper, Morgan Stanley, Goldman plummet after AIG takeover, Bloomberg (Sep. 17, 2008).
69. Id.
70. See Press Release, Bd. of Governors of Fed. Res. Sys. (Sep. 21, 2008).
71. See Press Release, Fed. Deposit Ins. Corp., FDIC announces plan to free up bank liquidity (Oct. 14, 2008).
72. Press Release, Bd. of Governors of Fed. Res. Sys. (Dec. 12, 2007).
73. Press Release, Bd. of Governors of Fed. Res. Sys. (March 7, 2008).
74. Bd. of Governors of Fed. Res. Sys., Term securities lending facility (2015), available at http://www.federalreserve.gov/monetarypolicy/tslf.htm; see also Press Release, Bd. of Governors of Fed. Res. Sys. (Mar. 11, 2008).