ECOP 3019
Question 5

Stocks tumbled, with the Dow Jones shedding more than 777 points, its worst one day loss as the House of Representatives barred a US$700 billion bailout package. [1] International capital markets collapsed, while the Dollar (USD) rallied on extreme risk aversion. Nations who lacked the foreign reserves to support their liabilities became victims of a credit crunch, while survivors of the Great Depression from the likes of Lehman Brothers and Washington Mutual folded. From all corners of the globe, millions lost their source of employment as economies slipped into the stages of economic contraction not seen in generations. Indeed, the Global Financial Crisis (GFC) was a horrific period that ultimately required extraordinary policy responses to provide liquidity and stabilise global markets.

To cope with the GFC and its aftermath, the Federal Reserve System (Fed) of the United States (US) along with other major central banks including the European Central Bank, Bank of Japan and the Bank of England, has practiced unconventional monetary policy to reduce downside risks to growth and repair crippled markets. By far one of the world??™s largest financial agents, the Fed has been the backbone of the US economy since its establishment in 1913. The institution provides banking oversight, financial services to depository institutions, the government and international bodies in addition to regulating the money supply to achieve maximum employment, moderate interest rates and stable consumer prices, including the prevention of deflation or excessive inflation. [2] As the sole actor of monetary policy in the world??™s most influential economy, the Fed has become an enormous provider of liquidity and stability, not just to US institutions, but to global banking giants as seen recently with the onset of the European debt crisis.

When credit markets froze and banks collapsed in 2008, the Fed lowered interest rates towards zero percent and increased its balance sheet from US$900 billion in September to US$2.3 trillion by December that year (Figure 1). [3] The rapid expansion reflected a massive round of asset purchases, including US Treasuries and corporate securities, to shore up confidence and prevent the annihilation of financial institutions and the economy. Today, that figure is nearly US$2.9 trillion as the Fed has provided stimulus through programs known as Quantitative Easing (QE) and most recently Operation Twist. The logic behind QE involves the Fed increasing the money supply to fund the purchase of US Treasuries to reduce the government??™s borrowing costs, which also lowers the rate of interest consumers and businesses pay on loans and mortgages to encourage spending. Furthermore, forcing interest rates lower negatively affects cash deposit rates, which has encouraged investors to allocate funds in higher-risk assets, namely stocks.
Figure 1: Fed??™s Balance Sheet

In contrast to the methods the Fed is pursuing today to spur growth, traditionally, they have established interest rates through open market operations, which inflate or deflate the money supply. Particularly in the case of the GFC, when conventional monetary policy became ineffective, the Fed began buying financial assets, including US Treasuries and Commercial Mortgage Backed Securities (CMBS), to inject liquidity into the economy. These practices are easily distinguished from the usual policy of buying or selling assets to keep interest rates at a determined value. [4] While there are short-run benefits, there is the potential for QE and other asset purchase programs to create long-run inflation that??™s undermined the USD and ability for Uncle Sam to meets his liabilities, prompting Peter Schiff, a renowned investor and Chief Executive of Euro Pacific Capital, to remark ???I am a hundred percent convinced that anybody who has their wealth in US Dollars will be just as broke as the people who had their money with Madoff.??? [5]
Figure 2: US 2-Year Treasury Yield

Since the Fed began QE and buying CMBS in the depths of the recession, the USD has weakened in line with a large decline in real interest rates (Figure 2), encouraging investors to seek yield elsewhere. [6] At the same time, growth, while improving, has remained somewhat stagnant, keeping the US jobless rate above eight percent still five years since the first signals of an impending crisis first came to light. As a consequence of a depressed USD, the US inflation rate has begun rising above what??™s deemed to be acceptable. With more USD??™s in circulation, the less purchasing power each one has, resulting in higher prices for goods limited in supply. In the worst case, increasing the money supply may result in hyperinflation, hence why alternative assets that are considered an inflation hedge including Gold (Figure 3) have appreciated. ???I think it is a much tougher call to do more QE this time around,??? St. Louis Fed President James Bullard said last year when economists were calling for additional Fed stimulus to cushion the blow of Standard & Poor??™s US credit downgrade and the European crisis. ???The inflation picture is different this year than it was last year and the risk of deflation is much more remote than it was last year.??? [7]
Figure 3: Spot Gold (USD/oz)

There is little doubt that without the Fed??™s and fellow central banks actions, the global economy today could be stuck in an economic downturn that may have exceeded the Great Depression. Without their actions, institutions from the likes of American International Group (AIG), Citigroup and Royal Bank of Scotland could have collapsed under the weight of their toxic assets that would have wiped out domestic savings, killed economies and sent jobless rates in developed states soaring. In fact, since the Fed initiated its first round of QE in early 2009 the S&P 500, a bellwether gauge of US equities, has rebounded as much as 113 percent from its bear market lows, [8] the number of unemployed Americans has fallen by 2.9 million from a record-high of 15.4 million [9] and the nation??™s economy has recorded eleven straight quarters of growth. [10] Indeed, since the US is the world??™s largest economy and is a global centre of finance, its recovery is critical to trading partners, including emerging economies such as Brazil and China.

By March of 2008, Bear Stearns, which before its failure was the fifth-largest US investment bank, began to crumble. The institution was a major participant in the securitisation of ultimately toxic mortgages that remained on its books. At the time, it was deemed by the Fed that its sudden collapse would have a devastating impact on an already stressed financial system that was ill prepared. To prevent a panic, the Federal Reserve Bank of New York provided emergency loans and eventually orchestrated its sale to larger rival JPMorgan Chase. To complete the deal, the Fed established an entity known as Maiden Lane to facilitate the purchase of distressed assets from Bear Stearns that JPMorgan Chase refused to take on its own books. While the transaction was largely a success and prevented a sudden meltdown, the Fed was on the hook to ensure Maiden Lane did not collapse and therefore it provided a US$30 billion credit line. [11]

Soon after JPMorgan Chase??™s acquisition of Bear Stearns, in September, Lehman Brothers became the next domino to fall followed closely by AIG. In the absence of a private buyer, the Fed and US government decided to let Lehman fail, with the view that it would not bring down other institutions. The event, however, stressed AIG, the largest US underwriter of commercial and industrial insurance and counterparty to virtually every global financial institution by entering into credit default swap (CDS) contracts on more than $400 billion of AAA rated securities, [12] to the point of destruction. In what was probably the Fed??™s most controversial decision during the GFC, the central bank bailed out the insurer by establishing Maiden Lane II [13] to purchase AIG??™s highest risk RMBS and Maiden Lane III to cover AIG??™s credit default swaps, a form of insurance, on collateralised debt obligations (CDO) that combined had a market valuation in excess of US$40 billion. [14] The two entities were established with loans from the Fed totalling US$41.8 billion in addition to a US$85 billion credit facility the central bank provided AIG to ensure that the so called ???Too Big To Fail??™ institution remained liquid and could meet its daily obligations.

The Fed??™s involvement in the rescue of AIG and Bear Stearns marked a strategic change in the direction of the central bank. No longer was it an institution that was only involved in the implementation of monetary policy to meet its statutory objectives, but rather the Fed evolved to become an emergency provider of liquidity and stability to the financial system. Importantly, while there is little doubt that without the actions of the central bank the GFC could have been far worse, the actions the Fed has and is continuing to take are far from desirable as a strategy to secure long-term economic growth and prevent futures systemic crises. In fact, with a stronger regulatory framework and a better oversight of financial institutions, the Fed should never have to repeat its actions again and if the US economy continues to recover, they should normalise monetary policy to prevent excessive inflation and restore the purchasing power of the USD by avoiding excess money supply growth to fund asset purchases.

The fact that global governments and central banks deemed it necessary to rescue failing financial institutions in the GFC highlights that there was an abysmal lack of global regulation and capital requirements to ensure that banks did not exceed their operational mandates by betting customer deposits and overleveraging their balance sheets. The events that unfolded have resulted in a great distaste towards capitalism and the world of finance by ordinary citizens of society, who in many cases are struggling to overcome the effects of a depressed global economy, particularly in Europe where state governments are implementing austerity measures to reign in government spending that was supposed to provide stimulus amid the GFC. ???The banking culture has evolved radically, to the point where the perception amongst most members of society is that their actions are driven by the relentless pursuit of earnings with no regard to their potential negative impact on communities,??? said Anson Rosewall, a sales trader at BBY Ltd. ???The fact that banks have taken government cash, while the average person has lost his job and house without help, will probably forever tarnish the reputation of these major institutions.??? [15]

Only years after accepting taxpayer bailout funds, global banks are still taking aggressive risks, which in the future may require renewed emergency actions by central banks to stabilise conditions. Shockingly, JPMorgan Chase, which is renowned for its sound risk management and strength as an institution of finance, recently announced a US$2 billion trading loss tied to synthetic credit securities that were suppose to provide an economic hedge against its portfolio of loans. Chief Executive Jamie Dimon flagged that there were ???many errors, sloppiness and bad judgment,??? prompting renewed criticism that there is still a major lack of regulatory oversight. [16] ???Dimon should resign from his post at the New York Fed to send a signal to the American people that Wall Street bankers get it and to show that they understand the need for responsibility and accountability,??? Elizabeth Warren, a Massachusetts candidate for US Senate said in the wake of the scandal. [17]

The Fed and other central banks have an important role in promoting US and global economic stability. They have provided support to financial markets, helping steer the GFC away from an economic disaster that would have been comparable to the Great Depression. Unfortunately, the policies which the Fed in particular has conducted are not ideal and should not become a standard market management technique to sustain the economy and financial system, both in downturns and periods of sustained growth. Ultimately, they have devalued the purchasing power of the USD that may result in longer-run inflation and it has given the idea to banks that they can reap the rewards of good times and be bailed out when their profitability turns south. Ultimately, the fact the Fed was required to play a major role in bailing out financial firms who are still taking aggressive risks to this day highlights that there needs to a radical restructure of the regulatory system to ensure that no institution is ever allowed to become ???Too Big to Fail??™ again.
[1] ???Dow Sinks 777 Points As Bailout Plan Fails??? ?© 2008
[2] ???Mission??? ?© 2009 Federal Reserve System
[3] ???Price graph for Federal Reserve System Reserve Balances 11/05/2002 to 11/05/2012??? ?© 2012 Bloomberg L.P.

[4] ???Open Market Operations??? ?© 2012 Federal Reserve System
[5] Schiff, Peter. ???Dollar Collapse Peter Schiff???. 27 Feb. 2010. Youtube.
[6] ???Price graph for US 2-YearTreasury Yield 11/05/2002 to 11/05/2012??? ?© 2012 Bloomberg L.P.
[7] Matthews, Steve ???Fed Isn??™t on Brink of QE3 With 2013 Rate Promise, Bullard Says??? Bloomberg L.P. August 17, 2011
[8] ???Price graph for S&P 500 01/03/2009 to 11/05/2012??? ?© 2012 Bloomberg L.P.
[9] ???Price graph for US Unemployment Unemployed Workers Total 01/01/2009 to 11/05/2012??? ?© 2012 Bloomberg L.P.
[10] ???Price graph for GDP US Chained 2005 Dollars QoQ 01/01/2009 to 11/05/2012??? ?© 2012 Bloomberg L.P.
[11] ???Maiden Lane??? ?© 2012 Federal Reserve Bank of New York
[12] Pittman, Mark ???Goldman, Merrill Collect Billions After Feds AIG Bailout Loans??? Bloomberg L.P. September 29, 2008
[13] ???Maiden Lane II??? ?© 2012 Federal Reserve Bank of New York
[14] ???Maiden Lane III??? ?© 2012 Federal Reserve Bank of New York
[15] Miller, Rich ???Capitalism Seen in Crisis by Investors Citing Inequalities??? Bloomberg L.P. January 25th, 2012
[16] Kopecki, Dawn ???JPMorgan Loses $2 Billion on Unit??™s ???Egregious Mistakes??? Bloomberg L.P. May 12th, 2012
[17] Thompson, C. ???Elizabeth Warren Calls for Dimon to Resign From New York Fed??? Bloomberg L.P. May 13th, 2012