Facing a Lost Decade Ahead

Federal Reserve Power Unsupported by Credibility

By
Henry C.K. Liu

http://www.henryckliu.com/page200.html

Part I: No Exit

Part II: Facing a Lost Decade Ahead


Ben S. Bernanke, who has just been reappointed a second term as Chairman of the Federal Reserve by President Obama, has announced repeatedly his decision to turn the traditionally secretive Fed into a more open institution, saying his unusually large number of recent public appearances is the result of the “extraordinary” times the economy faces. It appears that the extraordinary times that both Chairman Bernanke and President Obama concede as likely to last a long time may well turn into a lost decade for the US economy while waiting for an anemic jobless recovery.

Troubling Economic Projections

White House Budget Director Peter R. Orszag predicts that US unemployment will surge past 10% in 2009 and the fiscal budget for 2010 will reach $3.7 trillion while the fiscal deficit will reach $1.5 trillion, some 40% over revenue. The figures are higher than previous administration forecasts because of a recession that was deeper and longer than expected by administration economists. The White House Office of Management and Budget (OMB) Mid-year Economic Review forecasts a weaker economic recovery than it saw in May, as the gross domestic product is expected to shrink 2.8% in 2009 before expanding 2% in 2010 from a lower base. The Congressional Budget Office (CBO), in a separate assessment, forecasts the economy will grow 2.8% in 2010 from a low base. Both see the GDP expanding 3.8% in 2011, an optimistic forecast likely to be revised downward by actual events.

“While the danger of the economy immediately falling into a deep recession has receded, the American economy is still in the midst of a serious economic downturn,” the White House OMB report said, adding: “The long-term deficit outlook remains daunting.” What the Administration and the Fed have done is to halt the sharp downdraft in the economy with measures that will guarantee a protracted lackluster recovery when it comes.

Budget Shortfall Projections

The Obama budget shortfall for 2010 would mark the second consecutive year of trillion-dollar fiscal deficits. Along with the unemployment numbers, the fiscal deficit may weigh heavily on Obama’s faltering drive for his top domestic priority, reforming the US health care system, a long overdue urgent task. Obama’s hope for change cannot be fulfilled without a vibrant economy. It cannot be financed with fiscal deficits.

Administration and congressional budget officials expect the unemployment rate, which was 9.4% in July, 2009 to keep rising even with recovery. White House officials at the OMB said the unemployment rate likely will rise past 10% by the end of 2009, averaging 9.3% for the entire year. A 7.9% estimate released in May 2009 by the White House was revised up to a 9.8% for 2010, no small revision.

The CBO report also estimates the 2009 jobless rate at 9.3% but a 2010 average of 10.2%. These estimates are predicated on the prospect that Fed policies work as hoped. There is no official data on underemployment which has become a serious problem in the economic meltdown when layoff workers have to settle for jobs below their qualification that pay less than their previous jobs. Moreover, the unemployment problem is hitting the service sector, traditionally the sector responsible for growth in recent decades.

Unprecedented Fiscal Deficit Projections

The OMB raised its deficit projection for fiscal 2010, which begins on Oct. 1, 2009 from the $1.26 trillion forecast in May, to $1.5 billion, reflecting slower economic growth in 2009 and 2010 because of “the severity of the crisis in the US and in our trading partners.” The OMB added almost $2 trillion to the 10-year fiscal deficit from its May forecast, to $9.05 trillion. The nonpartisan CBO lowered its long-range projection to $7.14 trillion for the decade in anticipation of Congress cutting the administration’s budget requests.

White House Budget Director Orszag defended the trillion-dollar deficits during a recession, saying they should not be used to block the administration’s long-term health-care reform initiative. Revising the way the nation pays for medical care will help save money in the long run, he asserts. The cruel fact is that there is no way to reduce health care cost absolutely without affecting quality. Systemic efficiency improvement can only come from spreading rising medical spending towards the needy rather than limiting it to the privileged rich, thus producing a healthier population. The correct way to look at medical expenses is to see it as investment rather than consumption. The same principle applies to education. Cutting cost is a dead-end solution for these sectors.

Even with economic conditions turning out worse than originally forecast, Christina Romer, highly respected economist on leave as Garff B. Wilson Professor of Economics at the University of California at Berkley, now Chair of the White House Council of Economic Advisors, expects “positive GDP growth” by the end of Q4 2009 as the economy reaches “a turning point”, albeit from a much reduced base. Still, she admits that “a return to employment growth will take longer.” So at best, it will be another jobless anemic recovery even if there is a recovery.

Romer predicts that the economic stimulus package probably is adding “between 2 and 3 percentage points” to economic growth in the second quarter of 2009, helping to cushion conditions that would have been worse, previewing a report on the effect of the stimulus program due to Congress in September. That means GDP growth would have been negative without the economic package. The wild card is what happens when the stimulus package is spent and the massive debt, which would take a decade to fully unwound, is still hanging over the economy.

Looming Inflation and Interest Rate Hikes

Romer thinks inflation will remain subdued. Projections for the consumer price index show a contraction to 0.7% in 2009, rising to 1.4% in 2010 and 1.5% in 2011. The good news is that deflation has been at least stopped temporarily, thanks to the stimulus money without which there might have been sharp deflation and sharp negative GDP growth for all three years. The economic assumptions were compiled jointly by the Council of Economic Advisers, Treasury Department and the Office of Management and Budget. The estimates reflect conditions as of early June 2009. This means the Fed Funds rate target should rise from its current low of 0-0.25% even in 2009 and rise to 2% in 2011 to support a neutral monetary stance on inflation. Any rise in interest rate will torpedo tenuous recovery.

Fed Openness in Response to Loss of Credibility

The Fed’s new openness is in response to the mounting public debate over the central bank’s ineffective role and poor performance so far in the current financial crisis in relation to the proposal to expand its regulatory powers going forward. A July 2009 Gallup Poll shows the Fed being held in lowest esteem by the US population among all government agencies, lower even than the Internal Revenue Service. The Centers for Disease Control (CDC) got the highest approval rating, with 61% of Americans saying it was doing a good job. The Fed has failed to impress the public as a Center for Financial Disease Control.

Notwithstanding Bernanke’s hero image on Wall Street and a 75% approval rating from international investors in a Bloomberg poll, only 30% of the US public thinks the Federal Reserve is doing a good job despite the central bank’s unprecedented heroic efforts to save the economy from the financial crisis and a crippling recession. The US public, parting company with Wall Street globalists, do not see the Fed as the people’s trusted friend and protector. In 2003, the last time Gallup polled the Americans on their view of the Fed, 53% said the Fed was doing a good job even when wealth and income disparity was already on the rise.

Bernanke is increasingly going public with a defense of the Federal Reserve’s handling of the crisis in an effort to ward off a populist headwind in Congress among some lawmakers, in the form of a bill introduced by Republican Representative Ron Paul of Texas with 250 co-sponsors, who want to cut down the Fed’s monetary independence from the will of the people.

The Threat on the Dollar

Bernanke in his April 3, 2009 speech described the ominous international situation of the dollar. Like depository institutions in the US, foreign banks with large dollar funding positions were also experiencing heavy liquidity pressures. Bernanke saw it as another temporary liquidity problem rather than a structural insolvency predicament. Money disintegrated from the financial system as the value of financial assets denominated in dollars dropped precipitately globally, and transnational banks need new dollars from the Fed to slow down the fall of prices because foreign central banks cannot issue dollars. To call this situation a liquidity problem is to confuse the issue. It is an insolvency problem with a liquidity dimension. The money did not just fail to circulate; wealth measured in money had vanished as prices fell while the monetary liability in debt remained unchanged. The debt/equity ratio has turned below zero into negative territory and leverage has risen to infinity.

Bernanke characterized the shortage of money caused by the bursting of the financial bubble as a temporary unmet foreign demand for dollars that spilled over into US markets, including the federal funds market. To address this issue, the Federal Reserve cooperated with foreign central banks in establishing reciprocal currency arrangements, or liquidity swap lines. In these arrangements, the Federal Reserve provides dollars to foreign central banks in hope that they in turn would lend to banks in their jurisdictions, even though the foreign banks could not find many credit-worthy borrowers. Thus the Fed dollars went into foreign bank reserves to write off nonperforming loans and toxic assets. Left unspoken is the problem that an unmet demand for dollars in Europe will upset the exchange rate market which is dominated by the dollar, the euro and the yen, the world’s three major freely exchangeable currencies.

The Fed views credit risk as minimal in these swap arrangements, as the foreign central bank is responsible for repayment, rather than the institutions that ultimately receive the dollar funds. Further, the Fed receives foreign currency from its foreign central bank partners of equal value to the dollars lent, albeit that exchange rate risk can be a problem. Liquidity provided through such arrangements peaked ahead of year-end 2008 but has since declined as pressures in short-term dollar funding markets have eased. The outstanding amount of currency swaps currently stands at about $310 billion. This was because several European central banks, led by the United Kingdom, took decisive steps to nationalize banks in severe distress. In contrast, the Fed went through torturous financial acrobatics to mask the “N” word in its rescue efforts.

Fed Emergency Lending

Following the sharp deterioration in market conditions in March 2008, the Federal Reserve used its emergency lending authority to provide primary dealers access to central bank credit. Primary dealers can now obtain short-term collateralized loans from the Fed through the Primary Dealer Credit Facility (PDCF). The PDCF, which is closely analogous to the discount window for commercial banks, currently has about $20 billion in borrowings outstanding. Another program for primary dealers, called the Term Securities Lending Facility (TSLF), lends Treasury securities to dealers, taking investment-grade securities as collateral. The primary dealers then use the more-liquid Treasury securities to obtain private-sector funding. Extensions of credit under this program, which currently total about $85 billion, do not appear as distinct assets on the Fed’s balance sheet, because the Federal Reserve continues to own the Treasury securities that it lends, unless the Fed suffers a massive counterparty default and could not get its Treasuries back.

Lender of Last Resort or Market Maker of Last Resort

Bernanke reminds his audience that the provision of liquidity on a collateralized basis to sound financial institutions is a traditional central bank function. This so-called lender-of-last-resort activity is particularly useful during a financial crisis, as it reduces the need for fire sales of assets and reassures financial institutions and their counterparties that those institutions will have access to liquidity as needed.

Bernanke glosses over the fact that the central bank’s role in current circumstances is that of a market maker for overextended illiquid markets, a role much different in both nature and operation than a neutral lender of last resort in brief temporary liquidity crunches. The Fed then becomes a market participant of last resort to buy not just top-rated assets, but toxic assets that cannot find private sector buyers not merely in a fire storm, but for extended periods with no fixable exit date. In fact, the Fed has become a market maker in failed markets for assets of little worth, paying bubble prices that can recover only with the devaluation of money.

Bernanke concedes that to be sure, the provision of liquidity alone cannot address solvency problems or erase the large losses that financial institutions have suffered during this crisis. Yet both the Fed’s internal analysis and external market reports suggest to him that the Fed’s “damned the torpedo” approach of providing ample supply of liquidity, along with liquidity provided by other major central banks, has significantly reduced funding pressures for financial institutions, helped to reduce rates in bank funding markets, and increased overall financial stability. But this stability is not support by new wealth creation, but by asset reflation.

Bernanke noted that for example, despite ongoing financial stresses, funding pressures around year-end 2008 and the second quarter-end in 2009 appear to have moderated significantly. Ironically, the example that Bernanke gave supports critical allegation that the Fed has confused funding pressures with financial stresses. The Fed has managed to moderate funding pressure for the financial sector with free money, but it has not relieved financial stress in the economy. The excess debt remains in the financial system to drag down the economy, possibly for a decade or more, as Japan has experienced.

Bernanke defended the Fed’s actions to ensure liquidity to another category of financial institution: money market mutual funds. In September 2008, a prominent money market mutual fund “broke the buck” -- that is, was unable to maintain a required net asset value of $1 per share. This event led to a run on other funds, which saw very sharp withdrawals. These withdrawals in turn threatened the stability of the commercial paper market, which depends heavily on money market mutual funds as investors.

Money market funds are not federally insured like bank deposits. Therefore, fund assets have an implied promise to preserve capital at all costs and preserve the $1 floor on share prices. These funds are regulated by the Securities and Exchange Commission and Rule 2a-7 restricts what they can invest in regarding credit quality and maturities with the hope of ensuring principal stability.

For 37 years no retail money market fund had broken the buck. In 2008, however, the day after Lehman Brothers Holdings Inc. filed bankruptcy on September 15, Reserve Primary Fund’s net asset value fell to 97 cents after writing off the debt owed to it by Lehman. The $64.8 billion fund held $785 million in commercial paper issued by Lehman which filed for bankruptcy protection that might eventually repay debt at cents on a dollar. This created the potential for a bank run in money markets as there was fear that more funds would break the buck.

Shortly thereafter, another large fund announced that it was liquidating, due to redemptions. The next day the US Treasury announced a program to insure the holdings of publicly offered money market funds so that should a covered fund break the buck, investors would be protected to $1 NAV.

Surely any economist as astute and experienced as Bernanke would understand that money of constant value allows its owners, or banks that did not pay interest for it, to hold it idle without penalty. The positive effect would be that the value of money might not fall. Money would, in market parlance, be "well held". The holders would be under no pressure to employ all of it, waiting instead to employ part at a higher rate later.

The negative effect is that money will be underemployed and cause to economy to stagnate. Thus the three conditions that compel money to be constantly fully employed are taxes, interest payments and mild inflation which forces holders of money to seek returns above inflation rate. Tax reduction, low interest rates and deflation are conditions that destabilized money markets by retarding money circulation.

In the current financial crisis, tax reduction had been implemented by the previous Republican administration, low interest rate had been implemented by the Bernanke Fed and mild inflation has been banished by the recession. No wonder that the economy is facing a liquidity crisis in the midst of an abundance of idle funds. The safe path to capital preservation is to withdraw funds from the falling market.

Bernanke must also know that money is economically productive only if it is not free. In the money market, money is normally held by those who must pay interest on it, such as money-market fund managers, and such entities must employ all the money in its care productively to avoid insolvency. Such entities do not so much care at what rate of interest they employ the money they manage: they can reduce the interest dividend they pay investors in proportion to that which they can make from lending, but they must pay something. They must also always avoid losing capital, known as breaking the buck, as each unit of investment is generally structured as $1.00. Yet if Fed funds rate stays near zero for long periods, the interest rate spread may not be sufficient to pay the fees of fund managers and may cause funds to fail.

Following the long-standing principle that the central bank should lend into a panic, the Federal Reserve established two programs to backstop money market mutual funds and to help those funds avoid fire sales of their assets to meet withdrawals. Together with an insurance program offered by the Treasury, the Fed’s programs helped end the run on mutual funds; the sharp withdrawals from the funds have been replaced by moderate inflows. Although credit extended to support money funds was high during the intense phase of the crisis in the fall, borrowings have since declined substantially, to about $6 billion.

On March 17, 2009 a proposal drafted by an industry group whose work began in late 2007 but became far more urgent in September2008 when a run on a giant money fund forced the Treasury Department to set up an ad hoc insurance program to stem a panic in the nearly $4 trillion money fund market.

That crisis underscored how vital money market funds have become as sources of short-term credit to American businesses and local governments, and prompted calls for changes in how they are regulated. The industry’s plan, endorsed by the board of the Investment Compnay Institutue seems aimed at heading off more sweeping and more damaging revisions to a product that has become a mainstay of household finances since its inception almost 40 ceades ago.

Under the industry proposal, money funds would be required to keep minimum levels of cash on hand, reduce the risks in their portfolios and increase the amount of information provided to investors and regulators. The plan also calls for regulators to pre-emptively question any money market fund that offers yields that are significantly above its peers, to determine whether the fund is taking undisclosed or unacceptable risks. These steps would lower most fund yields, but the industry is betting that lower risks will reassure most mainstream investors.

To protect funds from runs like the one that started the September 2008 crisis, the industry will ask regulators to give money funds greater leeway to halt redemptions temporarily or liquidate entirely if they are hit by a flood of redemptions. That would reassure investors that all shareholders would be treated equally if disaster struck
These proposals differ sharply from those offered in January by the Group of 30, an international forum of senior public and private sector representatives whose chairman is Paul Volcker, an top adviser to the Obama administration on recovery. The Volcker panel recommended that money funds be stripped of their check-writing feature and their fixed dollar-a-share pricing unless they submitted to regulations similar to those that govern banks — steps that would eliminate the defining features of the modern money fund.
The first-ever panic in the money fund industry came after Lehman Brothers filed for bankruptcy protection on September 15, 2008. That prompted an avalanche of redemptions from the Reserve Primary Fund, a multibillion-dollar money fund with a big stack of Lehman notes in its portfolio.

The next day, the fund reported it had “broken the buck,” reporting a share value below a dollar. That spurred widespread concern among money fund investors who have long trusted that they could always redeem a money fund share for a dollar without the risk of losses.
As hundreds of billions of dollars were withdrawn from money funds, the Treasury rushed to create a temporary money-fund insurance program, which would expire no later than September 2008. Critics ask: Given public skepticism about financial self-regulation, why should the fund industry be trusted to write its own prescription for reform?

The nature of financial panics

A panic is a species of neuralgia. A financial panic is cured by having it starved, stopping the drain of confidence from a market that runs on confidence. To cure a financial panic, the holders of cash reserves must, in contrast to natural instinct, be ready not only to keep the reserves for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to all market participants in need of liquidity whenever credit is otherwise good in normal situations. The problem with toxic assets in the current financial crisis is that they are worth the value in normal times and the credit of many holders of such assets is not good in normal, non-bubble times.

The hesitance is related to the unhappy prospect of unnecessary larger loss in the event the cure fails to stem the panic, resulting in throwing good money after bad. And the cure will fail if any entity in the chain of credit should decide to bail itself out at the expense of the system. In wild periods of alarm, one failure will generate many others in a falling domino effect, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.

This was easier to do when the number of counterparties in the distressed contract was relatively small, as in the case of the 1998 crisis involving Long Term Capital Management (LTCM), a large hedge fund, where they could all be gathered in one room is the New York Fed Building to work out a rescue deal. But in the case of the Refco collapse in 2005, where counterparties were spread over 240,000 customer accounts in 14 countries, it became a different problem. The identities of counterparties for over-the-counter derivative contracts were unknown as risks were unbundled and sold off to a variety of investors with varying appetite for risk. In 2007, the problem of the credit crunch was even more widespread.

The management of a panic is mainly a confidence restoring problem. It is primarily a trading problem. All traders are under liabilities; they have obligations to meet that are time-sensitive and unconditional, and they can only meet those obligations by discounting obligations from other traders. In other words, all traders are dependent on borrowing money as bridge loans until settlement of their trades, and large traders are dependent on borrowing much money. At the slightest symptom of panic, traders want to borrow more than usual; they think they will supply themselves with the means of meeting their obligations while those means are still forthcoming. If the bankers gratify the traders, they must lend largely just when they like it least; if they do not gratify them, there is a panic. Fear generates more fear in a vortex toward an abyss.

There is a great structural inconsistency of logic in this. First, bank reserves are established where the last dollar in the economy is deposited and kept in a central bank. This final depository is also to be the lender of last resort; that out of it unbounded, or at any rate immense, advances are to be made when no one else can lend. Thus central banks posit themselves both as depositories of reserves and as lenders of last resort to the banking system. This seems like saying, first, that a bank reserve should be kept, and then that it need not be kept because in a real panic, the central bank will lend where bank reserve is insufficient.

What is more problematic is that banks now constitute only a small part of the credit market. The lion’s share is in the non-bank derivatives market. Granted, notional values in derivative contracts are not true risk exposures, but a swing of 1% in interest rate on a notional value of $220 trillion in the current derivative market is $2.2 trillion, approximately 20% of US gross domestic product.

When reduced to abstract principles, a financial panic is caused by a collective realization that the money in a system will not pay all creditors when those creditors all want to be paid at once. A panic can be starved out of existence by enabling those alarmed creditors who wish to be paid to get paid immediately. For this purpose, only relatively little money is needed. If the alarmed creditors are not satisfied, the alarm aggravates into a panic, which is a collective realization that all debtors, even highly creditworthy ones, cannot pay their creditors. A panic can only be cured by enabling all debtors to pay their creditors, which takes a great deal of money. No one has that much money, or anything like enough, but the lender of last resort - the central bank. And injecting that amount of money suddenly after a panic has begun will alter the financial system beyond recognition, and produce hyperinflation instantly, because the extinguishment of all credit with cash creates an astronomical increase in the money supply.

David Ricardo (1772-1823), brilliant British classical economist and a bullionist along the line of Henry Thornton (1760-1815), wrote: “On extraordinary occasions, a general panic may seize the country, when everyone becomes desirous of possessing himself of the precious metals as the most convenient mode of realizing or concealing his property against such panic, banks have no security on any system.”

Thornton in his classic The Paper Credit of Great Britain (1802) provided the first description of the indirect mechanism by observing that new money created by banks enters the financial markets initially via an expansion of bank loans, through increasing the supply of lendable funds, temporarily reducing the loan rate of interest below the rate of return on new capital, thus stimulating additional investment and loan demand. This in turn pushes prices up, including capital good prices, drives up loan demands and eventually interest rates, bringing the system back into equilibrium indirectly.

The Bullionist Controversy emerged in the early 1800s regarding whether or not paper notes should be made convertible to gold on demand. But today, no central bank has enough precious metal (gold) to back its currency because the global currency system is based on fiat money. The use of credit enables debtors to use a large part of the money their creditors have lent them. If all those creditors were to demand all that money at once, their demands could not be met, for that which their debtors have used is for the time being employed, and not to be obtained for payment to the creditors. Moreover, every debtor is also a creditor in trade who can demand funds from other debtors. With the advantages of credit come disadvantages of illiquidity that require a store of ready reserve money, and advance out of it very freely in periods of panic, and in times of incipient alarm.

Notwithstanding the fact that the global money market has already run away from the control of every central bank, the management of the global money market is much more difficult than managing banking reserves in any particular country by its central bank, because periods of internal panic and external virtual demand for gold bullion commonly occur together. The virtual demand for gold bullion in today's fiat-currency world is expressed in the exchange rates of currencies. A falling exchange rate drains the global purchasing power of a currency and the resulting rise in the rate of discount, as expressed in a change in the exchange rate, tends to frighten the market. The holders of bank reserves have, therefore, to treat two opposite maladies at once: one requiring punitive remedies such as a rapid rise in the market rates of interest; and the other, an alleviative treatment with large and ready loans to combat illiquidity.

Experience suggests that the foreign drain must be counteracted by raising the rate of interest. Otherwise, the falling exchange rate will protract or exacerbate the alarm, generally known as a loss of confidence in the currency and the banking system and the functioning of the market. And at the rate of interest so raised, the holders of the final bank reserve must lend freely. Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not available, or that it may not be available at any price, only raises alarm to panic and enhances panic to madness, with a total loss of confidence. Yet the acceptance of loans at abnormally high interest rates is itself a sign of panic. This is the fate that awaits the dollar going forward. Against such contradictions, no central bank has found the appropriate wisdom. Former US Federal Reserve chairman Alan Greenspan’s formula had always been more liquidity at low interest rates, which pushes the monetary system into what John Maynard Keynes called the liquidity trap. This transformed Greenspan from a wise central banker to a wizard of bubbleland.

And great as the delicacy of such a problem in all countries, it is far greater in the US now than it was or is elsewhere because of dollar hegemony. The strain thrown by a panic on the final bank reserve is proportional to the magnitude of a country's trade, and to the number and size of the dependent banks and financial institutions holding no cash reserve that is grouped around the Federal Reserve. There are very many more entities under great liabilities than there are, or ever were, anywhere else because of the emergence of the debt-driven US economy.

At the commencement of every panic, all entities under such liabilities try to supply themselves with the means of meeting those liabilities while they can. This causes a great demand for new loans while loans are still available. And so far from being able to meet it, the bankers who do not keep extra reserve at that time borrow largely, or do not renew large loans, or very likely do both.

The repo (repurchase agreement) market relieves the need of any bank or institutions to hold extra reserves, as new loans are supposed to be always available. (Please see my February 16, 2006 AToL article: The Global Money and Currency Markets – The Nature of Financial Panics)

Direct Lending to Borrowers and Investors

A second set of programs initiated by the Federal Reserve -- including the Commercial Paper Funding Facility (CPFF) on October 27, 2008 and the Term Asset-Backed Securities Loan Facility (TALF) on November 25, 2008 -- aims to improve the functioning of key credit markets by lending directly to market participants, including ultimate borrowers and major investors. The lending associated with these facilities is currently about $255 billion, corresponding to roughly one-eighth of the assets on the Fed's balance sheet. The sizes of these programs, notably the TALF, are expected to grow in the months ahead.

The commercial paper market is a key source of the short-term credit that US businesses use to meet payrolls and finance inventories. Following the intensification of the financial crisis in the fall of 2008, commercial paper rates spiked, even for the highest-quality firms. Moreover, most firms were unable to borrow for periods longer than a few days, exposing both firms and lenders to significant rollover risk. By serving as a backstop for commercial paper issuers, the CPFF was intended to address rollover risk and to improve the functioning of this market. Under this facility, the Fed stands ready to lend to the highest-rated financial and nonfinancial commercial paper issuers for a term of three months.

As additional protection against loss, and to make the facility the last rather than the first resort, the CPFF charges borrowers upfront fees in addition to interest. Borrowing from this facility peaked at about $350 billion and has since declined to about $250 billion as more firms have been able to issue commercial paper to private lenders or have found alternative sources of finance. Conditions in the market have improved markedly since the introduction of this program, with spreads declining sharply and with more funding available at longer maturities. Market participants are of the opinion that the CPFF contributed to these improvements.

TALF is aimed at restoring securitization markets, now virtually shut down. The closing of securitization markets, until recently an important source of credit for the economy, has added considerably to the stress in credit markets and financial institutions generally. Under the TALF, eligible investors may borrow to finance their holdings of the AAA-rated tranches of selected asset-backed securities. The program is currently focused on securities backed by newly and recently originated auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. The first TALF subscription attracted about $8 billion in total asset-backed securities deals and used about $4.7 billion in Federal Reserve financing. Over time, the list of securities eligible for the TALF is expected to expand to include additional securities, such as commercial mortgages, as well as securities that are not newly issued.

Relative to the Fed’s short-term lending to financial institutions, the CPFF and the TALF are rather unconventional programs for a central bank to undertake. Bernanke sees them as justified by the extraordinary circumstances in which the Fed finds itself and by the need for central bank lending practices to reflect the evolution of financial markets, After all, a few decades ago securitization markets barely existed. Notably, other central banks around the world have shown increasing interest in similar programs as they address the credit strains in their own countries. These programs also meet the criteria I stated at the beginning of my remarks regarding credit risk and credit allocation. Credit risk is very low in both programs; in particular, the TALF program requires that loans be over-collateralized and is further protected by capital provided by the Treasury. Both programs are directed at broad markets whose dysfunction impedes the flow of numerous types of credit to ultimate borrowers; consequently, I do not see these programs as engaging in credit allocation--the favoring of a particular sector or a narrow class of borrowers over others. (Please see my August 20, 2009 AToL article: Integrity Deficit has its Price)

In the US, the money market is a subsection of the fixed-income market. A bond is one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term high-grade debt securities (debt that matures in less than one year). Money-market investments are also called cash investments because of their short maturities and low risk. Money-market securities are in essence IOUs issued by governments, financial institutions and large corporations of top credit ratings. These instruments are very liquid and considered extraordinarily safe. Because they are extremely secured, money-market securities offer significantly lower return than most other securities that are more risky.

One other main difference between the money market and the stock market is that most money-market securities trade in very high denominations. This limits the access of the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this with the stock market, where a broker receives a commission to act as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems. Individuals gain access to the money market through money-market mutual funds, or sometimes through money-market bank accounts. These accounts and funds pool together the assets of hundreds of thousands of investors to buy the money-market securities on their behalf. However, some money-market instruments, such as Treasury bills, may be purchased directly from the Treasury in denominations of $10,000 or larger. Alternatively, they can be acquired through other large financial institutions with direct access to these markets.

There are different instruments in the money market, offering different returns and different risks. The desire of major corporations to avoid costly banks borrowing as much as possible has led to the widespread popularity of commercial paper. Commercial paper is an unsecured, short-term loan issued by a corporation, typically for financing accounts receivables and inventories. It is usually issued at a discount, reflecting current market interest rates. Maturities on commercial paper are usually no longer than nine months, with maturities of one to two months being the average.

Commercial Paper Market

For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and creditworthiness issue commercial paper. Over the past four decades, there have only been a handful of cases where corporations have defaulted on their commercial-paper repayment. Commercial paper is usually issued with denominations of $100,000 or multiples thereof. Therefore, small investors can only invest in commercial paper indirectly through money market funds.

On December 23, 2005, commercial paper placed directly by GE Capital Corp (GECC) was 4.26% on 30-44 days and 4.56% on 266-270 days, while the Fed Funds rate target was 4.25% and the discount rate was 5.25%, both effective since December 13. On August 14, 2009, commercial paper was 0.21% on 30-44 days and 0.27% on 90 to 119 days, while the effective Fed Funds Rate was 0.16%. Shares of GE reached a high of $42.12 on October 12, 2007, three months after the credit crisis broke out, and fell to a low of $6.69 on March 4, 2009. It was $13.92 on August 14, 2009, still less than a third of its peak. GE market capitalization fell from $447.63 billion at its high in 2007 to $71.09 billion at it low in 2009 and bounced back to $147.93 billion on August 14, 2009. Before the collapse of the commercial-paper market, GE had become the world’s biggest non-bank finance company until the financial crisis of 2007. GE commercial paper is no longer listed in the financial press as a bench mark rate.

Rates on AA ranked financial commercial paper due in 90 days fell to a record low of 0.28% on Jan. 8, 2008, or 21 basis points more than the US borrowing rate,

The market for commercial paper backed by assets such as auto loans and credit cards was the first to seize up. It fell 37% over five months to $772.8 billion, from its peak in August 2007 of $1.22 trillion, as defaults on subprime home loans began to soar.

After Lehman Brothers Holdings Inc. filed for bankruptcy on September 15, 2008, the broader commercial paper market froze. The next day, the flagship $62.6 billion money-market fund of Reserve Management Co. became the second of its kind to “break the buck” in market history, or fell below the $1-a-share price paid by investors, triggering a run that helped freeze global credit markets and drove up borrowing costs. Returns on money-market funds have dropped 62% since then.

Meanwhile, the commercial paper market slumped 20% over six weeks as money-market investors fled for safer assets such as Treasuries. Prime money-market funds’ holdings of first-tier paper, rated at least P-1 by Moody’s Investors Service and A-1 by Standard & Poor’s, fell by 33% from September 9 to October 7, 2008.

On October 21, 2008, the Fed had set up the Money Market Investor Funding Facility (MMIFF), to provide liquidity to money-market investors. The facility buys commercial paper due in 90 days or less. The short-term debt markets had been under considerable strain in recent weeks as money market mutual funds and other investors had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs. By facilitating the sales of money market instruments in the secondary market, the MMIFF is designed to improve the liquidity position of money market investors, thus increasing their ability to meet any further redemption requests and their willingness to invest in money market instruments. Improved money market conditions enhance the ability of banks and other financial intermediaries to accommodate the credit needs of businesses and households.

A week later, on October 27, 2008, the Fed set up the Commercial Paper Funding Facility (CPFF), complementing a separate program for providing liquidity to the asset-backed debt market that had begun in September. These programs were intended to ensure companies would have access to short-term credit and to ease redemption concerns at money-market funds. The amount outstanding under the asset-backed program peaked at $152.1 billion on October 1, 2008 before plunging to a low of $14.8 billion as redemption concerns subsided.

About $220 billion to $230 billion of 90-day commercial paper was sold to the Fed above market rates in October 2008 through the CPFF matures in the first week of operation. That was as much as 66% of the $350 billion in debt that the CPFF owns. The Fed has purchased about one-fifth of the commercial paper market through the CPFF.

Fed Purchases of High-Quality Assets

The third major category of assets on the Fed's balance sheet is holdings of high-quality securities, notably Treasury securities, agency debt, and agency-backed MBS. These holdings currently total about $780 billion, or about three-eighths of Federal Reserve assets. Of this $780 billion, holdings of Treasury securities currently make up about $490 billion. Some of these Treasury securities are lent out through the Term Securities Lending Facility mentioned earlier. Obviously, these holdings are very safe from a credit perspective. Longer-term securities do pose some interest-rate risk; however, because the Federal Reserve finances its purchases with short-term liabilities, on average and over time, that risk is mitigated by the normal upward slope of the yield curve.

The Fed’s holdings of high-quality securities are set to grow considerably as the FOMC, in an attempt to improve conditions in private credit markets, has announced large-scale open-market purchases of these securities. Specifically, the Federal Reserve will purchase cumulative amounts of up to $1.25 trillion of agency MBS and up to $200 billion of agency debt by the end of 2009, and up to $300 billion of longer-term Treasury securities over the next six months. The principal goal of these programs is to lower the cost and improve the availability of credit for households and businesses.

Fed Support for Specific Institutions

In addition to those programs discussed, the Federal Reserve has provided financing directly to specific systemically important institutions. With the full support of the Treasury, the Fed used emergency lending powers to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Co. and also to prevent default by AIG. These extensions of credit are very different than the other liquidity programs discussed previously and were put in place to avoid major disruptions in financial markets. From a credit perspective, these support facilities carry more risk than traditional central bank liquidity support, but the Fed nevertheless expect to be fully repaid. Credit extended under these programs has varied but as of Bernanke’s April 3, 2009 speech accounted for only about 5% of Fed balance sheet. That said, these operations have been extremely uncomfortable for the Federal Reserve to undertake and were carried out only because no reasonable alternative was available. As noted in the joint Federal Reserve-Treasury statement mentioned earlier, the Fed and the Treasury are working with the Administration and the Congress to develop a formal resolution regime for systemically critical nonbank financial institutions, analogous to one already in place for banks. Such a regime should spell out as precisely as possible the role that the Congress expects the Federal Reserve to play in such resolutions.

Fed Liabilities

Having reviewed the Federal Reserve's main asset accounts, Bernanke described briefly on the liability side of the balance sheet. Historically, the largest component of the Federal Reserve's liabilities has been Federal Reserve notes--that is, US paper currency—the dollar. Currency has expanded over time in line with nominal spending in the United States and demands for US currency abroad. By some estimates, a bit over one-half of US currency is held outside the country to maintain dollar hegemony.

Other key liabilities of the Federal Reserve include the deposit accounts of the U.S. government and depository institutions. The US government maintains a “checking account” with the Federal Reserve--the so-called Treasury general account--from which most federal payments are made. More recently, the Treasury has established a special account at the Federal Reserve as part of its Supplementary Financing Program (SFP). Under this program, the Treasury issues special Treasury bills and places the proceeds in the Treasury supplementary financing account at the Federal Reserve. The net effect of these operations is to drain reserve balances from depository institutions.

Depository institutions also maintain accounts at the Federal Reserve, of course, and over recent months, as the size of the Federal Reserve's balance sheet has expanded, the balances held in these accounts have increased substantially. The large volume of reserve balances outstanding must be monitored carefully, as--if not carefully managed--they could complicate the Fed's task of raising short-term interest rates when the economy begins to recover or if inflation expectations were to begin to move higher.

The Fed has a number of tools it can use to reduce bank reserves or increase short-term interest rates when that becomes necessary.

First, many of the Fed’s lending programs extend credit primarily on a short-term basis and thus could be wound down relatively quickly. In addition, since the lending rates in these programs are typically set above the rates that prevail in normal market conditions, borrower demand for these facilities should wane as conditions improve.

Second, the Federal Reserve can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities. Of course, for any given level of the federal funds rate, an unwinding of lending facilities or a sale of securities would constitute a de facto tightening of policy, and so would have to be carefully considered in that light by the FOMC.

Third, some reserves can be soaked up by the Treasury's Supplementary Financing Program.

Fourth, in October 2008, the Federal Reserve received long-sought authority to pay interest on the reserve balances of depository institutions. Raising the interest rate paid on reserves will encourage depository institutions to hold reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves. Thus, the interest rate paid on reserves will tend to set a floor on the federal funds rate.

Bernanke said the FOMC will continue to closely monitor the level and projected expansion of bank reserves to ensure that--as noted in the joint Federal Reserve-Treasury statement--the Fed's efforts to improve the workings of credit markets do not interfere with the independent conduct of monetary policy in the pursuit of its dual mandate of ensuring maximum employment and price stability. As was also noted in the joint statement, to provide additional assurance on this score, the Federal Reserve and the Treasury have agreed to seek legislation to provide additional tools for managing bank reserves.

Bernanke said that in these extraordinarily challenging times for the US financial system and economy, he is confident that the Fed can meet these challenges, not least because he has “great confidence in the underlying strengths of the American economy.” He asserts the Fed will make responsible use of all its tools to stabilize financial markets and institutions, to promote the extension of credit to creditworthy borrowers, and to help build a foundation for economic recovery. Over the longer term, the Fed also look forward to working with its counterparts at other supervisory and regulatory agencies in the US and around the world to address the structural issues that have led to this crisis so as to minimize the risk of ever facing such a situation again.

The Federal Reserve operates with a sizable balance sheet that includes a large number of distinct assets and liabilities. The Federal Reserve’s balance sheet contains a great deal of information about the scale and scope of its operations. For decades, market participants have closely studied the evolution of the Federal Reserve's balance sheet to understand more clearly important details concerning the implementation of monetary policy. Over recent months since the financial crisis, the development and implementation of a number of new lending facilities to address the financial crisis have both increased complexity of the Federal Reserve’s balance sheet and has led to increased public interest in it.

Each week, the Federal Reserve publishes its balance sheet, typically on Thursday afternoon around 4:30 p.m. The balance sheet is included in the Federal Reserve's H.4.1 statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," available on this website. The various tables in the statistical release are described below, an explanation of the important elements in each table is given, and a link to each table in the current release is provided.
Factors Affecting Reserve Balances

The Fed’s balance sheet, a broad gauge of its lending to the financial system, grew in the week previous to its data release on August 20, expanding to $2.037 trillion from $2 trillion in the previous week. It is composed of holdings of Treasuries and mortgage-backed securities. It was only $941 billion in the week ending July 17, 2007 before the start of the credit crunch. In the week of September 11, 2008, it was still $940 billion.

On September 16, 2008, the Federal Reserve announced that it would extend credit to the American International Group (AIG) under the authority of section 13(3) of the Federal Reserve Act. This secured lending will assist AIG in meeting its obligations as they come due and facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.

On September 19, the Federal Reserve announced a new lending facility to extend non-recourse loans to US depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from money market mutual funds.

On September 21, the Board of Governors authorized the Federal Reserve Bank of New York to extend credit to the U.S. broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley, and Merrill Lynch against all types of collateral that may be pledged at the Federal Reserve’s primary credit facility for depository institutions or at the existing Primary Dealer Credit Facility. In addition, the Board authorized the Federal Reserve Bank of New York to extend credit to the London-based broker-dealer subsidiaries of
Goldman Sachs, Morgan Stanley, and Merrill Lynch against the types of collateral that would be eligible to be pledged at the Primary Dealer Credit Facility. Credit extended under these authorizations will be included, along with credit extended under the Primary Dealer Credit Facility under the entry “Primary dealer and other broker-dealer credit.”

By week ending November 5, 2008, the Fed balance sheet has risen to $2.11 trillion.

The Fed’s holding of mortgage-backed securities increased to $609.53 billion on August 19, 2009 from $542.89 billion a week earlier, while its Treasuries ownership rose to $736.09 billion from $728.97 billion a week earlier.

Along with holding down the Fed Funds rate target, which controls short-term interest rate, the Fed’s purchases of U.S. government and mortgage debt have been critical components of loose monetary policy intended to bring down long-term interest rates and to end the worst economic downturn since the Great Depression.

The Fed has pledged to buy $300 billion in Treasuries and $1.25 trillion in mortgage-backed securities. This increase in the Fed’s Treasuries and MBS holdings in August 2009 was mitigated somewhat by ongoing decreases in loans to banks, commercial paper holdings and overseas lending of dollars.

The Fed’s backstop for commercial paper created in reaction to the credit crunch in September 2008. It fell to $53.74 billion on August 19, 2009 from $58.05 billion a week ago.

The Fed’s inter-central bank liquidity swap lines, which make dollars available overseas via other central banks, averaged $69.14 billion per day in the week ended August 19, 2009, below the average daily rate of $76.28 billion in the previous week. The Fed’s direct overnight lending to the most creditworthy US banks slowed to a daily rate of $30.71 billion from $33.93 billion in the previous week. But overall discount window borrowings averaged $107.14 billion a day in the latest week, up from the daily rate of $105.98 billion in prior week. The latest credit picture is far from positive. The economy faces the prospect of a lost decade from massive debt overhang.

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