Federal Reserve Lender of Last Resort Facilities During the 2007–2009 Financial Crisis
The onset of the 2007–2009 financial crisis in August of 2007 led to a massive increase in Federal Reserve lender of last resort facilities to contain the crisis. In mid August 2007, the Federal Reserve lowered the discount rate to just 50 basis points (0.5 percentage point) above the federal funds rate target from the normal 100 basis points. In March 2008, it narrowed the spread further by setting the discount rate at only 25 basis points above the federal funds rate target. In September 2007 and March 2008, it extended the term of discount loans: Before the crisis they were overnight or very short term loans; in September the maturity of discount loans was extended to 30 days and to 90 days in March. In December 2007, the Fed set up a temporary Term Auction Facility (TAF) in which it made discount loans at a rate determined through competitive auctions. This facility carried less of a stigma for banks than the normal discount window facility. It was more widely used than the discount window facility because it enabled banks to borrow at a rate less than the discount rate and because the rate was determined competitively, rather than being set at a penalty rate. While the TAF was a new facility for the Fed, the European Central Bank already had a similar facility. The TAF auctions started at amounts of $20 billion, but as the crisis worsened, the amounts were raised dramatically, with a total outstanding of over $400 billion. On March 11, 2008, the Fed created the Term Securities Lending Facility (TSLF) in which it would lend Treasury securities to primary dealers for terms longer than overnight, as in existing lending programs, with the primary dealers pledging other securities. The TSLF’s purpose was to supply more Treasury securities to primary dealers so it had sufficient Treasury securities to act as collateral, thereby helping the orderly functioning of financial markets. On the same day, the Fed authorized increases in reciprocal currency arrangements known as swap lines, in which it lent dollars to foreign central banks (in this case, the European Central Bank and the Swiss National Bank) in exchange for foreign currencies so that these central banks could in turn make dollar loans to their domestic banks. These swap lines were enlarged even further during the course of the crisis. On March 14, 2008, as liquidity dried up for Bear Stearns, the Fed announced that it would in effect buy up $30 billion of Bear Stearns’s mortgage related assets in order to facilitate the purchase of Bear Stearns by J.P. Morgan.* The Fed took this extraordinary action because it believed that Bear Stearns was so interconnected with other financial institutions that its failure would have caused a massive fire sale of assets and a complete seizing up of credit markets. The Fed took this action under an obscure provision of the Federal Reserve Act, section 13(3), that was put into the act during the Great Depression. It allowed the Fed under “unusual and exigent circumstances” to lend money to any individual, partnership, or corporation, as long as certain requirements were met. This broadening of the Fed’s lender of last resort actions outside of its traditional lending to depository institutions was described by Paul Volcker, a former chairman of the Federal Reserve, as the Fed going to the “very edge of its lawful and implied powers.” The broadening of the Fed’s lender of last resort activities using section 13(3) grew as the crisis deepened. On March 16, 2008, the Federal Reserve announced a new temporary credit facility, the Primary Dealer Credit Facility (PDCF), under which primary dealers, many of them investment banks, could borrow on similar terms to depository institutions using the traditional discount window facility. On September 19, 2008, after money market mutual funds were subject to large amounts of redemptions by investors, the Fed announced another temporary facility, the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), in which the Fed would lend to primary dealers so that they could purchase asset backed commercial paper from money market mutual funds. By so doing, money market mutual funds would be able to unload their asset backed commercial paper when they needed to sell it to meet the demands for redemptions from their investors. A similar facility, the Money Market Investor Funding Facility (MMIFF), was set up on October 21, 2008, to lend to special purpose vehicles that could buy a wider range of money market mutual funds assets. On October 7, 2008, the Fed announced another liquidity facility to promote the smooth functioning of the commercial paper market that had also begun to seize up, the Commercial Paper Funding Facility (CPFF). With this facility, the Fed could buy commercial paper directly from issuers at a rate 100 basis points above the expected federal funds rate over the term of the commercial paper. To restrict the facility to rolling over existing commercial paper, the Fed stipulated that each issuer could sell only an amount of commercial paper that was less than or equal to its average amount outstanding in August 2008. Then on November 25, 2008, the Fed announced two new liquidity facilities, the Term Asset Backed Securities Loan Facility (TALF), in which it committed to the financing of $200 billion (later raised to $1 trillion) of asset backed securities for a one year period, and a Government Sponsored Entities Purchase Program, in which the Fed made a commitment to buy $100 billion of debt issued by Fannie Mae and Freddie Mac and other government sponsored enterprises (GSEs), as well as $500 billion of mortgage backed securities guaranteed by these GSEs. In the aftermath of the Lehman Brothers failure, the Fed also extended large amounts of credit directly to financial institutions that needed to be bailed out. In late September, the Fed agreed to lend over $100 billion to prop up AIG and also authorized the Federal Reserve Bank of New York to purchase mortgage backed and other risky securities from AIG to pump more liquidity into the company. In November, the Fed committed over $200 billion to absorb 90% of losses resulting from the federal government’s guarantee of Citigroup’s risky assets, while in January, it did the same thing for Bank of America, committing over $80 billion. The expansion of the Fed’s lender of last resort programs during the 2007–2009 financial crisis was indeed remarkable, expanding the Fed’s balance sheet by over one trillion dollars by the end of 2008, with continuing expansion thereafter. The unprecedented expansion in the Fed’s balance sheet demonstrated the Fed’s commitment to get the financial markets working again.