Financial Turmoil: Federal Reserve Policy Responses

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The Federal Reserve (Fed) has been central in the response to the current financial turmoil that
began in August 2007. It has sharply increased reserves to the banking system through open
market operations and lowered the federal funds rate and discount rate on several occasions. As
the turmoil has progressed without signs of subsiding, the Fed has introduced new policy tools to
try to restore normality.
Through new credit facilities, the Fed first expanded lending to the banking system and then
extended lending to non-bank financial firms. Lending to non-banks is a major departure from
past policy, for it is the first time that financial institutions that are not member banks of the
Federal Reserve System have been allowed to borrow directly from the Fed on a routine basis. As
the crisis worsened, the Fed began providing credit directly to markets for commercial paper and
asset-backed securities. As a result of these programs, the Fed’s outstanding loans and private
asset purchases have ranged from $0.5 trillion to $1 trillion in recent months. The Fed’s authority
and capacity to lend is bound only by fears of the inflationary consequences, which have been
offset by additional debt issuance by the Treasury.
In March 2008, JPMorgan Chase agreed to acquire Bear Stearns. As part of the agreement, the
Fed made a $28.82 billion loan to a limited liability corporation (LLC) it created to buy $29.97
billion of assets from Bear Stearns. The Fed has also agreed to make loans and purchase assets
through an LLC from the American International Group (AIG) worth up to $112.5 billion. In
November 2008, the Fed and federal government agreed to guarantee losses on $306 billion of
assets owned by Citigroup. In all of these agreements, the Fed is exposed to downside financial
risk if the assets purchased or guaranteed fall in value.
The statutory authority for most of the Fed’s recent actions is based on a clause of the Federal
Reserve Act to be used in “unusual or exigent circumstances” that had not been invoked in more
than 70 years. All loans are backed by collateral that reduces the risk of losses. Any losses borne
by the Fed from its loans or asset purchases would reduce the profits it remits to the Treasury,
making the effect on the federal budget similar to if the loans were made directly by Treasury. It
is highly unlikely that losses would exceed its other profits and capital, and require revenues to be
transferred to the Fed from the Treasury.
The primary policy issues raised by the Fed’s actions are the issues of systemic risk and moral
hazard. Moral hazard refers to the phenomenon where actors take on more risk because they are
protected. The Fed’s involvement in stabilizing Bear Stearns, AIG, and Citigroup stemmed from
the fear of systemic risk (that the financial system as a whole would cease to function) if either
were allowed to fail. In other words, the firms were seen as “too big (or too interconnected) to
fail.” The Fed’s regulatory structure is intended to mitigate the moral hazard that stems from
access to government protections. Yet Bear Stearns and AIG were not under the Fed’s regulatory
structure because they were not member banks.

Introduc tion ..................................................................................................................................... 1
Traditional Tools..............................................................................................................................2
Open Market Operations and the Federal Funds Rate..............................................................2
The Discount Window...............................................................................................................3
New Tools........................................................................................................................................4
Term Auction Facility................................................................................................................4
Term Securities Lending Facility..............................................................................................6
Primary Dealer Credit Facility..................................................................................................7
Term Asset-Backed Securities Loan Facility............................................................................8
Intervention in the Commercial Paper Market..........................................................................9
Swap Lines with Foreign Central Banks.................................................................................10
Payment of Interest on Bank Reserves.....................................................................................11
Assistance to Individual Financial Institutions..............................................................................12
The Fed’s Role in the JPMorgan Chase Acquisition of Bear Stearns.....................................12
Assistance to American International Group (AIG)................................................................15
Initial Loan........................................................................................................................15
Second Loan.....................................................................................................................15
Revised Agreement ..........................................................................................................16
Legal Authority.................................................................................................................17
Guarantee of Citigroup’s Assets..............................................................................................17
Policy Issues..................................................................................................................................18
Cost to the Treasury................................................................................................................18
How Much Can the Fed Lend? Will the Fed Run Out of Money?..........................................19
Why Have the Fed’s Actions Not Successfully Restored Financial Normalcy?.....................20
Lender of Last Resort, Systemic Risk, and Moral Hazard......................................................22
Effects on the Allocation of Capital........................................................................................25
Liquidity Trap?........................................................................................................................25
St agflation? ............................................................................................................................. 26
Concluding Thoughts....................................................................................................................27
Table 1. Use of Funds Raised by Liquidation of Bear Stearns Assets...........................................14
Author Contact Information..........................................................................................................28

On August 9, 2007, liquidity abruptly dried up for many financial firms and securities markets.
Suddenly some firms were able to borrow and investors were able to sell certain securities only at
prohibitive rates and prices, if at all. The “liquidity crunch” was most extreme for firms and
securities with links to subprime mortgages, but it also spread rapidly into seemingly unrelated ¹
areas. The Federal Reserve (Fed) was drawn into the liquidity crunch from the start. On August
9, it injected unusually large quantities of reserves into the banking system to prevent the federal
funds rate from exceeding its target.
It has been observed that the most unusual aspect of the crisis is its persistence for more than a
year. Over that time, the Fed has aggressively reduced the federal funds rate and the discount rate
in an attempt to calm the waters. When this proved not to be enough, the Fed greatly expanded its
direct lending to the financial sector through several new lending programs, some of which can be
seen as adaptations of traditional tools and others which can be seen as more fundamental ²
departures from the status quo. Most controversially, in March 2008, the Fed was involved in the
“bailout” of the investment bank Bear Stearns, which was not a member bank of the Federal
Reserve system (because it was not a depository institution), and, therefore, not part of the ³
regulatory regime that accompanies membership. In August, Fannie Mae and Freddie Mac, the
housing government-sponsored enterprises (GSEs) were taken into conservatorship by the ⁴
government. In September, the investment bank Lehman Brothers filed for bankruptcy (it did not
receive emergency government assistance) and the financial firm American International Group
(AIG), which was also not a member bank, received a credit line from the Fed in order to meet its
obligations. Lending to non-members requires emergency statutory authority that had not ⁵
previously been used in more than 70 years. In November 2008, the Fed and federal government
agreed to guarantee losses on $306 billion of assets owned by Citigroup.
One of the original purposes of the Federal Reserve Act, enacted in 1913, was to prevent
recurrence of financial panics. To that end, the Fed has been given broad authority over monetary
policy and the payments system, including the issuance of federal reserve notes as the national
currency. As with any statutory delegations of authority, the Fed’s actions are subject to
congressional oversight. Although the Fed has broad authority to independently execute monetary
policy on a day-to-day basis, questions have arisen as to whether the unusual events of recent
months raise fundamental issues about the Fed’s role, and what role Congress should play in

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assessing those issues. This report reviews the Fed’s actions since August 2007 and analyzes the
policy issues raised by those actions.

The Fed, the nation’s central bank, was established in 1913 by the Federal Reserve Act (38 Stat.
251). Today, its primary duty is the execution of monetary policy through open market operations
to fulfill its mandate to promote stable economic growth and low and stable price inflation.
Besides the conduct of monetary policy, the Federal Reserve has a number of other duties: it
regulates financial institutions, issues paper currency, clears checks, collects economic data, and
carries out economic research. Prominent in the current debate is one particular responsibility: to
act as a lender of last resort to the financial system when capital cannot be raised in private
markets to prevent financial panics. The next two sections explain the Fed’s traditional tools,
open market operations and discount window lending, and summarizes its recent use of those
tools.
Open market operations are carried out through the purchase and sale of U.S. Treasury securities ⁶
in the secondary market to alter the reserves of the banking system. By altering bank reserves,
the Fed can influence short-term interest rates, and hence overall credit conditions. The Fed’s
target for open market operations is the federal funds rate, the rate at which banks lend to one
another on an overnight basis. The federal funds rate is market determined, meaning the rate
fluctuates as supply and demand for bank reserves change. The Fed announces a target for the
federal funds rate and pushes the market rate toward the target by altering the supply of reserves ⁷
in the market through the purchase and sale of Treasury securities. More reserves increase the
liquidity in the banking system and, in theory, should make banks more willing to lend, spreading
greater liquidity throughout the financial system.
When the Fed wants to stimulate economic activity, it lowers the federal funds target, which is
referred to as expansionary policy. Lower interest rates stimulate economic activity by
stimulating interest-sensitive spending, which includes physical capital investment (e.g., plant and
equipment) by firms, residential investment (housing construction), and consumer durable
spending (e.g, automobiles and appliances) by households. Lower rates would also be expected to
lead to a lower value of the dollar, all else equal. A lower dollar would stimulate exports and the
output of U.S. import-competing firms. To reduce spending in the economy (called contractionary
policy), the Fed raises interest rates, and the process works in reverse.
Central banks across the world, including Europe, Japan, and the United States acted quickly to
restore liquidity to the financial system following August 9, 2007. On a normal day, the Fed

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might need to buy or sell a couple billion dollars of Treasury securities to keep the federal funds
rate within a few one-hundredths of a percent of its target. Suddenly on August 9, the federal
funds rate approached 6%, and the Fed was forced to purchase $24 billion of Treasury securities
in order to add enough liquidity to bring the federal funds rate back down to its target of 5.25%.
On August 10, the Fed needed to purchase an additional $38 billion to keep the rate at its target,
and issued a statement that began, “The Federal Reserve is providing liquidity to facilitate the
orderly functioning of financial markets.” The European Central Bank provided 156 billion euros
($215 billion) of liquidity to markets on August 9 and 10. Normalcy soon returned to the federal
funds market, although other parts of the financial system remained illiquid. The Fed took similar
actions on March 7, 2008, when it announced that it would be injecting up to $100 billion in
liquidity for at least 28 days through open market operations. It took similar actions again in
September 2008.
How should the Fed’s actions in these instances be characterized? The Fed’s actions cannot be
classified as a policy change since it left the federal funds target rate unchanged—in the August ⁸
case for over a month. Nor can it be considered unusual that the Fed bought Treasury securities
to keep the federal funds rate at its target—the Fed does this on a daily basis. What was unusual
about the incidents was the magnitude of liquidity the Fed needed to add to keep the rate near its
target.
On September 18, 2007, the Fed reduced the federal funds target rate by 0.5 percentage points to
4.75%, stating that the change was “intended to forestall some of the adverse effects on the
broader economy that might otherwise arise from the disruptions in financial markets...” Since
then, the Fed has aggressively lowered interest rates several times. The Fed decides whether to
change its target for the federal funds rate at meetings scheduled every six weeks. In normal
conditions, the Fed would typically leave the target unchanged or change it by 0.25 percentage
points. From September to March, the Fed lowered the target at each regularly scheduled
meeting, by an increment larger than 0.25 percentage points at most of these meetings. It also
lowered the target by 0.75 percentage points at an unscheduled meeting on January 21, 2008.
As the financial turmoil persisted, the Fed became more concerned about rising inflationary
pressures. Although financial conditions had not returned to normal, the Fed kept the federal
funds rate steady from April 30, 2008, until October 9, 2008, when it again reduced the federal
funds rate, this time by 0.5 percentage points, to 1.5%. Unusually, this rate reduction was
coordinated with several foreign central banks. On October 29, 2008, the Fed reduced the federal
funds rate to 1%.
The Fed can also provide liquidity to member banks (depository institutions that are members of ⁹
the Federal Reserve system) directly through discount window lending. Discount window
lending dates back to the early days of the Fed, and was originally the Fed’s main policy tool.
(The Fed’s main policy tool shifted from the discount window to open market operations several
decades ago.) Loans made at the discount window are backed by collateral in excess of the loan

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value. A wide array of assets can be used as collateral, but they must generally have a high credit
rating. Most discount window lending is done on an overnight basis. Unlike the federal funds
rate, the Fed sets the discount rate directly through fiat.
During normal market conditions, the Fed has discouraged banks from borrowing at the discount
window on a routine basis, believing that banks should be able to meet their normal reserve needs
through the market. Thus, the discount window has played a secondary role in policymaking to
open market operations. In 2003, the Fed made that policy explicit in its pricing by changing the
discount rate from 0.5 percentage points below to 1 percentage point above the federal funds rate.
A majority of member banks do not access the discount window in any given year. Since the
beginning of the financial turmoil, the Fed has reduced the spread between the federal funds rate
and the discount rate, although it has kept the spread positive.
On August 17, 2007, the Fed took further actions to restore calm to financial markets when it
reduced the discount rate from 6.25% to 5.75%. Since then, the discount rate has been lowered
several times, typically at the same time as the federal funds rate. From 1959 to 2007, discount
window lending outstanding never surpassed $8 billion. Discount window lending (in the primary
credit category) increased from a daily average of $45 million outstanding in July 2007 to $1,345
million in September 2007. Lending continued to increase to more than $10 billion outstanding
per day from May 2008, and has reached as high as $90 billion, but was superseded in economic
significance by the creation of the “Term Auction Facility” in December 2007 (discussed below).

The Fed’s traditional tools are aimed at the commercial banking system, but current financial
turmoil has occurred outside of the banking system as well. The inability of traditional tools to
calm financial markets since August 2007 has led the Fed to develop several new tools to fill
perceived gaps between open market operations and the discount window.
Traditionally, the lender of last resort function has focused on the banking system, and the Fed’s
relationship with the banking system is prescribed in detail by the Federal Reserve Act. Many of
the new facilities are aimed at other parts of the financial system, however, and the Federal
Reserve Act is largely silent on the Fed’s authority outside the banking system. One exception is
the broad emergency authority under Section 13(3) of the Federal Reserve Act, which the Fed has
frequently invoked since the financial crisis began.
A stigma is thought to be attached to borrowing from the discount window. In good times,
discount window lending has traditionally been discouraged on the grounds that banks should
meet their reserve requirements through the marketplace (the federal funds market) rather than
the Fed. Borrowing from the Fed was therefore seen as a sign of weakness, as it implied that
market participants were unwilling to lend to the bank because of fears of insolvency. In the
current turmoil, this perception of weakness could be particularly damaging since a bank could be
undermined by a run based on unfounded, but self-fulfilling fears. Ironically, this means that
although the Fed encourages discount window borrowing so that banks can avoid liquidity
problems, banks are hesitant to turn to the Fed because of fears that doing so would spark a crisis
of confidence. As a result, the Fed found the discount window a relatively ineffective way to deal

with liquidity problems in the current turmoil. It created the supplementary Term Auction Facility ¹⁰
(TAF) in response.
Discount window lending is initiated at the behest of the requesting institution—the Fed has no
control over how many requests for loans it receives. The TAF allows the Fed to determine the
amount of reserves it wishes to lend out to banks, based on market conditions. The auction
process determines the rate at which those funds will be lent, with all bidders receiving the lowest
winning bid rate. The winning bid may not be lower than the prevailing federal funds rate.
Determining the rate by bid provides the Fed with additional information on how much demand
for reserves exists.
Any depository institution eligible for discount window lending can participate in the TAF.
Auctions through the TAF have been held twice a month beginning in December 2007. The
amounts auctioned have greatly exceeded discount window lending, which averages in the
hundreds of millions of dollars outstanding daily in normal times and more than $10 billion
outstanding since May 2008. The TAF initially auctioned $20 billion every two weeks, but this
amount was increased on several occasions to as much as $150 billion every two weeks, so that ¹¹
the daily loans outstanding have exceeded $100 billion since April 2008. Like discount window
lending, TAF loans must be fully collateralized with the same qualifying collateral. As with
discount window lending, the Fed faces the risk that the value of collateral would fall below the
loan amount in the event that the loan was not repaid. For that reason, the amount lent diminishes
as the quality of the collateral diminishes.
Loans mature in 28 days—far longer than overnight loans in the federal funds market or the
typical discount window loan. (In July 2008, the Fed began making some TAF loans that matured
in 84 days.) Another motivation for the TAF may have been an attempt to reduce the unusually
large divergence that had emerged between the federal funds rate and interbank lending rates for
longer maturities. This divergence, which can be seen as a sign of how much liquidity had
deteriorated in spite of the Fed’s previous efforts, became much smaller after December. In
subsequent periods of market stress, such as September 2008, the divergence reemerged. The ¹²
evidence on the effectiveness of the TAF in reducing this divergence is mixed.
The TAF program was announced as a temporary program that could be made permanent after
assessment. Given that the discount rate is set higher than the federal funds rate to discourage its
use in normal market conditions, it is unclear what role a permanent TAF would fill, unless the
funds auctioned were minimal in normal market conditions. A permanent TAF would seem to run
counter to the philosophy governing the discount window that financial institutions, if possible,
should rely on the private sector to meet their short-term reserve needs during normal market
conditions.

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¹²^Se^e^Ja^m^e^{s Mc}^A^ndre^w^{s e}^t^a^l^{, “}^T^h^e^Eff^e^c^t^of^the^Te^r^m^A^u^c^{tion Fa}^cⁱ^lity^{on the}^L^oⁿ^d^oⁿ^Iⁿ^te^r-baⁿ^k^Of^fe^re^{d Ra}^te^,”
^Fe^de^ra^{l Re}^se^rv^e^Ba^nk^o^f^Ne^w^York^{, Sta}^f^f^Re^{port n}^o^.³³^{5, Ju}^ly²⁰⁰^{8; Jo}^{hn T}^a^y^l^{or a}^{nd Jo}^{hn W}^illia^m^s^{, “}^A^Bla^c^k^Swaⁿ
^{in t}^h^e^Mo^ne^y^Ma^r^k^e^t^,”^Fe^de^r^a^{l R}^e^s^e^r^v^e^B^a^nk^of^Sa^{n Fr}^aⁿ^cⁱ^s^c^{o, w}^o^r^k^ing^pa^pe^r²⁰⁰⁸^-⁰^{4, A}^p^r^il²⁰^08.

For many years, the Fed has allowed primary dealers (see box for definition) to swap Treasuries
of different maturities or attributes with the Fed on an overnight basis through a program called
the System Open Market Account Securities Lending Program to help meet the dealers’ liquidity
needs. (While all Treasury securities are backed by the full faith and credit of the federal
government, some securities are more liquid than others, mainly because of differences in
availability.) Securities lending has no effect on general interest rates or the money supply since it
does not involve cash, but can affect the liquidity premium of the securities traded. Since the
loans were overnight and collateralized with other Treasury securities, there was very little risk
for the Fed.
What is a Primary Dealer?
^{Primary dealers are abo}^{ut 2}⁰^larg^{e financial institutions who are}^th^{e counter}^{parties with w}^{hich t}^he^{Fed undertakes}
^{open market}^{operations (b}^uying^{and selling of Treasury se}^curities)^{. To be a primary dealer, an in}^{stitution must, among}
^{other things, meet}^{relevant Basel}^{or SEC capital req}^uirements^and^{maintain a good trading relationship with t}^{he Fed.}
On March 11, 2008, the Fed set up a more expansive securities lending program for the primary
dealers called the Term Securities Lending Facility (TSLF). Under this program, up to $200
billion of Treasury securities could be lent for 28 days instead of overnight (as of September
2008). Initially, loans could be collateralized with U.S. Treasuries, government “agency” debt
(including debt issued by Fannie Mae and Freddie Mac), mortgage-backed securities (MBS)
issued by government agencies or private labels with an AAA/Aaa rating, agency commercial
mortgage-backed securities, and agency collateralized mortgage obligations. On September 14,

2008, the Fed expanded acceptable collateral to include all investment-grade debt securities.

Given the recent drop in MBS and other asset prices, this made the new lending program
considerably more risky than the old one. But the scope for losses is limited by the fact that the
loans are fully collateralized with a “haircut” (i.e., less money is loaned than the value of the
collateral), and if the collateral loses value before the loan is due, the Fed can call for substitute
collateral. The first auction on March 27 involved $75 billion of securities. In August 2008, the
program was expanded to allow the primary dealers to purchase up to $50 billion of options (with
prices set by auction) to swap for Treasuries through the TSLF. The TSLF was announced as a
temporary facility. The facility was subsequently extended, most recently until the end of April

2009.

By allowing the primary dealers to temporarily swap illiquid assets such as MBS for highly liquid
Treasuries, “[t]he TSLF is intended to promote liquidity in the financing markets for Treasury and
other collateral and thus to foster the functioning of financial markets more generally,” according ¹³
to the Fed. Given the timing of the announcement—less than a week before the failure of one of
its primary dealers, Bear Stearns—critics have alleged that the program was created, in effect, in
an attempt to rescue Bear Stearns from its liquidity problems. But it should be noted that the new
program did not involve Bear Stearns’ most illiquid and devalued assets. As will be discussed
below, the Fed would take much larger steps to aid Bear Stearns later the same week.

¹³^B^o^a^r^d^of^G^ove^r^nor^s^of^the^Fe^de^r^a^{l R}^e^s^e^r^v^e^S^y^s^t^em^{, pr}^e^s^s^r^e^le^a^s^e^,^Ma^r^c^{h 11}^{, 2}⁰⁰⁸^.

On March 16—a day too late to help Bear Stearns—the Fed announced the creation of the
Primary Dealer Credit Facility (PDCF), a new direct lending program for primary dealers very
similar to the discount window program for depository institutions. Loans are made through the
PDCF on an overnight basis at the discount rate, limiting their riskiness. Acceptable collateral
initially included Treasuries, government agency debt, and investment grade corporate, mortgage-
backed, asset-backed, and municipal securities. Borrowing from the facility has been sporadic,
with average daily borrowing outstanding above $10 billion in the first three months, hitting zero
in August 2008, and above $50 billion following the financial deterioration in September 2008.
On September 14, 2008, the Fed expanded acceptable collateral to include certain classes of
equities. Many of the classes of eligible assets can and have fluctuated significantly in value. Fees
will be charged to frequent users.
The program was announced as lasting six months, or longer if events warrant. The program is
authorized under paragraph 3 of Section 13 of the Federal Reserve Act. The facility was
subsequently extended, most recently until the end of April 2009.
Although the program shares some characteristics with the discount window and the Term
Securities Lending Facility, the fact that the program was authorized under paragraph 3 of Section
13 of the Federal Reserve Act suggests that there is a fundamental difference between this
program and the Fed’s normal operations. The Fed is referred to as the nation’s central bank
because it is at the center of the banking system—providing reserves and credit, and acting as a
regulator, clearinghouse, and lender of last resort to the banking system. The privileges for banks
that come from belonging to the Federal Reserve system—access to Fed credit—come with the
costs of regulation to ensure that banks do not take excessive risks. Although the primary dealers
are subject to certain capital requirements, they are not necessarily part of the banking system,
and do not fall under the same “safety and soundness” regulatory structure as banks.
Emergency Authority Under Section 13(3) of the Federal Reserve Act
^{The Fed has limited authority to assist non-membe}^{r ba}^nks^under^t^{he Federal Reserve Act. O}^{ne e}^x^c^{eption where}
^{authority is grant}^{ed is under}^para^graph^{3 of Section 1}³^{of t}^{he Federal Reserve Act. It reads,}
^{In u}ⁿ^u^{sual and e}^{xigent circ}^umsta^{nces, the Board of Gove}^{rnors of}^{the Federal Reserve System,}^{by t}^{he affirmative vote}
^{of not less than}^{five mem}^{bers, m}^{ay authorize any}^{Federal reserve}^{bank...to discount for any individual, partner}^{ship, or}
^{corporation, notes, drafts, and bills of excha}^{nge.... Prov}^{ided, that before discounting an}^{y suc}^h^{note, draft, or bill}
^excha^{nge...the Federal reserve}^ba^{nk shall obtain evidence t}^{hat s}^uch^{individual, partnership, or corpo}^{ration is unable to}
^{secure ade}^quate^{credit accommodations from other ba}^{nking instit}^utions...
^{It is noteworthy t}^{hat t}^{his text allows emergencies to}^{be identified by th}^{e Board of Governor}^{s and}^{places few limits on}
^{what type}^{of institution can}^recei^{ve financial assistance}^{from th}^{e Fed or what form t}^{hat assistan}^{ce c}^{an take. The fact}
^{that the a}^{uthority is justified only}^{by u}ⁿ^u^{sual and e}^{xigent circ}^umsta^{nces s}^{uggests t}^{hat decisions made under}¹^3(3),
^{such a}^s^the^{creation of lending fa}^cilit^{ies, could not be made perma}^nent^under^{existing a}^{uthority. As}^{will be discussed}
^{below, on a few occasions in 2}⁰⁰^{8, Section 13(3)}^{has be}^{en invoke}^{d to lend to an entity that t}^{he Fe}^{d created.}
^{According to the New York Fed, this aut}^{hority had not}^been^used^{in about}^{70 y}^ears^{prior to the B}^{ear Stearns}
^{incident. It has}^{been in}^{voked num}^{erous times in}²⁰^{08, including to}^{authorize the Primary}^{Dealer Cr}^{edit Facil}^{ity, the}
^{Fed’s role in the Bear Stearns m}^e^{rger, and the}^{Fed’s extension of c}^{redit to AIG. Financial crises can}^{spread q}^uickly,
^{and Section 13(3) ma}^{kes a}^promp^{t respons}^{e possible. But rec}^{ent e}^vents^{have demonstra}^{ted that it v}^{ests the Fed with}
^{the ability to take large, wide-ranging actions without Congression}^{al approval. (It has volunta}^{rily sought and re}^ceived
^{Treasury a}^p^p^{roval in each insta}^nc^e.)
^{Section 13(3) was ame}^{nded in O}^{ctober 2}⁰⁰^{8. P.L. 110-}³⁴^{3 re}^quir^{es the Fed to re}^{port to Congress}^{on its justification}
^{for exercising Section}^{13(3), the}^t^{erms of the}^assistance^{provided, and regular}^{updates o}ⁿ^the^status^{of the loan.}

^{For more information, see Federal Reserve Bank of New}^{York, “The Discount Window,”}^Fedpoint^{, Aug. 20}^{07; David}
^{Fettig, “The History of a Powerfu}^{l Paragraph,” Federal Reserve Ba}^{nk of Min}^neapolis,^{The Region}^{, Jun}^{e 20}^08..
In November 2008, the Fed created the Term Asset-Backed Securities Loan Facility (TALF) in
response to problems in the market for asset-backed securities (ABS). According to the Fed,
^Ne^wⁱ^s^s^u^an^{ce of}^A^B^{S declin}^ed^precipitou^s^l^yⁱⁿ^Septe^m^{ber a}^{nd cam}^{e to a h}^a^{lt in}^October.^A^t
^th^{e sa}^m^e^ti^m^e^{, i}ⁿ^{terest rate}^sp^read^{s o}ⁿ^AAA-^ra^ted^traⁿ^ch^e^s^o^f^A^B^{S so}^ared^to^lev^e^ls^w^e^ll¹⁴
^ou^ts^{ide th}^{e ra}ⁿ^g^e^o^f^hⁱ^s^t^{orical ex}^perien^ce,^ref^l^ectⁱⁿ^g^unu^su^al^l^y^hⁱ^gh^ri^sk^pre^mⁱ^u^m^s^.
The TALF is intended to stimulate the issuance of new securities backed by pools of student
loans, automobile loans, credit card loans, and loans guaranteed by the Small Business
Administration. (The Fed announced that the TALF may later be expanded to other classes of
ABS, such as mortgage-related securities.) The Fed fears that if lenders cannot securitize these
types of loans, eventually households will be forced to reduce consumption spending, which
would exacerbate the economic downturn. For a security to be eligible for use as collateral, its
issuer (not the borrower) must follow the executive compensation policies under Section 111(b) ¹⁵
of the Emergency Economic Stabilization Act, P.L. 110-343.
Rather than purchase ABS directly, the Fed will make non-recourse loans to private individuals to
purchase newly issued ABS receiving the highest credit rating, using the ABS as collateral. If the
ABS lose value, the losses will be borne by the Fed and the Treasury through the TARP program
instead of by the borrower. The Fed will lend less than the current value of the collateral, so the
Fed would not bear losses on the loan until losses exceed the value of the “haircut.” The loans
will have a term of one year, but can be renewed. The amount lent and the interest rate on the
loans will be determined by an auction process, with maximums and minimums set by the Fed.
The total amount lent will not exceed $200 billion. Any U.S. citizen or business may borrow from
the Fed via a primary dealer under this program; since the Fed is lending to non-banks, the
facility is authorized under Section 13(3) of the Federal Reserve Act. The facility is scheduled to
cease making new loans at the end of 2009.
If the loans are not repaid, the Treasury will bear the first $20 billion in total losses on the
underlying collateral, and the Fed will bear any additional losses. The Treasury’s losses will be
financed through the Troubled Assets Purchase Program (TARP), authorized by P.L. 110-343.
TALF has some similarities to TARP as it was originally envisioned, with the primary differences
being that the Fed is lending to purchase rather than purchasing assets, and the assets backing the
loans are newly issued as opposed to “troubled” existing assets. Since the Treasury’s funds will
finance loan losses rather than asset purchases, the $20 billion will support a much larger volume
of assets than would be possible through direct purchase via TARP.

¹⁴^B^o^a^r^d^of^G^ove^r^nor^s^of^the^Fe^de^r^a^{l R}^e^s^e^r^v^e^S^y^s^t^em^{, pr}^e^s^s^r^e^le^a^s^e^,^N^o^v^e^m^b^e^r^25,²⁰^08.
¹⁵^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^L³⁴⁷³^0,^The^Em^e^r^ge^nc^y^Ec^on^om^ic^St^abi^liz^ati^oⁿ^Ac^{t a}ⁿ^d^C^u^r^r^e^{nt Fi}^na^nc^ial
^T^u^rmo^il:^Issu^{es a}ⁿ^d^Aⁿ^alysis^{, by}^B^a^ir^{d W}^e^be^{l a}^{nd E}^d^w^a^r^d^V.^Mur^phy^.

Many large firms routinely issue commercial paper, which is short-term debt purchased directly
by investors that matures in less than 270 days, with an average maturity of 30 days. There are
three broad categories of commercial paper issuers: financial firms, non-financial firms, and pass-
through entities that issue paper backed by assets. The commercial paper issued directly by firms
tends not to be backed by collateral, as these firms are viewed as large and creditworthy and the
paper matures quickly.
Individual investors are major purchasers of commercial paper through money market mutual
funds and money market accounts. The Securities and Exchange Commission regulates the
holdings of money market mutual funds, limiting their holdings to highly rated, short-term debt;
thus, investors widely perceived money market mutual funds as safe and low risk. On September
16, the Reserve Fund, which is a money market mutual fund, “broke the buck,” meaning that the
value of its shares had fallen below face value. This occurred because of losses it had taken on
short-term debt issued by Lehman Brothers, which filed for bankruptcy on September 15. Money
market investors had perceived “breaking the buck” to be highly unlikely, and its occurrence set
off a run on money market funds, as many investors simultaneously attempted to withdraw their
investments. This run greatly decreased the demand for new commercial paper. Firms rely on the
ability to issue new debt to roll over maturing debt to meet their liquidity needs.
Fearing that disruption in the commercial paper markets could make overall problems in financial
markets more severe, the Fed announced on September 19 that it would create the Asset-Backed
Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF). This facility would
make non-recourse loans to banks to purchase asset-backed commercial paper. Because the loans
were non-recourse, the banks would have no further liability to repay any losses on the
commercial paper collateralizing the loan. In its first week of operation, there were daily loans of
$152 billion outstanding through the AMLF. The temporary facility was subsequently extended
until the end of April 2009.
Although the creation of the AMLF and the Treasury’s temporary guarantee of money market
mutual fund deposits had eased conditions in the commercial paper market, the market remained
strained. For example, commercial paper outstanding fell from more than $2 trillion outstanding
in August 2007 to $1.8 trillion on September 7, 2008, to $1.6 trillion on October 1, 2008. The
yield on 30-day, AA-rated asset-backed commercial paper rose from 2.7% on September 8, 2008,
to 5.5% on October 7, 2008.
Because of the importance of commercial paper for meeting firms’ liquidity needs, the Fed ¹⁶
decided to take stronger action to ensure that the market was not disrupted. On October 7, it
announced the creation of the Commercial Paper Funding Facility (CPFF), a special purpose
vehicle (SPV) that would borrow from the Fed to purchase all types of three-month, highly rated
U.S. commercial paper, secured and unsecured, from issuers. The interest rate charged by the
CPFF was set at the three month overnight index swap plus 1 percentage point for secured
corporate debt, 2 percentage points for unsecured corporate debt, and 3 percentage points for
asset-backed paper. The CPFF can buy as much commercial paper from any individual issuer as
that issuer had outstanding in the year to date. Any losses borne by the CPFF would ultimately be

¹⁶^Fⁱⁿ^aⁿ^cⁱ^a^l^fⁱ^rm^{s exp}^e^ri^en^ciⁿ^g^an^{y d}ⁱ^srup^tⁱ^oⁿ^t^o^t^h^ei^{r l}ⁱ^q^uⁱ^dⁱ^t^yⁿ^eed^{s i}ⁿ^t^h^{e co}^mm^erci^al^p^a^p^e^r^m^a^rk^et^w^e^r^e^al^read^y
^e^lig^ible^to^borr^o^w^f^r^o^m^the^Fe^{d o}ⁿ^a^c^o^lla^te^ra^liz^e^d^ba^sis.

borne by the Fed. The Fed has hired the private company PIMCO to manage the SPV’s assets.
The facility is authorized under Section 13 (3) of the Federal Reserve Act, its emergency
authority. It will operate until April 2009, subject to renewal by the Fed. The Fed argued that the
assurance that firms will be able to roll over commercial paper at the CPFF will encourage private
investors to buy commercial paper again.
The CPFF is notable on several grounds. First, it is the first Fed standing facility in modern times
with an ongoing commitment to purchase assets, as opposed to lending against assets.
Technically, the Fed is lending against the assets of the SPV, but the SPV was created by the Fed
and is controlled by the Fed. (The arrangement is similar to the Fed’s creation of Maiden Lane, a
limited liability corporation, to purchase Bear Stearns’ assets (discussed below), but that involved
a one-time purchase.) Second, in the case of non-financial commercial paper, it is the first time in ¹⁷
several decades that the Fed is providing financial assistance to non-financial firms. Third, in
the case of commercial paper that is not asset backed, it is unusual for the Fed (through the SPV)
to purchase uncollateralized debt.
On October 21, 2008, the Fed announced the creation of the Money Market Investor Funding
Facility (MMIFF), and pledged to lend it up to $540 billion. The MMIFF will lend to private
sector SPVs that invest in commercial paper issued by highly rated financial institutions. Each
SPV will be owned by a group of financial firms and can only purchase commercial paper issued
by that group. These SPVs can purchase commercial paper from money market mutual funds
facing redemption requests to help avoid runs such as the run on the Reserve Fund. (The Treasury
has already guaranteed existing money market deposits to avoid further runs.) The Fed hopes that
if money market mutual funds, in turn, do not have to worry about how to finance redemptions,
they will become more willing to purchase commercial paper. Financial firms have an incentive
to participate in these SPVs since mutual funds will be more willing to purchase an institution’s
commercial paper if it is able to sell it back to an SPV. To reduce the risk to the Fed, its lending
will be equal to 90% of the value of the commercial paper the SPV purchases (the other 10% of
financing will be provided by the money market fund), and done with recourse on an overnight
basis at the discount rate. Since the SPVs are not member banks of the Federal Reserve System,
the Fed authorized the MMIFF under Section 13(3) of the Federal Reserve Act. The MMIFF is
scheduled to wind down by the end of April 2009. Upon winding down, the SPVs will receive a
fixed profit, with any additional profits accruing to the Fed.
In December 2007, the Fed announced the creation of temporary reciprocal currency agreements,
known as swap lines, with the European Central Bank and the Swiss central bank. These
agreements let the Fed swap dollars for euros or Swiss francs for a fixed period of time. Since
September 2008, the Fed has extended similar swap lines to central banks in several other
countries. In October 2008, it made the swap lines unlimited in size. The swap lines are currently
authorized through the end of January 2009.
The swap lines are intended to provide liquidity to banks in non-domestic denominations. For
example, many European banks have borrowed in dollars to finance dollar-denominated
transactions, such as the purchase of U.S. assets. Normally, foreign banks could finance their

¹⁷^Se^e^Da^vⁱ^{d Fe}^ttig^{, “}^L^e^nde^{r of}^Mo^re^T^h^aⁿ^L^a^{st Re}^sort,”^Fe^de^ra^{l Re}^s^e^rv^e^Ba^nk^of^Minne^a^polis,^The^R^e^gion^,^Dece^m^b^er
²⁰⁰^2.

dollar-denominated borrowing through the private inter-bank lending market. As banks have
become reluctant to lend to each other through this market, central banks at home and abroad
have taken a much larger role in providing banks with liquidity directly. But through normal
lending channels, banks can only borrow from their home central bank, and central banks can
only provide liquidity in their own currency. The swap lines allow central banks to provide
needed liquidity in other currencies.
Banks hold reserves to meet daily cash-flow needs and requirements imposed by the Fed. At
times over the past year, the Fed has faced conflicting goals—it seeks to ensure that banks have
enough reserves to remain liquid, but it also seeks to maintain its target for the federal funds rate
to meet its economic goals. The federal funds rate is the market rate in the private market where a
bank with excess reserves lends them overnight to other banks. At times, ensuring that all banks
have adequate reserves has resulted in an overall level of reserves in the market that has pushed
the federal funds rate below its target. In other words, the only way for the Fed to make sure that
each bank has enough reserves has been to oversupply the banking system as a whole with
liquidity at the given federal funds target.
To avoid this problem, Congress authorized the Fed to pay interest on bank reserves in the
Emergency Economic Stabilization Act of 2008 (H.R. 1424/P.L. 110-343). By setting an interest
rate on bank reserves close to the federal funds rate, the Fed would in effect place a floor on the
rate. In theory, the federal funds rate would not fall below the interest rate on reserves because
banks would rather hold excess reserves to earn interest than lend them out to other banks at a ¹⁸
lower interest rate. Paying interest on reserves may also encourage banks to hold more reserves
overall, which may somewhat reduce banks’ liquidity problems during the current period of
heightened uncertainty.
The interest rate on excess reserves was initially set at 0.75 percentage points less than the federal
funds rate. Immediately after the Fed began paying interest, the federal funds rate was still falling
below the target, and some days was even below the interest rate on reserves. In response, the Fed
subsequently changed the interest rate, most recently in November 2008 to 0.1 percentage points
less than the federal funds rate. Even after this change, the actual federal funds rate continued to
fall below the target rate.
Paying interest on reserves does not encourage banks to increase overall lending to firms and
households, however, because it increases the attractiveness of holding reserves. Thus, it is not a
policy that stimulates the economy, at least in any direct sense; on the contrary, it prevents the
increase in liquidity to banks from stimulating the economy by preventing the federal funds rate
from falling.
P.L. 110-343 gave the Fed permanent authority to pay interest on reserves. Once financial
conditions return to normal, the liquidity benefits from paying interest will be less important
(since banks will again be able to meet reserve needs through the federal funds market), and the
primary remaining benefit would be a reduction in the volatility of the federal funds rate. The Fed
previously intervened in the federal funds market on a daily basis to keep the market rate close to

¹⁸^Se^e^T^{odd K}^e^is^te^r^e^t^a^l^{, “}^D^iv^or^cⁱⁿ^g^Mone^y^Fr^om^Mone^ta^r^y^P^o^lic^y^,^Fe^de^r^a^{l R}^e^s^e^r^v^e^B^a^nk^o^f^N^e^w^Y^o^r^k^,^Ec^onom^ic
^P^o^lⁱ^{cy R}^evi^ew^{, Se}^pte^m^be^r²⁰^08.

the target, sometimes unsuccessfully. The volatility partly resulted from banks devoting resources
to activities that minimize reserves, such as “sweep accounts.”
Paying interest on reserves reduces the Fed’s profits, and thus reduces its remittances to the
Treasury, thereby increasing the budget deficit, all else equal. It can be viewed as a transfer from
the federal government to the banks, although in the long run, competition makes it likely that the
banks will pass on the benefit to depositors in the form of higher interest paid on deposits. From
Congress’s perspective, the benefit of a less volatile target rate and less resources spent
minimizing reserves would have to be weighed against the lost federal revenue, over time. The
decision to pay interest on required, as well as excess, reserves also increases the cost of the
policy without any additional benefit to liquidity or reduced volatility (because banks must keep
required reserves even if no incentive is offered).

Over the course of the year, several financial firms that were deemed “too big to fail” received
financial assistance from the Fed. This assistance went beyond its traditional role of acting as a ¹⁹
lender of last resort by providing loans to illiquid but solvent firms.
The investment bank Bear Stearns came under severe liquidity pressures in early March, in what ²⁰
many observers have coined a non-bank run. On Friday, March 14, JPMorgan Chase announced
that, in conjunction with the Federal Reserve, it had agreed to provide secured funding to Bear
Stearns, as necessary. Through its discount window, the Fed agreed to provide $13 billion of
back-to-back financing to Bear Stearns via JPMorgan Chase. It was a non-recourse loan, meaning
that the Fed had no general claim against JPMorgan Chase in the event that the loan was not
repaid and the outstanding balance exceeded the value of the collateral. Bear Stearns could not
access the discount window directly because, at that point, only member banks could borrow
directly from the Fed. This loan was superseded by the events of March 16, and the loan was
repaid in full on March 17.
On Sunday, March 16, after negotiations between the two companies, the Fed and the Treasury,
JPMorgan Chase agreed to acquire Bear Stearns. As part of the agreement, the Fed will purchase
up to $30 billion of Bear Stearns’ assets through Maiden Lane, a new Limited Liability
Corporation (LLC) based in Delaware that it has created and controls. After the merger was
completed, the loan was finalized on June 26, 2008. Two loans were made to the LLC: the Fed
lent the LLC $28.82 billion, and JPMorgan Chase made a subordinate loan to the LLC worth

¹⁹^T^hⁱ^s^sectⁱ^oⁿ^di^scu^{sses t}^h^{e sp}^eci^al^assi^st^an^{ce t}^h^at^t^h^{e t}^r^o^u^b^l^ed^fⁱ^rm^s^recei^ved^f^r^o^m^t^h^{e F}^e^d^.^T^h^{e sa}^m^e^fⁱ^r^m^s^m^a^{y al}^so
^ha^v^e^subse^que^nt^ly^a^c^c^e^s^s^e^d^Fe^{d r}^e^sourc^e^s^thro^ug^{h its}^norm^a^{l le}^ndi^ng^f^a^c^ilitie^s.^A^{ll le}^nding^t^h^ro^ug^h^f^a^c^ilitie^{s is}
^c^onf^ideⁿ^tia^{l, s}^o^k^now^le^dg^e^of^suc^h^a^c^tiv^ity^{is li}^m^ite^{d to se}^lf^-^r^e^por^ti^ng^by^the^fⁱ^r^m^s^.^For^e^x^am^ple^,^the^C^E^O^of^J^P^M^o^r^g^aⁿ
^Cha^s^e^te^stif^ie^{d to Cong}^re^{ss tha}^t^B^e^a^r^Ste^a^r^{ns ha}^d^borr^o^w^e^{d a}ⁿ^a^dditⁱ^ona^l^$2⁵^billi^{on f}^r^om^the^Fe^{d. (}^S^ourc^e^:^Ka^ra
^Sc^a^nne^{ll a}ⁿ^{d S}^ude^e^p^R^e^ddy^{, “}^O^f^fⁱ^cⁱ^a^l^s^Say^T^h^ey^Soug^{ht to A}^v^oid^B^e^a^r^B^a^ilout,”^W^a^ll^Str^e^e^t^J^o^ur^na^l^{, A}^p^{ril 4,}²⁰⁰⁸^,^p.
^A¹^.)^Sim^ila^r^l^y^,^A^I^G^a^nnounc^e^d^t^h^a^t^it^ha^d^accessed^th^{e Co}^mm^erci^{al P}^a^p^e^{r Fu}ⁿ^dⁱⁿ^g^Facility^{. (So}^u^r^c^e^{: “U.S. T}^r^easu^r^y^,
^Fe^de^r^a^{l R}^e^s^e^r^v^e^a^{nd A}^I^G^Es^ta^{blish C}^o^m^p^r^e^he^ns^iv^e^Sol^u^tio^{n f}^o^r^A^I^G^,^”^A^I^G^pr^e^s^s^r^e^lea^s^e^,^N^o^v^e^m^b^e^r^10,²⁰⁰⁸^.)
²⁰^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^L³⁴⁴²^0,^Be^ar^Ste^a^rⁿ^s^:^C^r^is^is^and^“Re^s^c^u^e^”^f^o^r^a^M^a^jor^Pr^ov^ide^r^of
^M^o^r^t^gage^-^R^e^l^ate^d^Pr^od^uc^ts^{, by}^G^a^r^y^Shor^te^r^.

$1.15 billion, based on assets initially valued at $29.97 billion.²¹ The Fed’s loan will be made at
an interest rate set equal to the discount rate (2.5% when the terms were announced, but ²²
fluctuating over time) for a term of 10 years, renewable by the Fed. JPMorgan Chase’s loan will
have an interest rate 4.5 percentage points above the discount rate.
Using the proceeds from that loan, the LLC will purchase assets from Bear Stearns worth $29.97
billion at marked to market prices by Bear Stearns on March 14. The Fed reported that
^T^h^{e po}^rt^f^o^lⁱ^o^s^u^pportⁱⁿ^g^t^h^{e cr}^edi^t^ex^t^e^nsⁱ^oⁿ^s^consⁱ^s^t^s^l^a^rg^el^{y of}^m^o^rt^g^a^g^e^-^r^el^at^ed^a^s^s^e^t^s^.^Iⁿ
^particu^l^{ar, it in}^cl^u^d^es^cas^h^as^s^e^ts^as^w^e^l^l^as^{related h}^e^dg^e^s^{. T}^h^{e cas}^h^as^s^e^t^s^con^sⁱ^s^{t of}
ⁱⁿ^v^e^st^m^eⁿ^t^g^r^ad^{e secu}^r^itie^{s (}ⁱ^{.e. secu}^r^{ities r}^a^ted^B^B^B^-^o^r^hⁱ^g^h^e^r^b^y^{at least o}ⁿ^{e o}^f^th^{e t}^h^r^ee
^p^rⁱⁿ^cip^a^{l cr}^ed^{it r}^a^tin^g^ag^eⁿ^ci^{es an}^dⁿ^o^lo^w^e^r^th^aⁿ^th^{at b}^y^th^{e o}^t^h^e^r^s⁾^aⁿ^d^r^e^sid^eⁿ^{tial o}^r
^com^m^e^rcial^m^o^rt^g^a^g^e^loaⁿ^s^c^l^as^sⁱ^fⁱ^{ed as}^“^p^erf^o^r^m^ing^”^.^All^of^t^h^{e a}^s^s^e^t^s^{are c}^u^rren^t^as^to
^p^rⁱⁿ^cip^a^{l an}^dⁱⁿ^ter^e^s^t⁽^a^{s o}^f^M^a^r^c^h¹⁴^,²⁰⁰⁸⁾^{. A}^{ll secu}^r^itie^{s ar}^{e d}^o^m^iciled^an^dⁱ^s^s^u^edⁱⁿ^t^h^e
^{U.S. an}^d^d^eⁿ^o^mⁱⁿ^a^tedⁱⁿ^U.S^.^d^o^llar^s^{. T}^h^{e p}^o^r^tf^o^lio^coⁿ^s^is^{ts o}^f^co^llater^a^lized^m^o^r^t^g^a^g^e
^o^b^lⁱ^g^a^tⁱ^o^ns⁽^C^M^O^s⁾^,^t^h^e^ma^j^o^ri^t^y^o^f^whⁱ^c^{h a}^r^e^o^b^lⁱ^g^a^tⁱ^oⁿ^s^o^f^gov^er^nm^eⁿ^t^-^s^pons^or^{ed en}^tities
^(GSEs⁾^{, s}^u^c^h^a^s^t^h^{e Federal H}^o^m^e^L^o^an^Mortg^a^g^e^C^o^rporation^{(“Freddie Mac”), as}^w^e^{ll as}
^a^s^s^e^t^-^b^a^c^k^e^d^s^e^c^u^rⁱ^tⁱ^e^s^,^a^d^j^u^s^t^a^b^l^e^-^r^a^t^e^m^o^r^t^g^a^g^e^s^,^c^o^m^m^e^r^cⁱ^a^l^m^o^r^t^g^a^g^e^-^b^ac^k^e^d^secu^r^itie^s^,²³
ⁿ^oⁿ^-^GSE^{CMOs, co}^llater^a^lize^d^b^oⁿ^d^o^b^lig^atioⁿ^s^{, a}ⁿ^d^v^a^rⁱ^o^u^s^o^t^h^e^r^lo^an^o^b^lig^atioⁿ^s^.
The CEO of JPMorgan Chase testified that JPMorgan Chase “kept the riskier and more complex
securities in the Bear Stearns portfolio...We did not cherry pick the assets in the collateral pool ²⁴
(for the LLC).” These assets are owned by the LLC, which will eventually liquidate them to pay
back the principal and interest owed to the Fed and JPMorgan Chase. The LLC’s assets
(purchased from Bear Stearns) are the collateral backing the loans from the Fed and JPMorgan
Chase. A private company, BlackRock Financial Management, has been hired to manage the
portfolio. Neither Bear Stearns nor JPMorgan Chase owes the Fed any principal or interest, nor
are they liable if the LLC is unable to pay back the money the Fed lent it. The New York Fed
explained that the LLC was created to “ease administration of the portfolio and will remove
constraints on the money manager that might arise from retaining the assets on the books of Bear ²⁵
Stearns.” JPMorgan Chase and Bear Stearns did not receive the $28.82 billion from the LLC ²⁶
until the merger was completed.
It was announced that the Fed is planning to begin liquidating the assets after two years. The
assets will be sold off gradually, “to minimize disruption to financial markets and maximize

²¹^Fe^de^r^a^{l R}^e^s^e^r^v^e^B^a^nk^of^New^Yor^k^{, “}^N^e^w^Y^o^r^k^Fe^{d C}^o^m^p^le^te^s^Fⁱ^na^nc^ing^A^r^r^a^ng^em^eⁿ^{t R}^e^la^te^{d to}^J^P^M^o^r^g^aⁿ
^Cha^s^e^’^s^A^c^quis^itioⁿ^of^Be^a^r^Ste^a^r^ns^,”^pre^s^s^re^le^a^s^e^,^J^une²⁶^,²⁰^08.^A^s^ubordi^na^te^loaⁿ^is^oⁿ^e^w^h^e^r^e^the^priⁿ^cⁱ^pa^{l a}ⁿ^d
^inte^re^s^t^a^r^e^not^re^pa^id^un^{til a}^f^te^{r the}^prim^a^r^y^loaⁿ^is^re^pa^id^.^T^h^e^ori^g^ina^lly^a^nnounc^e^d^te^rm^s^of^the^lo^aⁿ^s^w^e^re^f^o^{r up to}
^$29^bi^llio^{n f}^r^om^the^Ne^w^York^F^e^{d a}^nd^$1^bil^lio^{n f}^r^om^JP^Mo^rg^aⁿ^Cha^s^e^.^Af^te^r^m^o^re^thoroug^h^l^y^re^vie^w^ing^the^a^sse^ts
^t^h^{e L}^L^C^w^o^u^l^d^recei^ve,^t^h^{e F}^e^d^c^h^an^ged^t^h^{e t}^e^rm^{s o}^f^t^h^{e l}^o^an^.
²²^Fe^de^ra^{l Re}^se^rv^e^Ba^nk^of^N^e^w^Y^o^rk^{, “}^S^um^m^a^r^y^o^f^Te^r^m^{s a}^{nd Co}^nditi^ons^Re^g^a^rding^the^J^P^M^o^rg^aⁿ^Cha^s^e^Fa^c^ility^,”
^pr^e^s^s^r^e^le^a^s^e^,^Ma^r^c^{h 24,}²⁰⁰⁸^{. M}^a^ny^o^f^the^de^ta^ils^of^the^l^o^aⁿ^,^inc^l^udi^ng^the^sⁱ^z^e^,^w^e^r^e^{not a}ⁿ^no^unc^e^d^oⁿ^Ma^r^c^h¹⁶^.
²³^Tⁱ^m^o^thy^G^e^ithne^r^,^“^T^e^s^ti^m^oⁿ^y^B^e^f^o^r^e^the^Se^na^te^C^o^m^m^itte^e^f^o^r^B^a^nk^ing^,^H^ousⁱⁿ^g^a^{nd U}^r^ba^{n A}^f^f^aⁱ^r^s^,^”^A^p^r^{il 3,}
²⁰⁰^{8, A}^nne^x^I^I^.
²⁴^J^a^mi^e^Dⁱ^moⁿ^,^Te^s^tim^oⁿ^y^Be^for^e^the^Seⁿ^a^te^C^o^m^mⁱ^t^t^e^e^on^Ba^nkⁱⁿ^g^,^H^ousⁱⁿ^g^,^aⁿ^d^U^r^ba^{n Aff}^a^ir^s^{, A}^p^{ril 3,}²⁰⁰⁸^.
²⁵^Fe^de^ra^{l Re}^se^rv^e^Ba^nk^of^N^e^w^Y^o^rk^{, “}^S^um^m^a^r^y^o^f^Te^r^m^{s a}^{nd Co}^nditi^ons^Re^g^a^rding^the^J^P^M^o^rg^aⁿ^Cha^s^e^Fa^c^ility^,”
^pr^e^s^s^r^e^le^a^s^e^,^Ma^r^c^{h 24,}²⁰⁰⁸^.
²⁶^Tⁱ^m^o^thy^G^e^ithne^r^,^“^T^e^s^ti^m^oⁿ^y^B^e^f^o^r^e^the^Se^na^te^C^o^m^m^itte^e^f^o^r^B^a^nk^ing^,^H^ousⁱⁿ^g^a^{nd U}^r^ba^{n A}^f^f^aⁱ^r^s^,^”^A^p^r^{il 3,}
²⁰⁰^{8, p. 17}^.

recovery value.”²⁷ As the assets are liquidated, interest will continue to accrue on the remaining
amount of the loan outstanding. Thus, in order for the principal and interest to be paid off, the
assets will need to appreciate enough or generate enough income so that the rate of return on the
assets exceeds the weighted interest rate on the loans (plus the operating costs of the LLC). Table
1 shows how the funds raised through the liquidation will be used. Any difference between the
proceeds and the amount of the loans is profit or loss for the Fed, not JPMorgan Chase. Because
JPMorgan Chase’s $1.15 billion loan was subordinate to the Fed’s $28.82 billion loan, if there are
losses on the total assets, the first $1.15 billion of losses will be borne, in effect, by JPMorgan
Chase, however. As of November 2008, the value of the assets had already been written down by ²⁸
nearly $3 billion, exceeding the maximum losses borne by JPMorgan Chase. The interest on the
loan will be repaid out of the asset sales, not by JPMorgan Chase.
Table 1. Use of Funds Raised by Liquidation of Bear Stearns Assets
^{Payments from the liquidation will be made in the follo}^w^{ing or}^der:
^{(1) operating ex}^pe^{nses of t}^{he limited liabil}^{ity corporation}
^{(2) $2}^{9 billion principal owed to the Federal Reserve}
^{(3) interest due}^{to the Federal Reserve on t}^{he $}²⁹^{billion loan}
^{(4) $1}^{billion principal owed to JP}^{Morgan Cha}^se
^{(5) interest due}^{to JPMorgan C}^h^a^{se on $1}^{billion subordinated not}^e
^{(6) non-operating e}^xpe^{nses of t}^h^e^{limited l}^iabil^{ity corporation}
^{(7) remaining f}^{unds ac}^crue^{to Federal Reserve}
^Source:^{Federal Reserve Bank}^{of New York.}
^Note:^{Each category m}^{ust be}^{fully paid before}^{proceeding to the}ⁿ^{ext category.}
The CEO of JPMorgan Chase testified that “we could not and would not have assumed the ²⁹
substantial risks of acquiring Bear Stearns without the $30 billion facility provided by the Fed.”
The primary risk was presumably that the value of mortgage-related assets would continue to
decline. Had the transaction been crafted as a typical discount window loan directly to JPMorgan
Chase, JPMorgan Chase would have been required to pay back the principal and interest, and it
(rather than the Fed) would have borne the full risk of any depreciation in value of Bear Stearns’
assets.
The Fed’s statutory authority for its role in both Bear Stearns transactions comes from paragraph
3 of Section 13 of the Federal Reserve Act. In his testimony, New York Fed President Timothy
Geithner stated that the Fed did not have authority to acquire an equity interest in Bear Stearns or ³⁰
JPMorgan Chase. Yet the LLC controlled by the Fed acquired assets from Bear Stearns, and the
profits or losses from that acquisition will ultimately accrue to the Fed. It is unclear why the Fed

²⁷^Fe^de^r^a^{l R}^e^s^e^r^v^e^B^a^nk^of^New^Yor^k^{, “}^S^ta^te^m^e^{nt on Fi}^na^nc^ing^A^r^r^a^ng^em^eⁿ^{t of}^J^P^Mor^g^aⁿ^C^h^a^s^e^’^s^A^c^quis^ition^of
^{Bear S}^t^earn^s^,^”^p^r^{ess rel}^ease,^M^a^rch²⁴^,²⁰⁰⁸^.
²⁸^Fed^e^{ral Reserv}^e,^Fac^t^{ors Affe}^c^tⁱ^{ng Re}^se^rv^e^Balaⁿ^c^e^s^{of De}^p^o^sit^o^ry^Institutⁱ^oⁿ^s^{, pr}^e^s^s^r^e^le^a^s^e^H^.^4.1^,^Se^pte^m^be^r^11,
²⁰⁰^8.^Inf^o^rm^a^{tion on}^the^por^tf^{olio w}^{ill be}^u^pda^te^d^q^u^a^r^te^rly^a^{nd a}^nno^unc^e^d^thr^oug^h^this^pre^{ss re}^le^a^s^e^.
²⁹^J^a^mi^e^Dⁱ^moⁿ^,^Te^s^tim^oⁿ^y^Be^for^e^the^Seⁿ^a^te^C^o^m^mⁱ^t^t^e^e^on^Ba^nkⁱⁿ^g^,^H^ousⁱⁿ^g^,^aⁿ^d^U^r^ba^{n Aff}^a^ir^s^{, A}^p^{ril 3,}²⁰⁰⁸^.
³⁰^Tⁱ^m^o^thy^G^e^ithne^r^,^“^T^e^s^ti^m^oⁿ^y^B^e^f^o^r^e^the^Se^na^te^C^o^m^m^itte^e^f^o^r^B^a^nk^ing^,^H^ousⁱⁿ^g^a^{nd U}^r^ba^{n A}^f^f^aⁱ^r^s^,^”^A^p^r^{il 3,}
²⁰⁰^{8, p. 13}^.

decided to create and lend to a LLC to complete the transaction, rather than engaging in the
transaction directly. Although the Fed did not buy Bear Stearns’ assets directly, there are certainly
important policy questions raised by the Fed’s creation and financing of an LLC in order to buy
Bear Stearns’ assets. Typically, the Fed lends money to institutions and receives collateral in
return to reduce the risk of suffering a loss. When the loan is repaid, the collateral is returned to
the institution. In this case, the Fed made a loan, but to a LLC they created and controlled, not to
a financial institution. From the perspective of JPMorgan Chase or Bear Stearns, the transaction
was a sale (to the LLC), not a loan, regardless of whether the Fed or the LLC was the principal.
On September 16, 2008, the Fed announced, after consultation with the Treasury Department, that
it would lend up to $85 billion to the financial institution American International Group. AIG had
experienced a significant decline in its stock price and was facing immediate demands for $14
billion to $15 billion in collateral payments due to recent downgrades by credit rating agencies, ³¹
according to press reports. The Fed and Treasury feared that AIG was also “too big to fail”
because of the potential for widespread disruption to financial markets that would result.
The Fed announced that AIG could borrow up to $85 billion from the Fed over the next two ³²
years. On September 18, the Fed announced that it had initially lent $28 billion to AIG. The
interest rate on the funds drawn is 8.5 percentage points above the London Interbank Offered
Rate (LIBOR), a rate that banks charge to lend to each other. AIG will also have to pay a (lower)
interest rate on any funds that it is does not draw from the facility. In return, the government will
receive warrants that, if exercised, would give the government a 79.9% ownership stake in AIG.
The Fed will name three independent trustees to oversee the firm for the duration of the loan.
The lending facility is backed by the assets of AIG’s non-regulated subsidiaries (but not the assets
of its insurance company). In other words, the Fed can seize AIG’s assets if the firm fails to honor
the terms of the loan. This reduces the risk that the Fed (and ultimately, taxpayers) will suffer a
loss. The risk still remains that if AIG turned out to be insolvent, its assets would be insufficient
to cover the amount it had borrowed from the Fed. Since AIG has been identified as too big to
fail, it is unclear how its assets could be seized in the event of non-payment without precipitating
failure.
On October 8, the Fed announced that it was expanding its assistance to AIG and swapping cash
for up to $37.8 billion of AIG’s investment-grade, fixed-income securities. These securities,
belonging to AIG’s insurance subsidiaries, had been previously lent out and unavailable as
collateral at the time of the original agreement. It has been reported that as AIG’s loans matured,
AIG realized losses on investments it had made with the collateral and some counterparties

³¹^S^ee,^f^o^{r exa}^m^p^l^e,^“U.^S^.^t^o^T^a^{ke Over}^A^I^Gⁱⁿ^$⁸⁵^Bi^l^lⁱ^o^{n Ba}^ilo^ut;^Ce^ntra^{l Ba}^nk^{s Inje}^c^t^Ca^{sh a}^s^Cre^d^{it Drie}^{s Up,”}
^W^a^{ll Str}^e^e^t^J^o^ur^na^l^{, Se}^pte^m^be^r^{17, 2}⁰⁰⁸^,^pp^{. A}¹^-^A^6.
³²^Fe^de^r^a^{l R}^e^s^e^r^v^e^,^“^F^a^c^t^or^s^A^f^f^e^c^t^ing^R^e^s^e^r^v^e^B^a^la^nc^es^,”^pr^e^s^s^r^e^lea^s^e^H^.^4.1,^Se^pte^m^be^r^18,²⁰⁰⁸^.

stopped participating in the lending program.³³ As a result, AIG needed liquidity from the Fed to
cover these losses and counterparty withdrawals.
Although this assistance resembles a typical collateralized loan (the Fed receives assets as
collateral, and the borrower receives cash), the Fed characterized the agreement as a loan of
securities from AIG to the Fed in exchange for cash collateral. It appears the arrangement was
structured this way because New York insurance law prevents AIG from using the securities as ³⁴
collateral in a loan. The terms of the agreement are unavailable at this time.

On November 10, 2008, the Federal Reserve and the U.S. Treasury announced a restructuring of
the federal intervention to support AIG. Since the initial loan, some, notably AIG’s former CEO
Maurice Greenberg, had criticized the terms as overly harsh, arguing that the loan itself might be
contributing to AIG’s eventual failure as a company. As evidenced by the additional borrowing
after the September 16 loan, AIG had continued to see cash flow out of the company, particularly
to post collateral for the credit default swaps that were arguably the primary cause of the financial
problems in the company. The revised agreement points to the tension between making the terms
of the assistance undesirable enough to deter other firms from seeking government assistance in
the future, compared to making the terms of assistance so punitive that it exacerbates the financial
problems of the recipient firm. It also points to the fact that once a firm has been identified as too
big to fail, government assistance to the firm can become open-ended, as the original amounts
offered were quickly revised upward.
The November 10 restructuring eased the payment terms for AIG and had three primary parts: (1)
a $40 billion direct capital injection, (2) restructuring of the $85 billion loan, and (3) a $52.5
billion purchase of troubled assets.
The initial $85 billion loan facility from the Federal Reserve was reduced to $60 billion, for a
time period extended to five years, and the financial terms are eased considerably. Specifically,
the interest rate on the amount outstanding is reduced by 5.5 percentage points (to Libor plus 3%)
and the fee on undrawn funds is reduced by 7.75 percentage points (to 0.75%).
While P.L. 110-343 provided for the government purchase of troubled assets, the purchases
related to AIG are being done by limited liability corporations (LLCs) created and controlled by
the Federal Reserve. This structure is similar to that created by the Federal Reserve to facilitate
the purchase of Bear Stearns by JPMorgan Chase in March 2008. There are two LLCs set up for
AIG—one for residential mortgage-backed securities (RMBS) and one for collateralized debt
obligations (CDO).

³³^Lⁱ^a^m^P^l^even^et^al^,^“A^I^G^Bai^l^o^u^t^Hi^t^By^Ne^w^C^a^sh^W^o^es,^”^W^a^{ll St}^r^e^e^t^J^our^nal^{, O}^c^to^be^r^9,²⁰⁰⁸^{, p}^.^A¹^.
³⁴^N^.^Y^.^Ins^.^L^a^w^,^Se^c^.¹⁴¹^0.
³⁵^T^h^is^s^e^c^{tion w}^a^s^pr^e^p^a^r^e^d^w^{ith B}^a^ir^{d W}^e^be^{l, a}ⁿ^a^l^y^s^{t in Fina}^nc^ia^{l E}^c^onom^ic^s^.

The RMBS LLC will be lent up to $22.5 billion by the Federal Reserve and $1 billion from AIG
to purchase RMBS from AIG’s securities lending portfolio. The AIG loan is subordinated and
AIG will bear the first $1 billion in losses should there be future losses on these securities. AIG
and the Federal Reserve will “share” in any future gains, though it is unclear exactly how such
gains would be shared. The previous $37.8 billion loan securities lending loan facility is to be
repaid and terminated with the proceeds from this LLC plus additional AIG funds if necessary.
The CDO LLC will be lent up to $30 billion from the Federal Reserve and $5 billion from AIG to
purchase CDOs on which AIG has written credit default swaps. The $5 billion loan from AIG is
subordinated and AIG will bear the first $5 billion in future losses on these securities. AIG and
the Federal Reserve will “share” in any future gains, though it is unclear exactly how such gains
would be shared. The Federal Reserve also indicates that the credit default swaps will be
unwound at the same time that the CDOs are purchased. Many credit default swaps, however, are
purchased by entities not holding the underlying CDOs; it is unclear how, or if, such credit default
swaps written by AIG will be addressed.
Through the Troubled Asset Relief Program (TARP), the Treasury purchased $40 billion in
preferred shares of AIG. In addition to $40 billion in preferred shares, the Treasury also receives
warrants for common shares equal to 2% of the outstanding AIG shares. TARP was authorized by
Congress in H.R. 1424/P.L. 110-343 and the Capital Purchase Program (CPP) under TARP was
first announced by Treasury Secretary Paulson on October 14, 2008. AIG would be the first
announced non-bank to receive TARP funds. The $40 billion in preferred AIG shares now held by ³⁶
the Treasury are slated to pay a 10% dividend per annum, accrued quarterly. Participation in
TARP triggers restrictions on executive pay as required by Congress, including a restriction on
“golden parachutes” and a requirement for clawbacks on previously provided bonuses in the case
of accounting irregularities. According to the November 10, 2008, AIG filings with the Securities
and Exchange Commission, the amount of shares held in trust for the benefit of the U.S. Treasury
will be reduced by the shares and warrants purchased under TARP, so the total equity interest
currently held by the U.S. government equals 77.9% plus warrants to purchase another 2%.
All Fed assistance to AIG is authorized under Section 13 (3) of the Federal Reserve Act, the same
emergency authorization used for the Bear Stearns loan. This authorization was needed because
the Fed cannot normally lend to a financial firm that is neither a depository institution nor a
primary dealer.
Similar to Bear Stearns and AIG, Citigroup faced a sudden drop in its stock price in late 2008. Its
stock price fell from $23 per share on October 1, 2008, to $3.77 on November 21, 2008, amidst
investor concern about its losses. Stepping in before a potential run began, the Federal Reserve
and federal government announced on November 23 that it would purchase an additional $20

³⁶^F^u^l^l^d^e^t^aⁱ^l^s^o^f^t^h^{e p}^r^ef^erred^sh^{ares can}^b^e^f^o^uⁿ^d^on^t^h^{e T}^r^easu^r^y^web^sⁱ^t^e^at^h^t^t^p^:^/^/^u^s^t^r^eas.^g^o^v^/^p^ress/^rel^eases/^r^ep^o^r^t^s^/
¹¹¹⁰⁰^8a^ig^te^r^m^s^h^e^e^t^.pdf^.

billion of Citigroup preferred shares through TARP and guarantee a pool of up to $306 billion of
Citigroup’s assets. These assets were described as “loans and securities backed by residential and ³⁷
commercial real estate and other such assets.” The guarantee is in place for 10 years for
residential assets and 5 years for non-residential assets. Citgroup will exclusively bear up to the
first $29 billion of losses on the pool. Any additional losses will be split between Citigroup and
the government, with Citigroup bearing 10% of the losses and the government bearing 90%. The
first $5 billion of government’s losses will be borne by the Treasury using TARP funds; the next
$10 billion will be borne by the FDIC; all further losses will be borne by the Fed through a non-
recourse loan. Citigroup will pay the federal government a fee for the guarantee in the form of
preferred stock. The assets will remain on Citigroup’s balance sheet, and Citigroup will receive
the income stream generated by the assets.
In the cases of Bear Stearns and AIG, management was replaced and shareholders equity was ³⁸
diluted to limit moral hazard problems associated with government assistance. Similar steps
were not taken in the case of Citigroup.

Unlike all other institutions, currency (Federal Reserve notes) is the Fed’s primary liability. Along
with its holdings of Treasury securities, its assets are the loans it makes (through the discount
window and the new programs detailed above) and the private assets it hold through LLCs (e.g.,
for AIG and the Bear Stearns takeover). Its loans and asset purchases are financed by increasing
its liabilities (Federal Reserve notes), and does not inherently impose any cost to the Treasury.
Indeed, if the loans are repaid, they would increase the profits of the Fed, which in turn would ³⁹
increase the Fed’s remittances to the Treasury. Even if the loans are not repaid, they are fully
collateralized (in some cases, over collateralized), so the Fed would not suffer losses unless the
collateral had lost value. In addition, some of the loans discussed above are made with recourse,
which means that the firms are liable if the collateral loses value.
The Fed had net income of $38.4 billion and remitted $34.6 billion to the Treasury in 2007. In the
past, most of the Fed’s net income has derived from the interest on its Treasury securities
holdings, not its loans. The earnings and any losses the Fed took on its loans would increase or
reduce its net income, respectively. If loan losses caused an overall net loss, the Fed’s capital (the
excess of its assets compared with its liabilities) would be reduced. The Fed had capital of $36.9
billion at end of 2007, half of which was paid-in capital of member banks and the other half was
surplus. The Fed has not had an annual net operating loss since 1915. However, the Fed’s assets
became more risky in 2008 due to the shift in its assets from U.S. Treasuries to direct loans and
due to the increase in its assets and liabilities relative to its capital.

³⁷^“^J^oint^Sta^t^e^m^eⁿ^{t by}^T^r^e^a^sur^y^{, Fe}^de^ra^{l Re}^se^rv^e^,^a^{nd the}^FDIC^{on C}^itig^roup^,”^jo^int^pre^{ss re}^le^a^s^e^,^Nov^e^m^b^e^r^23,²⁰⁰⁸^.
³⁸^Fo^{r a f}^u^ll^dⁱ^scu^ssioⁿ^{, see th}^{e sect}^ioⁿ^b^e^lo^w^en^titled^“L^eⁿ^d^e^{r o}^f^L^a^s^t^Reso^{rt, Sy}^ste^m^{ic Risk}^{, an}^d^M^o^r^a^{l Hazard}^“^.
³⁹^A^ssu^mⁱⁿ^g^t^h^at^t^h^{e i}ⁿ^t^e^rest^rat^e^on^t^h^e^l^o^an^{s exceed}^ed^t^h^{e rat}^e^o^f^ret^u^rn^oⁿ^t^h^{e T}^r^easu^rⁱ^e^{s t}^h^at^t^h^{e F}^e^d^w^o^u^l^d^h^a^ve
^p^u^r^ch^asedⁱ^f^t^h^{e l}^o^an^s^h^a^dⁿ^o^t^o^ccu^rred^.

Thus, any potential losses on loans to the Fed would not involve taxpayer dollars unless the losses
exceeded the sum of its other earnings and its capital. For example, in October 2008, the Fed’s
capital would be depleted if its realized net losses were equal in value to 3.5% of its holdings of
securities (U.S. Treasuries and loans). However, any losses could result in a smaller remittance of
earnings to the Treasury than would have occurred had the Fed not made the loans. Therefore, the
ultimate cost to the government is the same whether loans to the financial sector are made
through the Fed or the Treasury. Although the Fed has taken steps to minimize the risk that recent
activities will result in losses, Members of Congress have raised the question of whether
taxpayers should be exposed to additional fiscal risks without congressional approval, particularly
since some of the Fed’s actions have similarities to those authorized under TARP.
As direct loans from the Fed have multiplied, some observers have questioned at what point the
Fed’s lending power will be exhausted. The Fed cannot “run out of money” to lend because it
controls the monetary base, through which it expands or contracts the amount of money
outstanding to suit its needs. There are no statutory limits on the size of the money supply (and,
thus, how much it can loan); the ultimate constraint on the monetary base, and thus its willingness
to lend, comes from the part of its congressional mandate requiring stable prices (i.e., a low and
stable rate of price inflation.) If the Fed allows the money supply to become too large, then price
inflation will become uncomfortably high (discussed in the section below on “Stagflation?”). In
the 12 months ending in August 2008, inflation (as measured by the consumer price index) had
risen 5.4%—significantly higher than the Fed’s self-identified “comfort zone.” Thus, the Fed is ⁴⁰
reluctant to allow its loans to result in a significant expansion in the money supply. (As
commodity prices fell later in 2008, the inflation rate also fell.)
When the Fed makes loans to private financial firms, it increases the money supply unless offset
by open market operations, namely, the sale of Treasury securities. In practice, before September
2008, the Fed had kept the monetary base relatively constant by selling enough Treasury
securities to offset the additional loans it makes. (When the Fed sells Treasury securities, it
removes the money it receives from circulation.) On the Fed’s balance sheet, both Treasury
securities and loans outstanding are assets. Thus, as loans outstanding have risen, its holdings of
Treasury securities have declined. For example, in September 2007, 88% of its assets were
Treasury securities held outright and less than 1% were loans to the financial system. In
November 2008, 23% of its assets were Treasury securities, 32% were loans, and 16% were
private securities (mostly commercial paper).
Some have worried that, if this trend continued, the Fed would eventually hold too few Treasury ⁴¹
securities to be able to conduct open market operations. This scenario is not imminent—as of
October 2008, the Fed still held about $480 billion in Treasury securities (although some of those
are lent through the TSLF). Nevertheless, to safeguard against any risk of this eventuality, the
Treasury announced the Supplementary Financing Program on September 17, 2008. Under this

⁴⁰^W^e^r^e^the^am^ount^of^loaⁿ^s^to^inc^r^e^a^s^e^sⁱ^gⁿⁱ^f^ic^aⁿ^tl^y^b^ecau^{se f}ⁱⁿ^aⁿ^cⁱ^a^l^c^ondi^tio^ns^b^ecam^{e si}^gnⁱ^fⁱ^can^t^l^y^w^o^rse,ⁱ^tⁱ^s
^uⁿ^lⁱ^k^el^y^t^h^at^t^h^{e F}^e^{d w}^o^u^l^d^con^tⁱⁿ^u^e^t^o^f^{ear t}^h^at^{a l}^a^rger^m^oⁿ^e^y^su^p^p^l^y^w^o^u^l^d^h^a^{ve u}ⁿ^accep^t^a^b^l^{e con}^s^eq^u^eⁿ^{ces f}^o^r
^inf^l^a^{tion. I}^f^s^o^,^the^Fe^{d c}^o^uld^be^c^o^m^e^le^s^s^c^onc^e^r^ne^{d a}^bout^ta^kⁱ^ng^s^t^e^p^s^to^of^f^s^e^t^the^loaⁿ^s^’^e^f^f^e^c^t^s^{on the}^m^one^y
^s^upply^.
⁴¹^{It sho}^u^l^d^be^note^d^t^h^a^t^a^p^o^rtf^o^lio^of^T^r^e^a^sur^y^se^c^u^ritie^{s is only}^ne^e^d^e^d^t^o^tig^hteⁿ^m^one^ta^ry^polic^y^.^Ex^pa^nsiona^ry
^m^one^ta^r^y^polic^y^inv^o^lv^e^s^the^purc^h^a^s^e^of^T^r^e^a^s^ur^y^se^c^u^ritie^s.

program, the Treasury will temporarily auction more new securities than it needs to finance
government operations and will deposit the proceeds at the Fed. As of December 2008, about
$500 billion had been borrowed by the Treasury and deposited at the Fed through this program.
Congress authorized this borrowing only indirectly by raising the statutory debt limit, most
recently in P.L. 110-343.
This program has two effects. First, it supplies more Treasuries to investors when there is excess
demand because of a “flight to quality.” (The Treasuries issued under the program are
indistinguishable to investors from regularly-issued securities.) Second, it allows the Fed to take
on more loans without requiring a reduction to its Treasury holdings in order to offset the effects
on the money supply. (The increase in the money supply is offset because the money received by
the Treasury is held at the Fed and not allowed to circulate.) Ultimately, the program will not
affect the Treasury’s fiscal position, however, because it will increase the profits of the Fed,
which are then remitted to the Treasury.
The fact that the Fed has been “sterilizing” the effects of its loans on the money supply may be
limiting the effects of those loans on financial conditions. In essence, the Fed has two methods for
providing the financial system with liquidity—open market operations or direct loans. The Fed
has increased the role of direct loans to directly meet individual financial institutions’ liquidity
needs. But the Fed has to offset the effects of the direct loans on the money supply to meet its
goals for inflation. Thus, the loans do not provide additional overall monetary stimulus to the ⁴²
economy when sterilized. Since the Fed is sterilizing the loans because of its concerns with
inflation, the utility of the program is fundamentally a question of whether the Fed has achieved
the proper balance between stabilizing the financial sector and providing price stability, two
topics that are discussed below.
The Fed’s actions since 2007 have been primarily focused on restoring liquidity to the financial
system—lending to financial firms to convert their illiquid assets into cash or U.S. Treasury
securities. But as financial conditions have deteriorated in spite of increasing Fed intervention, it
has become apparent that the problems facing financial firms are not exclusively related to
liquidity.
The crux of the firms’ problem stems from the large losses on some of their assets, particularly ⁴³
mortgage-related assets. This has caused a number of problems for the firms related to capital
adequacy, which is the difference between the value of their assets and the value of their
liabilities. First, losses and write-downs associated with those assets have reduced the firms’
existing capital. According to Bloomberg, financial firms had written down losses of $501 billion

⁴²^A^s^fⁱ^na^nc^ia^{l c}^ondi^tio^ns^de^te^rⁱ^or^a^t^e^d^a^f^te^r^Se^ptem^be^r²⁰⁰^{8 a}ⁿ^{d t}^h^e^Fe^{d inc}^r^e^a^s^e^d^its^a^s^s^e^ts^{to s}^u^p^por^t^the^fⁱ^na^nc^ia^l
^s^y^st^e^m^,^t^h^{e F}^e^d^’^{s l}ⁱ^a^bⁱ^lⁱ^tⁱ^e^{s i}ⁿ^creased^si^gnⁱ^fⁱ^can^t^l^y^b^ecau^{se o}^f^anⁱⁿ^{crease i}ⁿ^b^aⁿ^k^reserves.^T^h^u^s^,^t^h^e^F^e^d^di^dⁿ^o^t
^st^eri^lⁱ^{ze t}^hⁱ^sⁱⁿ^crease.^No^rm^al^l^y^,^t^hⁱ^s^w^o^u^l^d^h^a^{ve b}^eenⁱⁿ^f^l^atⁱ^oⁿ^a^ry^,^b^u^tⁱ^t^app^{ears t}^h^at^t^h^{e i}ⁿ^{crease i}ⁿ^reserv^es^w^a^s
^cau^sed^b^y^{a d}^e^si^{re b}^y^b^aⁿ^k^{s t}^oⁱⁿ^{crease t}^h^ei^{r reserv}^{es rat}^h^{er t}^h^an^t^h^ei^{r l}^eⁿ^dⁱⁿ^g^.^If^so^,^t^h^{ere m}^a^yⁿ^o^t^{be i}ⁿ^f^l^atⁱ^oⁿ^a^ry
^coⁿ^s^eq^u^eⁿ^{ces t}^o^t^h^eⁱⁿ^{crease i}ⁿ^t^h^{e F}^e^d^’^{s asset}^s^.
⁴³^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^S²²⁹⁶^3,^Fin^ancⁱ^a^{l M}^a^rk^e^t^Inte^rv^eⁿ^tioⁿ^,^by^Edw^a^r^d^{V. Mu}^r^phy^a^{nd B}^a^ir^d
^We^b^e^l^.

on mortgage-related assets and raised $353 billion in capital to compensate as of August 2008.⁴⁴
Second, in the current environment, investors and creditors are demanding that firms hold more
capital relative to assets than before so that firms can better withstand any future losses.
Third, the losses to date have impaired the firms’ ability to raise enough new capital. Firms can
raise new capital through retained earnings, which have been greatly reduced for many firms by
the poor performance of their assets, or by issuing new capital (equity) and selling it to new
investors. But in current market conditions, investors have been reluctant to inject new capital
into struggling firms. Part of the explanation for this is that current losses have made the firms
less profitable. But another part of the reason is that investors fear that there will be further losses
in the future that would reduce the value of their investment, and perhaps even cause the firm to
become insolvent. Uncertainty about future losses is partly caused by the opacity surrounding the
assets that have been declining in value, which makes it hard for investors to determine which
assets remain overvalued and which are undervalued. The result for companies such as Bear
Stearns, Lehman Brothers, AIG, Washington Mutual, and Wachovia was a downward spiral in
their stock price, which had two self-reinforcing characteristics. First, there was little demand for
existing stock since its worth would either be diluted by new capital (raised privately or through
government intervention) or lost in insolvency. Second, new capital could not be attracted
because the fall in stock value had left the market capitalization of the firms so low. If a firm’s
capital is completely depleted, there is no longer a buffer between its assets and liabilities, and it
becomes insolvent.
Many large financial firms, including the firms that have failed, are heavily dependent on short-
term borrowing to meet their current obligations. As financial conditions have worsened, some of
the firms that have had the problems described above have had problems accessing short-term
borrowing markets that in normal conditions could be taken for granted. In an atmosphere where
creditors cannot perceive which firms have insufficient capital, they become unwilling to lend for
even short intervals. This is the essence of the liquidity problem—although the firms’ assets may
exceed their liabilities, without access to short-term borrowing, the firm cannot meet its current
obligations because it cannot convert its assets into cash quickly enough (at least not if it wishes
to avoid “fire sale” prices).
The Fed has always been the “lender of last resort” in order for banks to avoid liquidity problems
during financial turmoil. To borrow from the Fed, a financial firm must post collateral. In essence,
this allows the firm to temporarily convert its illiquid assets into cash, enabling the firm to meet
its short-term obligations without sacrificing its assets. The Fed has always lent to commercial ⁴⁵
banks (depository institutions) through the discount window. As discussed above, it has
extended liquidity to non-bank financial firms in 2008 through new lending facilities.
Borrowing from the Fed increases liquidity but it does not change a firm’s capital position since it
now has a liability outstanding to the Fed. So borrowing from the Fed cannot solve the problems
of undercapitalization that some firms currently face. Indeed, the Fed will generally not lend to

⁴⁴^Ya^lm^aⁿ^Ona^r^aⁿ^{, “}^B^aⁿ^k^s^{’ Su}^bpri^m^e^L^o^sse^{s T}^{op $5}^{00 Bi}^llioⁿ^on^W^r^ite^dow^ns,”^Bloom^be^rg^,^A^u^g^u^{st 12}^{, 2}⁰⁰⁸^.
⁴⁵^Iⁿ^nor^m^a^{l c}^onditi^ons^{, b}^o^r^r^o^wⁱ^ng^f^r^o^m^the^dis^c^ou^{nt w}ⁱ^nd^ow^is^a^llow^e^{d but dis}^c^o^u^r^a^g^e^{d, a}ⁿ^d^ba^nk^s^a^r^e^e^x^pe^c^t^e^d^to
^m^e^e^t^theⁱ^r^liq^uidi^ty^ne^e^d^s^thr^oug^h^pr^iv^a^t^e^m^a^r^k^e^t^s^.^{Soon a}^f^te^r^the^fⁱ^na^nc^ia^{l tur}^m^oil^be^g^a^{n, the}^Fe^{d be}^g^a^{n to e}ⁿ^c^o^ur^a^g^e
^dis^c^ou^{nt w}ⁱ^nd^ow^bor^r^o^wⁱ^ng^.

firms that are not creditworthy because it wants to provide liquidity only to firms that are solvent, ⁴⁶
and thus able to repay.
H.R. 1424, which was signed into law on October 3 (P.L. 110-343), created the Troubled Assets
Relief Program (TARP). Thus far, the Treasury has announced it would use TARP funds to
address the capital adequacy problem directly by providing $250 billion in capital to banks ⁴⁷
directly through preferred share purchases by TARP.
If TARP proves insufficient to restore financial calm, some have asked whether there is any
program that the Fed could operate to address the financial firms’ capital adequacy problems. All
of the Fed’s standing lending facilities involve collateralized lending, and as discussed above, any
program involving collateralized lending would not change a firm’s capital position. According to
one legal analysis, there is no express statutory authority for the Fed to purchase corporate bonds, ⁴⁸
mortgages, or equity. But the Fed’s assistance in the Bear Stearns merger with JPMorgan Chase
took a form that has some similarities to the TARP proposal. In the case of Bear Stearns, the Fed
created a limited liability corporation called Maiden Lane, and lent Maiden Lane $28.82 billion.
Maiden Lane used the proceeds of that loan and another loan from JPMorgan Chase to purchase
mortgage-related assets from Bear Stearns. Thus, although the Fed created and controlled Maiden
Lane, the assets were purchased and held by Maiden Lane, not the Fed. Similar to TARP, Maiden
Lane plans to hold the assets until markets recover, and then sell the assets to repay its loans to
the Fed and JPMorgan Chase. Maiden Lane was created under the Fed’s Section 13(3) emergency ⁴⁹
authority.
The Fed was presumably granted broad emergency powers under Section 13(3) so that it had the
flexibility to deal with unforeseen circumstances. Nonetheless, too broad of a reading of its
powers could provoke displeasure in Congress or legal challenges. Creating TARP within the
Treasury through legislation rather than the Fed through emergency powers avoided the argument
whether such a program extended beyond the Fed’s intended role.
Since its early days, one of the Fed’s main roles has been to act as a lender of last resort to the
banking system when private sources of credit become unavailable. The lender of last resort
function can be seen from the perspective of an individual institution or the financial system as a ⁵⁰
whole. From the perspective of the individual institution, discount window lending is meant to
provide funds to institutions that are illiquid (cannot meet current obligations out of current cash
flow) but still solvent (assets exceed liabilities) when they cannot access funds from the private

⁴⁶^In^addⁱ^tⁱ^oⁿ^,^t^h^e^F^e^d^f^{aces so}^m^e^s^t^at^u^t^o^r^y^lⁱ^mⁱ^t^a^tⁱ^oⁿ^s^oⁿ^l^eⁿ^dⁱⁿ^{g t}^o^unde^r^c^a^p^ita^liz^e^d^ba^nk^s^u^nde^r^nor^m^a^l
^ci^rcu^m^st^an^ces.^S^ee,^f^o^{r exa}^m^p^l^e,^S^ectⁱ^oⁿ¹⁰^B^o^f^t^h^{e F}^e^d^e^ral^Reserve^A^c^t^.
⁴⁷^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^L³⁴⁷³^0,^The^Em^e^r^ge^nc^y^Ec^on^om^ic^St^abi^liz^ati^oⁿ^Ac^{t a}ⁿ^d^C^u^r^r^e^{nt Fi}^na^nc^ial
^T^u^rmo^il:^Issu^{es a}ⁿ^d^Aⁿ^alysis^{, by}^B^a^ir^{d W}^e^be^{l a}^{nd E}^d^w^a^r^d^V.^Mur^phy^.
⁴⁸^D^a^vⁱ^{d Sm}^a^{ll a}^{nd J}^a^m^e^s^C^l^ous^e^,^“^T^he^Sc^ope^of^Mo^ne^ta^r^y^P^o^lic^y^A^c^tions^A^u^th^or^iz^e^d^u^nde^r^the^Fe^de^r^a^{l R}^e^s^e^r^v^e^A^c^t,”
^Fe^de^r^a^{l R}^e^s^e^r^v^e^,^FED^S^w^o^r^k^ing^pa^pe^rⁿ^o^.²⁰^04-^40,^J^u^ly²⁰⁰^4,^p.^29.
⁴⁹^T^h^e^Fe^{d a}^l^{so c}^r^e^a^t^e^d^the^T^e^rm^Asse^{t Ba}^c^k^e^d^Lⁱ^quidity^F^a^c^ility⁽^T^AL^{F) to le}^nd^to^priv^a^t^e^inv^e^stors^{to p}^u^rc^ha^se
^illiq^uid^a^sse^{ts of}^the^sa^m^e^t^y^pe^{s t}^h^a^t^T^A^RP^w^a^{s orig}^ina^lly^inte^nde^{d to}^p^u^rc^ha^se^{. T}^A^L^F^{is a}^l^{so a}ⁱ^m^e^{d a}^t^im^prov^ing
^liqui^dity^{, a}^nd^doe^s^{not a}^f^f^e^c^t^the^ca^pita^{l a}^d^e^q^ua^cy^pr^oble^m^{, how}^e^v^er^.
⁵⁰^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^S²¹⁹⁸^6,^Fed^e^ra^{l Reserve: L}^eⁿ^d^e^{r o}^f^L^a^st^Reso^{rt F}^uⁿ^c^ti^oⁿ^s^{, by}^Ma^rc
^L^a^bonte^.

market. Discount window lending was unable to end bank runs, however—bank runs did not
cease until the creation of federal deposit insurance. The experience of the Great Depression
suggested that bank runs placed intolerably high costs on the financial system as a whole, as they ⁵¹
led to widespread bank failures. Discount window lending is not meant to help insolvent
institutions, with one exception explained below.
Access to discount window lending and deposit insurance creates moral hazard for financial
institutions—they can take on more risk than the market would otherwise permit because of the
government safety net. To limit moral hazard, institutions with depository insurance and access to
the discount window are subject to a safety and soundness regulatory regime that includes capital
requirements, reserve requirements, bank examinations, and so on.
The exception to the rule that insolvent institutions cannot access the discount window is when
the institution is deemed “too big to fail.” Institutions that are too big to fail are ones that are
deemed to be big enough that their failure could create systemic risk, the risk that the financial ⁵²
system as a whole would cease to function smoothly. A systemic risk episode could impose
heavy costs on the overall economy, as the bank panics of the Great Depression demonstrated.
Although too big to fail institutions are not offered explicit guarantees, it can be argued that they
have implicit guarantees since the government would not be willing to allow a systemic risk
episode. This accentuates the moral hazard problem described above. There is no official
governmental classification of which financial institutions are too big to fail, presumably since
maintaining uncertainty over which institutions are too big to fail could help reduce the moral
hazard problem. But the lack of official designation arguably creates a vacuum in terms of policy
preparedness. (Making the problem more complex, as one report described the situation,
“Officials grimly concluded that while Bear Stearns isn’t too big to fail, it was too interconnected
to be allowed to fail in just one day.” It is unclear how to judge which institutions are too ⁵³
interconnected to fail.)
As the cases of Bear Stearns, Fannie Mae and Freddie Mac, and AIG illustrate, some of the
modern-day financial institutions that are too big to fail are not depository institutions that fall
under the strict regulatory umbrella that accompanies membership in the Federal Reserve system.
This highlights the shift in financial activity from a bank-dominated financial system at the time
of the Fed’s creation to a system whose health now depends on many types of institutions. The
Fed was set up to be a lender of last resort to only the banking system. In the current crisis, it has
been able to extend its lender of last resort functions to non-bank financial institutions only
because of its Section 13 (3) emergency powers. A policy issue going forward is whether the
extension of these functions should be made permanent, and if so, what types of regulatory
safeguards should accompany it. Because Section 13(3) is intended for emergencies, it grants
authority that is broader and more open-ended than the Fed’s normal authority.
It is possible that part of the reason these institutions failed is because they took on excessive
risks in the belief that they were too big to fail. Although that theory can be debated, it is clearer

⁵¹^Iⁿ^t^h^is^c^o^nte^x^{t, it is}^inte^r^e^s^ting^t^o^note^tha^t^t^h^e^B^e^a^r^Ste^a^r^ns^f^a^ilur^e^ha^s^be^eⁿ^de^s^c^rⁱ^be^{d a}^s^aⁿ^on-^ba^nk^r^un,^m^e^aⁿ^ing
^B^e^a^r^Ste^a^r^ns^w^a^s^unde^r^m^ine^d^be^c^a^us^e^{it w}^a^s^s^hunne^d^by^its^c^ounte^r^pa^r^tie^s^a^{nd i}ⁿ^v^e^s^t^or^s^,^aⁿ^a^l^og^ous^t^o^a^ba^nk^be^ing
^shun^ne^d^by^{its de}^posit^{ors. T}^h^e^de^fⁱ^ning^c^h^a^r^a^c^t^e^r^istic^of^a^{run is th}^a^t^the^f^e^a^r^of^f^a^ilure^be^c^o^m^e^{s se}^l^f-f^ulf^illing^sinc^e^it
^d^e^p^rⁱ^v^{es an}ⁱⁿ^stⁱ^t^u^tⁱ^o^{n o}^f^t^h^{e resou}^r^{ces i}^tⁿ^eed^{s t}^o^avoⁱ^{d f}^aⁱ^l^u^re.
⁵²^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^L³⁴⁴¹^2,^C^ont^aiⁿⁱⁿ^g^Fiⁿ^anc^ia^{l C}^r^is^is^{, by}^Ma^rk^Jⁱ^c^k^ling^.
⁵³^G^r^e^g^{Ip, “}^C^eⁿ^tra^l^Ba^nk^O^f^fe^rs^Loaⁿ^s^to^Brok^e^r^s^,^Cuts^K^e^y^Ra^te^,”^W^a^{ll Str}^e^e^t^J^o^ur^na^l^{, Ma}^rc^h¹⁷^,²⁰⁰⁸^{, p}^.^A¹^.

that the precedent of the Fed’s role in the Bear Stearns acquisition may strengthen the perception
of other institutions and investors that any financial firm, regardless of whether it is a depository
institution, will be bailed out in the future if it is too big to fail, or merely too interconnected to
fail. If so, it could be argued that the Bear Stearns episode may have increased moral hazard
going forward. The government’s decision not to intervene to prevent the failure of the
investment bank Lehman Brothers in September 2008, but to subsequently assist AIG and
Citigroup may have created further market uncertainty regarding which institutions the
government views as too big to fail. Lehman Brothers was larger than Bear Stearns and involved
in similar business activities. Others have argued that the decision to let Lehman Brothers fail
proves that Lehman Brothers was too big to fail, since it set off a wave of unrest in money ⁵⁴
markets (see above), interbank lending markets, and the market for credit default swaps.
The government assistance to Bear Stearns, Fannie Mae and Freddie Mac, and AIG all include
clauses that significantly reduced the value of existing shareholder equity. This was partly
justified in terms of reducing moral hazard—investors would be reluctant to buy equity in too big
to fail companies that were taking excessive risks if the government demanded a reduction in
existing shareholder value. But government assistance in all of these cases made creditors and
other counterparties whole. In these cases, the moral hazard problem manifests itself in a
willingness of creditors to lend to, and counterparties to transact with, a firm they know to be
taking excessive risks, thereby potentially allowing the firm to take more risks. More recent
government assistance to Citigroup was provided without similar measures to replace
management or dilute shareholders. Market participants may view this decision as a signal that
the government is no longer placing emphasis on avoiding moral hazard.
Going forward, policymakers must determine whether new regulation is needed to limit moral
hazard since there may be no credible way to maintain a policy that prohibits the rescue of future
institutions that are too big to fail even if such a policy were desired. The current situation raises
three broad points about systemic risk. First, risk is at the foundation of all financial
intermediation. Policymakers may wish to curb excessive risk taking when it leads to systemic
risk, but too little financial risk would also be counterproductive for the economy. (Indeed, some
would argue that part of the underlying problem for the financial system as a whole at present is
that investors are currently too risk averse.) Second, many analysts have argued that part of the
reason that so much financial intermediation has left the commercial banking system is to avoid ⁵⁵
the costs of regulation. This point applies to future regulatory changes as well. An attempt to
increase regulation on banks could lead more business to move to hedge funds, for example.
Third, financial markets have become significantly more complex and fast-moving in recent
years. Many of the financial instruments with which Bear Stearns, Lehman Brothers, and AIG
were involved did not exist until recently. For regulation to be effective in this environment, it
faces the challenge of trying to keep up with innovation. If used prudently, many of these
innovations can reduce risk for individual investors. Yet the Bear Stearns example implies that
innovation may also lead to more interconnectivity, which increases systemic risk.

⁵⁴^Ch^ai^rm^an^Bern^an^{ke argu}^ed^t^h^at^t^h^{e F}^e^d^dⁱ^{d no}^t^h^a^{ve t}^h^{e aut}^h^o^rⁱ^t^y^t^o^assi^st^L^e^h^m^an^Bro^t^h^e^rs^b^ecau^{se L}^e^h^m^an
^Bro^t^h^e^{rs cou}^l^{d no}^t^o^f^f^e^{r t}^h^{e F}^e^d^a^d^eq^u^a^t^e^co^l^l^at^eral^f^o^{r a l}^o^an^o^f^t^h^{e si}^{ze n}^eed^ed^,^w^hⁱ^c^h^acco^rdⁱⁿ^{g t}^o^Bern^an^ke,^w^o^u^l^d
^h^a^{ve b}^een^m^u^ch^l^a^{rger t}^h^an^t^h^{e as}^si^st^an^{ce f}^o^{r Bear S}^t^earn^s^.^S^{ee Ben}^Bern^an^ke,^“Cu^rren^t^E^c^on^o^mⁱ^c^an^d^Fⁱⁿ^aⁿ^cⁱ^a^l
^Coⁿ^d^itioⁿ^s^{,” sp}^eech^{at t}^h^{e Natio}ⁿ^a^{l A}^sso^ciatioⁿ^f^o^{r Bu}^sin^e^{ss Eco}ⁿ^o^m^ic^A^nnua^{l Me}^e^ting^,^O^c^to^be^r⁷^,²⁰^08.
⁵⁵^T^h^{is pro}^b^le^m^{in re}^la^tion^to^inv^e^stm^e^{nt ba}^nk^ing^ha^{s t}^o^so^m^e^d^e^gree^b^een^o^v^ert^a^ken^b^y^ev^en^t^s^,^{as n}^{one o}^f^t^h^{e f}ⁱ^ve
^la^rg^e^s^{t inv}^e^st^m^e^{nt ba}^nk^{s still e}^x^{ist in t}^h^eⁱ^r^orig^ina^l^f^o^rm^.^L^e^h^m^aⁿ^B^r^othe^{rs ha}^{s e}ⁿ^te^re^d^ba^nk^r^uptc^y^{, Be}^a^r^Ste^a^r^{ns a}^nd
^Me^{rrill Ly}^nc^{h ha}^v^e^m^e^rg^e^d^w^{ith c}^o^m^m^e^rc^ia^{l ba}^nk^{s, a}^{nd G}^o^ldm^a^{n Sa}^c^h^{s a}^nd^Morg^aⁿ^Staⁿ^le^y^ha^v^e^r^e^org^a^niz^e^d^a^s^ba^nk
^hol^ding^c^o^m^p^aⁿ^ie^s^tha^t^a^r^e^r^e^g^u^la^te^{d by}^the^Fe^d.

In normal conditions, the Fed primarily influences economic conditions through the purchase and
sale of U.S. Treasury securities on the secondary market. This enables the Fed to influence overall
economic conditions without favoring any particular financial firm or asset, thus minimizing its
effect on the market allocation of capital.
As the Fed has shifted to an increasing reliance on more direct intervention in the financial
system in 2008, its actions have had growing consequences for the allocation of private capital.
By purchasing commercial paper and Bear Stearns’ assets (via pass-through entities), the Fed has
increased the relative demand for those assets. In a time when liquidity is scarce, access to Fed
borrowing confers an advantage on banks and primary dealers over other types of institutions. It
may also arguably retard the process of weeding out bad institutions, since reputation is needed to
access private liquidity, but not Fed liquidity. On the other hand, during a panic both good and
bad firms can be shut out of credit markets.
Other Fed programs adopted in 2008 also affect the allocation of capital. As discussed above,
assisting Bear Stearns and AIG after their mistakes may encourage inefficiently high risk taking
by other firms that are deemed “too big to fail.” Punitive conditions attached to the assistance ⁵⁶
mitigate but do not eliminate these effects. Allowing primary dealers to temporarily swap their
illiquid assets for Treasuries protects those who invested poorly. Assistance to the commercial
paper market confers and advantage to those firms that access that market, which are generally
large and have high credit ratings. The Fed has attempted to push down yields on certain assets
that it feels have become inefficiently high (e.g., through the Term Asset Backed Securities
Lending Facility), but it may be that at the height of the boom yields on these assets had become
inefficiently low because investors underestimated their riskiness. The Fed’s efforts could
eventually reintroduce inefficient underpricing of risk.
The Fed’s short-term goal is to avoid the downward spiral in conditions that could lead to a panic,
causing serious disruptions to the credit intermediation process for all firms, prudent or otherwise.
But in the long run, once financial stability has been restored, these distortions to the market
allocation of capital could result in economic inefficiencies. There is also a risk that the Fed’s
activities could “crowd out” private lenders and investors in the market for bank reserves and
commercial paper, leading to less robust private markets. Even if some of the Fed’s current
programs are allowed to expire, if investors believed that they would be revived during the next
downturn, capital allocation would be altered.
Some economists have argued that the Fed’s recent string of newly created programs points to
increasing desperation on its part to “right the ship.” Although monetary policy is credited with
having contributed to an unusual degree of economic stability since at least the mid-1980s, some
argue that it has been rendered ineffective by the current outlook. The argument is that lower
interest rates will not boost spending because the economy is stuck in a credit crunch in which
financial institutions are unwilling to lend to creditworthy borrowers because of balance sheet

⁵⁶^F^o^{r exam}^p^l^e,^t^h^{e d}^eci^si^oⁿ^t^o^m^a^k^e^credⁱ^t^o^{rs w}^h^o^l^{e i}ⁿ^t^h^{e case o}^f^{Bear S}^t^earn^s^an^d^A^I^G^red^u^{ces i}ⁿ^ceⁿ^tⁱ^v^{es f}^o^r
^c^r^e^d^{itors to}^c^u^rb^leⁿ^d^ing^t^o^o^t^he^r^institu^tio^{ns de}^e^m^e^d^“^t^{oo b}ⁱ^g^{to f}^a^il.”

concerns. The capital of financial firms has been depleted by investment losses. In turn, financial
firms are said to be hoarding capital and unable to access credit markets because of fears of future
losses. Following September 2008, banks greatly increased their reserve holdings, which could
potentially be a troubling sign. Borrower demand may increase in response to lower rates, but as
long as institutions are trying to rebuild their balance sheets, they will remain reluctant to extend
credit. This problem is sometimes referred to as a “liquidity trap.” Liquidity traps are rare in
modern times, but the decade of economic stagnation suffered by Japan in the 1990s after the
bursting of its financial bubble is cited as an example. Interest rates were lowered to almost zero ⁵⁷
in Japan, and the economy still did not recover quickly.
There are some problems with this line of reasoning at present. First, liquidity traps are seen as an
extreme form of recession, but while the U.S. economy has entered a recession, the fall in
economic output has so far been mild compared to previous recessions. Second, liquidity traps are
most likely to occur when overall prices of goods and services are falling (called deflation). The
Fed cannot reduce the federal funds rate below zero. When prices are falling, real interest rates
are higher than nominal interest rates, so it is more likely that a very low nominal interest rate
would still be too high in real terms to stimulate economic activity. But inflation has been above ⁵⁸
average in 2008, although falling more recently. Inflation would not be expected to be
persistently high if the economy were in a liquidity trap. Third, there is a more benign, well-
documented explanation for why the Fed’s expansionary policy has not yet stimulated economic
activity—monetary policy always suffers lags between a reduction in interest rates and
corresponding increases in economic activity.
While a liquidity trap cannot be ruled out, it is premature to conclude the economy is stuck in one
at this point in time. Liquidity traps are a threat when monetary policy has been kept too tight, but
the Fed has eased monetary policy aggressively since the crisis began.
Other critics have argued that the Fed has created the opposite problem of a liquidity trap—rising
inflation due to excessive liquidity. They argue that the economy has entered a period of
stagflation, where falling or negative economic growth is accompanied by high or rising ⁵⁹
inflation.
Typically, one would expect an economic slowdown to be accompanied by a decline in the
inflation rate. Excess capacity in the capital stock and rising unemployment would force firms
and workers to lower their prices and wage demands, respectively. But critics believe the
economy is in a situation where a modest but persistent increase in inflation in recent years has
led individuals to come to expect higher inflation, and factor that expectation into their price and
wage demands. Couple those higher inflation expectations with rising commodity prices and the
recent unusual large liquidity injections by the Fed, and critics argue that inflation will rise even if

⁵⁷^W^h^ile^the^te^r^m^liqui^dity^tr^a^p^w^a^{s of}^te^{n a}^pplie^{d t}^o^J^a^pa^n,^{it is}^t^h^e^o^r^e^tic^a^l^l^y^de^fⁱ^ne^{d a}^s^a^s^itua^{tion w}^h^e^r^e^hous^e^h^ol^d
^de^m^a^{nd f}^o^r^m^oney^be^c^o^m^e^s^s^o^g^r^e^a^t^tha^tⁿ^o^r^m^a^l^sⁱ^z^e^d^c^h^aⁿ^g^e^s^{in the}^m^oney^s^upply^do^{not a}^f^f^e^c^t^inte^r^e^s^t^r^a^te^s^.^U^nde^r
^{this stric}^t^de^fⁱ^nitio^{n, it}^{is n}^o^{t c}^l^e^a^r^tha^t^Ja^pa^n,^or^aⁿ^y^othe^{r e}^c^oⁿ^o^m^y^{, ha}^{s e}^x^pe^rieⁿ^c^e^d^a^li^qui^dity^tra^p^.
⁵⁸^A^s^s^e^{t pric}^e^s^ha^v^e^be^eⁿ^f^a^lling^la^te^l^y^{, but t}^h^e^y^a^r^e^{not inc}^l^u^d^e^d^{in st}^a^nda^{rd m}^e^a^s^ure^s^of^inf^l^a^{tion, w}^h^ic^{h m}^e^a^s^ure^s^the
^pr^ic^e^s^of^g^oods^aⁿ^{d s}^e^r^v^ic^e^s^.
⁵⁹^Se^e^C^R^S^R^e^por^{t R}^L³⁴⁴²⁸^,^Uⁿ^de^r^s^t^andi^ng^St^agf^lati^on^a^nd^the^Ris^k^{of I}^t^s^Re^c^u^r^r^e^nc^e^{, by}^B^r^ia^{n W}^.^C^a^s^h^e^{ll a}^nd^Ma^r^c
^L^a^bonte^.

the economy slows. They point to the experience of the 1970s, when inflationary expectations
became so ingrained that inflation continued to rise despite a fairly deep recession, as a potential
parallel to the current situation.
Data suggest that the fear of stagflation is premature—both unemployment and inflation remain
relatively low at present. It is true that in the long run inflation is primarily a monetary
phenomenon, and if the Fed’s recent monetary stance were maintained for too long, it would not
be consistent with stable inflation. But in the near term, if unemployment and excess capacity
rose, that would be expected to take much of the pressure off of the inflation rate. Furthermore,
commodity prices fell in the second half of 2008, reversing the immediate upward pressure on
prices. Ironically, if the Fed’s actions succeed in reviving the economy, then the probability that
its actions would boost inflation would increase. The key to maintaining a stable inflation rate is
finding the proper balance between the disinflationary pressures of the slowdown and the
inflationary pressures of expansionary monetary policy. The large amounts of liquidity that the
Fed has added to the system must be removed soon enough that inflation does not rise, but not so
soon that a nascent financial recovery is stubbed out. Given the uncertainty facing policymakers ⁶⁰
at present, finding the proper balance is extremely difficult.

Although turmoil plagues financial markets periodically, the current episode is notable for its
breadth and persistence. It is difficult to make the case that the Fed has not responded to the
current turmoil with alacrity and creativity. The Fed’s inability to restore normalcy is not
necessarily a sign that its policy decisions have been wrongheaded—the Fed can provide the
financial sector with additional liquidity, but it cannot force institutions to use that liquidity to
expand their lending or investing.
The Fed’s response has raised statutory issues that Congress may wish to consider in its oversight
capacity. Namely, the Fed’s role in the Bear Stearns acquisition, the AIG loan, the creation of the
Primary Dealer Credit Facility (a sort of discount window for a group of non-member banks), and
its intervention in the commercial paper market involved emergency authorities that had not been
used in more than 70 years. This authority was needed because the actions involved financial
institutions that were not member banks of the Federal Reserve System (i.e., depository
institutions). But because the authority is broad and open-ended, the Fed’s actions under this
authority are subject to few legal parameters. The authority allows lending to non-member banks,
but the loan in the Bear Stearns agreement is to a LLC that the Fed created and controls, and is
being used to purchase Bear Stearns’ assets. These actions raise an important issue—if financial
institutions can receive some of the benefits of Fed protection, in some cases because they are
“too big to fail,” should they also be subject to the costs that member banks bear in terms of
safety and soundness regulations, imposed to limit the moral hazard that inevitably results from
Fed and FDIC (Federal Deposit Insurance Corporation) protections?
Some policymakers have begun to question whether an institution largely independent from the
elected branches of government should be able to (indirectly) place significant taxpayer funds at
risk by assisting the financial sector through use of its emergency powers. Furthermore, without

⁶⁰^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^{t R}^L³⁴⁵⁶^2,^Slow^G^r^ow^th^or^Iⁿ^fl^atio^n?^The^Fe^de^r^a^{l Re}^s^e^r^v^e^’^s^D^ile^m^m^a^{, by}
^B^r^ia^{n W}^.^C^a^s^h^e^{ll a}ⁿ^d^Ma^r^c^L^a^bonte^.

Congressional input, hundreds of billions of dollars of borrowing by the Treasury (through the
Treasury Supplementary Financing Program) has allowed the Fed to increase its lending capacity
without detrimental effects on inflation. But as long as there is no government program to
systematically manage financial difficulties at too big to fail institutions, the Fed is the only
institution that can step in quickly enough to cope with problems on a case-by-case basis. While
some had believed TARP provided the type of systemic approach that would allow the Fed to
return to a more traditional role, the Fed’s subsequent creation of lending facilities to support the
commercial paper market suggests that TARP cannot cover all unforeseen contingencies.
^{Marc L}^a^bon^t^e
^Specialis^{t i}ⁿ^Macroecon^o^mⁱ^c^P^o^licy
^m^l^abon^t^e^@^c^rs^.l^oc.g^o^v^{, 7-}⁰⁶⁴⁰