Understanding the Role of the Fed in Today's Credit Crisis
With all the headlines screaming Credit Crisis! and Mortgage Meltdown!, what is the Federal Reserve doing about the situation? Are they doing enough? Should they be doing more???Well... the Fed IS doing something; we just need understand WHAT they are doing.
In order to understand the current credit crisis, please reference the article entitled, Saga of the US Mortgage Industry. Assuming you have read that article, you know that we are currently facing a "run on the mortgage banks" by the Wall Street investors and warehouse lenders who provide funding for US mortgage loans. Well, the Fed has looked at this situation and basically said, "Hmmmm, we better provide these financial institutions with a new source of short term funding so that they can continue to operate even during this liquidity crunch." There are currently five options for the Fed’s involvement:
It would be reckless for the Fed to reduce the amount of reserves banks are required to maintain because that would encourage banks to take more risk in an already risky environment. Therefore, this option is out of the question for the most part.
Option #2 - Lend money directly to the banks that are part of the Federal Reserve System through what is called the "discount window"
As far as the discount window, the Fed has lowered the discount rate through a series of rate cuts to 0.5% from the 6.25% rate that was effective in August, 2007.
You are on the run from the police who don’t really know that you are on their side in the first place. After a few days on the run, you start getting hungry. You find a grocery store, find some food and proceed to the check-out line. You are faced with two choices:
If you use the credit card, you know that the authorities will be monitoring all the activity on that card. This will tip them off to your location and BAM – you are caught! On the other hand, if you pay cash for the food, you can remain anonymous and continue with whatever it is you are doing to prove your innocence and give the movie a happy ending.
The banking industry is like an action movie, and the banks that need funds are like the heroes of the movie. The banks on the sidelines are like the authorities. If you are a bank that needs funds, and you go directly to the Fed and borrow from their discount window, this would tip off all the other banks that you could be experiencing financial difficulty. This in turn causes them to be more cautious when dealing with you and could potentially result in driving down your stock price because the stock market may interpret this as a sign of financial weakness.
That is why the discount rate is often referred to as symbolic, as most banks don’t like to borrow from the Fed’s discount window if they can avoid it. If a bank finds other sources of funding outside of the Fed’s discount window, they can borrow anonymously and avoid tipping off all the other banks to the fact that they are in need of short term funds.
Option #3 - Open Market Activities where the Fed injects cash into the banking system by purchasing the Treasury securities held by various banks and financial institutions
The Fed uses their “open market activities” to regulate the supply and demand of cash that is available between banks. They do this by buying or selling the Treasury securities held by the banks. Financial institutions can then use this cash injection to meet their liquidity needs. This process directly impacts the Federal Funds Rate, which is the interest rate banks charge each other for short term funds.
You see, the Fed sets a “target” for the Fed Funds Rate and then uses their open market activities to reach that target by altering the supply of cash available to the banks that are part of the US Federal Reserve System. This “wholesale” cost of borrowing money called the Fed Funds Rate trickles down into the various retail interest rates that banks charge the retail customers who borrow money from them. From September, 2007 through December, 2008, the Fed lowered the Fed Funds rate from 5.25% to 0% in response to the credit crisis and economic slowdown. The current Fed Funds rate is in a range between 0% - 0.25%.
For more info on how the Fed Funds Rate affects you and your mortgage, please see the article entitled The Fed and YOU.
Option #4 – The Term Auction Facility where the Fed auctions funds to banks that need short term financing
This is one of the latest tools that the Fed has created to help banks through the current credit crisis. Essentially, this auction process allows banks to bid anonymously on what interest rate they are willing to pay in order to borrow money directly from the Fed. Remember, if banks borrow money directly from the Fed using the discount window, this becomes public knowledge and could be interpreted as a sign of financial weakness. Therefore, on December 12, 2007, the Fed announced the creation of the Term Auction Facility where banks can borrow money directly from the Fed as part of a private bidding process that allows banks to maintain their anonymity. Since then, the Fed continues to roll over approximately $150 billion per month in short term loans through the Term Auction Facility, and this program has been extended for the foreseeable future.
Option #5 - Term Securities Lending Facility where the Fed lends money directly to non-depository financial institutions like brokerage firms and investment banks
The Federal Reserve is typically only allowed to lend money to commercial banks and other banks that take deposits from businesses and individual customers. However, under extreme financial emergencies, the Fed is allowed to lend money to stock brokerage firms, investment banks and other financial institutions that don’t take deposits. The Fed has not exercised this right since the days of the Great Depression back in the 1930s. However, on March 16, 2008, the Federal Reserve Board voted to authorize the Federal Reserve Bank of New York to lend money directly to non-depository institutions. This was the first time the Fed allowed such a thing to happen in over 70 years! Not only that, but the Fed also announced that it would accept high quality mortgage backed securities that were not issued by Fannie Mae and Freddie Mac as collateral for the loans they issued to these financial institutions. This provided even further flexibility and helped create a more liquid market for mortgage backed securities.
So there you have it!
In response to the current credit crisis, the Fed has:
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