sign in sign up
<<
Home , Financial risk, Moral hazard

Vol. 3, No. 10 October 2008­­ EconomicLetter

Insights from the of Dallas

Fed Intervention: Managing Moral in Financial Crises by Harvey Rosenblum, Danielle DiMartino, Jessica J. Renier and Richard Alm

Editor’s note: At the end of September 2008, U.S. policymakers had been working Federal agencies and regulators have for more than a year to contain the shock waves from plunging home prices taken decisive steps and the subsequent turmoil. For the Federal Reserve, the to combat the financial crisis that crisis has given new meaning to the adage that extraordinary times call for ex- began in the traordinary measures. The has dusted off Depression-era powers summer of 2007 and continued into and rewritten old rules to address serious to the . the fall of this year. This Economic The spreading financial crisis has led the Fed to pump liquidity Letter focuses on key into the economy and expand its lending beyond the commercial banking Federal Reserve actions through sector. In March, it assisted with J.P. Morgan Chase’s buyout of Bear Stearns, a early October. -strapped bank and brokerage. Six months later, the Fed took

direct action again, with an $85 billion bridge to prevent the disorderly failure of American International taken a hard turn toward intervention Group (AIG), a giant global company in an atmosphere in which fear of heavily involved in insuring against has been displaced by debt defaults.1 the reality of systemic ’s unaccept- These Fed actions—part of a able consequences. broader U.S. government effort to con- Fed intervention helped defuse tain the financial crisis—call to mind threats to the financial system from two earlier financial interventions: in the LTCM’s failure and the 9/11 terror- case of Long-Term Capital ist attacks. The central bank accepted (LTCM) in 1998 and in the aftermath of the moral hazard from intervention as the Sept. 11, 2001, terrorist attacks. the price for avoiding larger financial In both episodes, the Fed felt breakdowns. In the current crisis, the compelled to protect the financial sys- Fed’s actions have no doubt mitigated tem from severe shocks and the over- damage to the financial system and Concern about moral all economy from spillovers that might economy. Doing so, however, required produce serious downturns. Inherent developing new tactics to address the hazard helps explain why in the Fed’s moves was a natural by- crisis, going far beyond the traditional product of intervention—moral hazard instruments of monetary policy. the Fed has traditionally and the controversy that flows from it. Concern about moral hazard helps Intervention’s By-Product intervened only rarely and explain why the Fed has traditionally Moral hazard, a term first used intervened only rarely and reluctantly, by the industry, captures the reluctantly, trying to do trying to do what’s necessary, but as unfortunate paradox of efforts to miti- little as necessary, to achieve financial gate the adverse consequences of risk: what’s necessary, but as stability. Markets generally should and They may encourage the very behav- do self-correct. When potential finan- iors they’re intended to prevent. For little as necessary, to achieve cial problems arise, the Fed’s example, individuals insured against reaction has usually been to do noth- automobile theft may be less vigilant financial stability. ing and let the markets work their way about locking their cars because losses through the difficulties. due to carelessness are partly borne by On rare occasions, however, the the insurance company. markets themselves are at risk of fail- Moral hazard occurs whenever an ure. In such cases, the Fed can’t fulfill institution like the Fed cushions the its obligation to promote financial sta- adverse impact of events. More to the bility without direct action. Two factors point, lessening the consequences of have strengthened the case for central risky financial behavior encourages bank intervention in the past decade— greater carelessness about risk down the financial system’s increased global- the road as come to count on ization and the untested nature of the benign intervention. Moral hazard must new and complex financial instruments be weighed carefully in responding to that have come under stress. financial crises. The escalation of what’s now rec- In the cases of Bear Stearns and ognized as a global financial crisis has AIG, some argue that the greater good changed the modus operandi of Fed would have been served had the Fed interventions. The guiding principle of stood back and allowed the firms to do what is necessary, but as little as fail, immediately taking all manage- necessary, has been replaced by the ment, shareholders and creditors down recognition—reinforced by actions—of with them. This course would avoid the importance of doing whatever it moral hazard entirely—and satisfy the takes to break the downward spiral in general public’s desire for seeing Wall the financial and markets that Street highfliers brought low. has contaminated the overall economy. The Fed, however, must be ever With a broad understanding of the vigilant in its mission. The Federal consequences of inaction, the Fed has Reserve Act explicitly and implicitly

EconomicLetter 2 Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas EconomicLetter sets out several mandates to guide Fed financial markets and the economy.2 actions. The most important are Maximizing macro moral haz- • Full employment and sustain- ard recognizes the Fed’s obligation able economic growth; to reduce the risks of and • Price stability; price instability and the risks stemming • Banking and financial system from an unstable banking and finan- stability. cial system. By fostering a more stable By intervening in a financial crisis, macroeconomic environment, the Fed’s the Fed doesn’t allow markets to play policy actions reduce the private sec- their natural role of judge, jury and tor’s pain from bad decisionmaking. executioner. This raises the specter The outright, uncontrolled col- of setting a dangerous precedent that lapse of Bear Stearns or AIG could could prompt private-sector entities to have harmed millions of households take additional risk, assuming the Fed and companies as financial market will cushion the impact of reckless troubles brutalized accounts, When intervention is the only decisionmaking. So when intervention paralyzed the flow of capital, and is the only , the Fed has the ultimately led to layoffs, stunted con- option, the Fed has the duty duty to minimize micro moral haz- sumption and a severe recession. The ard—that is, the benefit to any specific goal of Fed intervention is to prevent, to minimize micro moral firm or industry. or at least forestall, such macroeco- Minimizing micro moral hazard nomic spillovers.3 hazard—that is, the starts with imposing tough terms—gen- erally the orderly closure of the trou- Fund on the Edge benefit to any specific firm bled firms that benefit from interven- Long-Term Capital Management tion. The Fed didn’t just shovel money provides an apt starting point for a or industry. at Bear Stearns’ and AIG’s problems. discussion of Fed intervention because It demanded collateral for the it involved the first financial disruption and charged interest—in AIG’s case, at after the rapid expansion of the shadow high rates. banking system, a shorthand term for Minimizing micro moral hazard the financial services segment that means keeping information about the includes big brokerage firms, hedge targets, timing and terms of any poten- funds and innovative financial products tial intervention as vague as possible, like structured investment vehicles.4 a tactic sometimes called “constructive These entities aren’t subject to the same ambiguity.” supervision as , so they don’t Minimizing micro moral hazard hold as much capital to cushion them- also means aiding selected firms only selves against losses. as a last resort. Federal authorities A high-profile founded found alternative solutions short of in 1993, LTCM brought together the direct intervention for some financial best minds of academia and Wall Street. giants. The Fed expedited the reclassi- John W. Meriwether, former manager of fication of investment banks Goldman one of ’ most profit- Sachs and Morgan Stanley to bank able divisions, recruited renowned holding companies. Private-sector buy- Ph.D.’s such as Myron Scholes and ers acquired Merrill Lynch, Washington Robert Merton, soon-to-be winners of Mutual and Wachovia. the 1997 Nobel Prize in , When direct intervention does and former Fed Vice Chairman David take place, the Fed’s duty goes beyond Mullins. The partners’ aim was to profit minimizing micro moral hazard. The from market-price anomalies using com- central bank has the equally important plex mathematical models. responsibility to maximize macro moral At its peak, the fund earned hazard—a somewhat counterintuitive stunning returns of more than 40 per- term that captures the greater good cent. In 1997, as increased competi- of preventing unnecessary damage to tion began squeezing margins, LTCM

EconomicLetter Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas 3 EconomicLetter reached for high returns by leverag- of LTCM triggered the seizing up of ing its capital through risky securities markets, substantial damage could repurchase contracts and derivatives have been inflicted on many mar- transactions. By some accounts, the ket participants, including some not fund used capital of $2.3 billion to directly involved with the firm, and support of $125 billion. could have potentially impaired the The first sign that LTCM might economies of many nations, including be in trouble came when the fund our own.” lost 10 percent on its investments in The Fed’s action helped contain June 1998. The situation worsened in possible spillovers, but it didn’t pre- mid-August, when a deep decline in serve LTCM. The hedge fund failed, oil prices left the economies of Russia but in a way that minimized the and other oil-exporting countries in a impact on financial markets and the precarious state. Russia’s debt default economy—at the cost of both micro The threat of and devaluation of the ruble prompted and macro moral hazard. a massive flight of investors from risky led the Fed to help arrange securities to U.S. Treasuries and a dra- Financial Crisis Averted matic widening in interest rate spreads. On Sept. 11, 2001, terrorists a managed unwinding of Global bond markets plunged, hijacked four planes, crashed two into and in August alone, LTCM lost $1.8 New York’s World Center, a LTCM’s affairs, which would billion—44 percent of its capital. third into the Pentagon and a fourth Losses piled upon losses and reached in a field in Pennsylvania. The nation let the fund fail and avoid a $4.8 billion. As LTCM faced increasing watched in horror as both WTC towers margin calls, default was imminent. collapsed. The financial system wasn’t fire sale of its . The speed with which LTCM spi- the target per se, but it was thrown raled out of control recalls an old say- into disarray. The most direct impact ing in financial circles: If I owe a bank was the closure of U.S. financial mar- a million dollars and I can’t pay, I’m in kets for four days—only the seventh trouble. If I owe a bank a billion dol- time they’d shut down for such a long lars and I can’t pay, the bank’s in trou- stretch. A secondary impact came from ble. If I owe a dozen banks billions of the closure of U.S. airspace, which dollars each and I can’t pay, the bank- stopped the movement of mail and ing system could be in trouble. checks around the country. The threat of systemic risk led Exacerbating the situation was the Fed to help arrange a managed the backdrop against which the events unwinding of LTCM’s affairs, which occurred. The U.S. economy was would let the fund fail and avoid a in the sixth month of a recession, fire sale of its assets. On Sept. 23, the although this wasn’t widely recog- New York Fed facilitated a meeting nized at the time, not even within the with top executives from 14 Wall Street Fed. And financial markets were skit- and international banking firms. With tish, mired in the biggest bear market the exception of Bear Stearns, which since the Great Depression. By early declined to participate, the financial September, the Standard & Poor’s 500 institutions agreed to back a capital Index was down 29 percent from its infusion of $3.5 billion. The deal trans- March 2000 peak and the Nasdaq had ferred oversight and veto power and a lost 67 percent of its value. 90 percent equity stake to the consor- Immediately after the attacks, the tium, leaving a 10 percent stake for the S&P 500 futures declined precipitously, LTCM partners as an incentive to close and chaos reigned on the streets near down operations in an orderly fashion.5 the New York Fed, the New York In his Oct. 1, 1998, congres- Exchange and elsewhere in the sional testimony, Fed Chairman Alan financial district—all within blocks of Greenspan explained why the Fed the fallen towers. It became apparent decided to intervene: “Had the failure that U.S. financial markets couldn’t

EconomicLetter 4 Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas EconomicLetter open. At 10 a.m., 74 minutes after the In the wake of 9/11, the Fed cast first plane hit the World Trade Center a wide and deep safety net to pre- and 30 minutes after the ’s vent the systemic risk that could have scheduled opening, the Fed released resulted from a meltdown of the finan- a statement: “The Federal Reserve cial system spreading to the U.S. and System is open and operating. The other economies around the globe. discount window is available to meet Despite the obvious need for interven- liquidity needs.” tion, the Fed’s actions entailed some Though the financial markets degree of moral hazard. would remain closed for the rest of the week, the Fed did indeed remain open. The Current Crisis In the days after the terrorists struck:6 Signs of trouble began surfacing • The discount window lent $45.5 in February 2007, when a handful of billion on Sept. 12, compared financial companies took losses on with the Wednesday average of assets related to U.S. subprime mort- In the wake of 9/11, the Fed $59 million the previous two gages. What would become the worst months. financial crisis since the Depression cast a wide and deep safety • Check float jumped to $22.9 wasn’t widely acknowledged for six billion that day, well above more months—not by financial mar- net to prevent the systemic the two-month average of $720 kets, not by policymakers.8 million. Since then, banks, brokerages, risk that could have resulted • The New York Fed used open investment houses and hedge funds market operations to inject $61 worldwide have revealed a seemingly from a meltdown of the billion in liquidity into the econ- endless succession of losses, write- omy on Sept. 12, then added downs and outright failures. Behind financial system spreading another $38 billion on Sept. 19. the crisis is the collapse of a five-year • The Fed arranged foreign boom in housing prices that had been to the U.S. and other exchange swap lines with the fueled by risky and exotic mortgage European Central Bank, the financing backed by unprecedented economies around the globe. Bank of England and the Bank levels of leverage. of Canada to provide dollar Some subprime loans offered liquidity to global markets. low initial interest rates; others only When the markets reopened required interest payments, needed no Sept. 17, the Federal Open Market down payment or were made with no Committee (FOMC) held an emergency proof of income. The mortgages were conference call and cut the fed funds bundled into multilayered securities rate, which applies to banks’ short- graded by risk, then sold to hedge term borrowing from one another, funds, investment banks, insurance from 3.5 percent to 3 percent. As companies and other investors, many other short-term rates fell in response of which sought to reduce risks associ- to the Fed’s move, many ated with the mortgages by purchasing and individuals saw their borrowing credit default swaps (CDS). costs decline. The statement the Fed A relatively new entry in the released in announcing its action reit- financial , these erated the central bank’s commitment instruments committed one party to to providing liquidity and keeping the cover its counterparty’s losses should fed funds rate below target, as needed. an investment go sour. In 2000, the Although the Dow Jones industri- CDS market was $1 trillion; by 2008, als suffered what was, until the cur- it was $62 trillion, roughly 4.5 times rent crisis, its worst one-day point loss U.S. gross domestic product. These on Sept. 17, panic was averted.7 The derivatives helped fuel the surge in payments system returned to normal mortgage-backed securities by reduc- within days, and the recession ended ing perceived default risk. two months later. When the housing bubble burst,

EconomicLetter Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas 5 EconomicLetter default risk far exceeded what inves- undermines the ability of other firms to tors had anticipated, and the market fulfill their obligations. Markets would for mortgage-backed securities cra- begin doubting the counterparties, and tered. Financial institutions found investors would flee these companies, themselves holding large portfolios of leaving them to face the grim task of hard-to-value assets that could only be attracting new capital in skeptical mar- sold at fire-sale prices. kets. If they can’t, they sink into trou- As assets deteriorated, we began ble. A significant number of troubled to hear a lot about counterparty risk. firms would trigger systemic risk. What if CDS sellers couldn’t fulfill their Credit default swaps and other obligation to insure assets against loss- financial innovations hadn’t been test- es? If a major player in the vast, tan- ed under adverse conditions. What’s gled credit derivatives market were to more, they took off at a time when collapse, it could start a chain reaction markets and the economy had become in which one counterparty’s default more globalized and technology-driv-

Minimizing Micro Moral Hazard: The Fed Rarely Intervenes

No Take no action • Customary response • No moral hazard • Markets self-correct Potential Assess economic Threat to Fed’s goals? Financial and financial conditions • Full employment/sustainable Crisis • Initial conditions matter economic growth • Price stability • Banking/financial system Yes Manage moral hazard stability in least costly way • Rare response • Contain the problem • Support the financial system • Intervention targets ultimately fail, but in orderly way

This decision tree summarizes how the Fed strives to manage the resulting moral hazard in the bled investment bank and brokerage with sufficient responds to potential financial crises. After getting a least costly way. remaining collateral to support the intervention. reading on the economy’s vital signs, the Fed deter- The first choice entails the Fed’s acting as an out- When private partners aren’t willing to step up, the mines whether the threat at hand might compromise side coordinator to bring together private institutions Fed can act alone if troubled firms still have sufficient the central bank’s three primary goals. to defuse the threat. It’s a strategy that minimizes collateral. In September 2008, the Fed arranged a If the Fed sees little risk, no action is taken, avoid- public-sector risk, and the central bank used it with the purely public intervention for AIG, a huge financial ing moral hazard and leaving the markets to sort out Long-Term Capital Management hedge fund in 1998. services company. the difficulties. The Fed reacts this way to nearly all When this option isn’t feasible, the Federal Reserve If remaining collateral is insufficient to support potential troubles in the financial sector. Act provides the authority to deal directly with press- taxpayer-financed actions, the Fed under current law A pervasive threat to the overall economy or the ing threats. The preferred strategy involves forging is obliged to let the markets decide a troubled firm’s financial system can justify direct action. The Fed with private institutions, a course the fate. The Fed accepted this outcome with Lehman rarely makes these interventions; when it does, it Fed took in March 2008 with Bear Stearns, a trou- Brothers in 2008.

EconomicLetter 6 Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas EconomicLetter en, factors that both made the financial prised financial markets by reducing universe more complex and increased the fed funds rate to 4.75 percent. The uncertainty about how to respond to Board also cut the discount rate a half potentially widespread failures of these point. Over the next year, the FOMC new instruments. cut the fed funds rate eight more The Fed didn’t sit idly by as trem- times, dropping it to 1 percent at the ors shook the financial markets. As end of October.9 The Board gradually with the 9/11 threat, its initial response reduced the discount rate from 5.75 focused on injecting liquidity into the percent on Sept. 18, 2007, to 1.25 per- financial system. On Aug. 17, 2007, cent on Oct. 29, 2008. the Federal Reserve Board cut a half Unlike the Long-Term Capital percentage point off the discount rate, Management and 9/11 episodes, which making it cheaper for commercial resolved themselves quickly, the latest banks to borrow short-term funds from financial turmoil continued to bubble the Fed. On Sept. 18, the FOMC sur- throughout 2008, leading the Fed to

Target Firm Fails

100% private-sector Public–private hybrid solution possible • Example: Bear Stearns • Example: LTCM

Sufficient collateral available • Invoke Federal Reserve Act § 13.3 Government control/ 100% private-sector • Minimize public-sector risk ownership solution not possible • Example: AIG

Insufficient collateral Firm declares available bankruptcy • Fed and Treasury legally • No moral hazard constrained • Market solution • Example:

EconomicLetter Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas 7 EconomicLetter take unorthodox steps to make money became self-reinforcing, compelling available to the financial system. The some trading partners to pull back central bank opened its lending opera- from doing with Bear Stearns. tions to different kinds of financial insti- A de facto run had begun. tutions, granted longer-term loans and On Thursday, Bear Stearns’ CEO accepted a broader range of collateral. reached out to the New York Fed In December 2007, the Fed intro- and the Treasury Department, setting duced the first of several new lending into motion a whirlwind that would mechanisms—the term auction facility, bring an end to an institution that had which lends to banks for longer peri- accumulated $1.6 billion in losses and ods and usually at a lower rate than write-downs. Two days later, a firm they could secure via the discount that had a peak market value of $25 window. Part of the reasoning behind billion in January 2007 was offered to the new facility was to avoid the per- J.P. Morgan Chase for $236 million, a The central bank opened its ception that discount window borrow- mere 3 cents on the dollar. ing is a sign of financial weakness. When Bear Stearns sought help, lending operations to A stickier issue was capital con- the New York Fed could have done straints at primary dealers, a class of what the Fed usually does when a ship different kinds of financial lenders not regulated by the Fed and is at risk of sinking on its watch: noth- without access to its credit facilities. ing. Bear Stearns would have been institutions, granted longer- (See box titled “Primary Dealers’ Critical allowed to fail, and the Fed would have Role.”) The term securities lending stood witness to a company reaping term loans and accepted a facility, established in March 2008, pro- what its missteps had sown. The tale vides extra liquidity through a 28-day would have been tragic in the same broader range of collateral. program that allows, for a fee, primary vein as the fates suffered by Drexel dealers to acquire Treasury-grade assets Burnham Lambert, the Wall Street by using riskier assets as collateral. brokerage that fell victim to the junk The primary dealer credit facil- bond bust of the 1980s, and Enron, the ity, also created in March, extends the energy giant that toppled in 2001. Fed’s safety net by opening discount The Fed did nothing for Drexel or window loans to primary dealers. Enron. However, it supported the J.P. As the financial crisis deepened, the Morgan deal with an unprecedented Fed created lending programs to add $29 billion loan to an entity created to liquidity to other segments of the purchase largely mortgage-related Bear financial markets. In September, for Stearns assets. The agreement calls for example, the central bank made mon- the loan, made at the discount rate ey available to foreign central banks, for up to 10 years, to be repaid as the commercial paper investors and money assets are sold. If they appreciate by market funds. more than operating expenses, the Fed No lending facility could effec- stands to make a profit. It will bear any tively address the kind of crisis of losses beyond the $1.15 billion contrib- confidence that befell Bear Stearns, an uted to the entity by J.P. Morgan. investment bank and brokerage that The Fed decided to facilitate the had been a Wall Street fixture since Bear Stearns sale because it feared dire 1923, surviving even the stock mar- consequences for the financial system. ket crash of 1929 without laying off Bear Stearns had open with no employees. fewer than 5,000 other firms. On a On Monday, March 10, 2008, much grander scale, the firm was one rumors hit European trading floors of the world’s largest counterparties, that Bear Stearns might be unable to reporting in a Nov. 30, 2007, Securities fulfill commitments for its trades. The and Exchange Commission filing that company’s management was quick to its holdings had total lever- address the reports but couldn’t quash age of $13.4 billion. The company the mounting . The rumors was involved in 750,000 contracts in

EconomicLetter 8 Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas EconomicLetter March 2008, according to the New York Fed. Allowing the company to default would have triggered the first Primary Dealers’ Critical Role stress test of the fast-growing, interwo- ven derivatives market, an event that Primary dealers are banks and securities broker-dealers that trade in U.S. government would undermine the Fed’s ability to securities with the Federal Reserve Bank of New York. They’re vital to monetary policy because meet its legal mandates for growth, the New York Fed’s Open Market Desk trades on behalf of the Federal Reserve System. price stability and financial stability. Purchasing government securities in the secondary market adds reserves to the banking The Fed actions were aimed at system; selling securities drains them. reducing risks to the financial system, The New York Fed established the system in 1960 with 18 primary dealers. The number not helping Bear Stearns’ owners. peaked at 46 in 1988 before starting to decline in the mid-1990s. By 2007, it was down to 20. The company’s stock price peaked The main reason for the dwindling number of dealers has been consolidation, as firms have above $171 a share in January 2007, merged or refocused their core lines of business. (A list of primary dealers can be found on the representing a market capitalization of New York Fed’s website at www.newyorkfed.org/aboutthefed/fedpoint/fed02.html.) some $25 billion. Despite the financial In addition to their role in monetary policy, primary dealers are important in keeping the turmoil of early 2008, it was at $70 a nation’s fiscal house in order. The federal government tends to spend more each year than share just before the ill-fated week of March 10–17. It’s difficult to fathom it takes in from revenue. To keep Washington open and operating, and the government how much more the Fed could have functioning around the world, the Treasury raises money by selling bills, notes and bonds to adhered to its commitment to minimize investors. In recent years, more than half the money raised has come from foreigners. micro moral hazard, considering the Primary dealers handle the bulk of the —that is, the buying, handling and $2 a share price reached during the distribution of the U.S. debt. In addition to distributing new Treasury securities, the dealer negotiations. To keep Bear Stearns network makes a deep, broad and liquid secondary market for previously issued Treasury out of bankruptcy court, J.P. Morgan securities. Chase eventually raised its offer to A liquid secondary market enhances the marketability of Treasury debt and lessens the $10 a share, or $1.4 billion, still a faint burden of financing government operations for taxpayers. Without this network of dealers, the shadow of where the market had val- Treasury would be hard-pressed to reliably finance essential government services. ued Bear a year earlier. An efficient primary dealer network is important for other reasons. Nearly all debt is The authority to intervene in priced off of interest rates on similar maturity Treasury securities. The Treasury rate is the Bear Stearns can be found in a 1932 so-called risk-free rate in the economy. Private-sector borrowers pay the risk-free rate, plus a amendment to the Federal Reserve premium to compensate for potential default risk. Act, allowing the central bank to make The U.S. and global financial systems, not to mention the U.S. economy and its millions direct loans outside the banking sys- of businesses and households, are absolutely dependent upon a smoothly functioning and tem “in unusual and exigent circum- reliable Treasury market for financing their credit needs. If the Treasury market is closed or not stances.” The power was last used in working properly because of problems with the primary dealer network, credit can’t be priced 10 the Great Depression. and can’t flow, leaving the private sector starved for credit. The Fed used this authority again With the primary dealers’ pivotal role in mind, on March 16 the Federal Reserve Board when AIG appeared on the brink. The invoked the emergency provisions of the Federal Reserve Act, authorizing the New York Fed company’s sound businesses were to extend the discount window’s safety net to primary dealers. In its announcement, the Fed being threatened by the excessive CDS said it created the primary dealer credit facility to “bolster market liquidity and promote orderly risks taken by its London-based AIG market functioning.” The action left no doubt about primary dealers’ important role: “Liquid, Financial Products unit. After a year in which AIG took $18 billion in losses, well-functioning markets are essential for the promotion of economic growth.” the company faced a cash crunch after mid-September downgrades to its cred- it rating. It needed a $13 billion capital , secured by warrants, infusion in a week in which investors to purchase nearly 80 percent of the showed their lack of confidence in the company if AIG fails to raise enough company by driving down its stock money through sales or other price 80 percent. means to repay the loan. The Sept. 16 When AIG couldn’t raise money agreement’s interest rate was steep— in the private sector, it turned to the indeed, punitive—at 8.5 percent above Fed and the Treasury. The central the London interbank offered rate bank provided a two-year, $85 billion (Libor), an industry benchmark.11

EconomicLetter Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas 9 EconomicLetter Like Bear Stearns, AIG had invest- The impact—both predictable and ed heavily in CDS markets. At the unpredictable—of Lehman’s failure end of September 2007, its Financial reverberated immediately through glob- Products unit had $505 billion in expo- al financial markets. The fallout spread sure, stretching into many parts of the to individuals and businesses with world. A year later, AIG had written seemingly no connection to Lehman. down a fifth of its exposure but still In the LTCM and Bear Stearns stood on the precipice. In announcing interventions, the Fed contended its its decision on Sept. 16, the Fed said actions were necessary to keep finan- it saw enough risk to conclude that “a cial markets from seizing up and to disorderly failure of AIG could add to minimize the negative spillovers on the already significant levels of financial broad economy. The Fed feared that market fragility and lead to substan- the quick and disorderly failures of tially higher borrowing costs, reduced some financial enterprises would have Interestingly, some critics household wealth and materially weak- systemic effects on the nation and er economic performance.” likely, around the globe. who chastised the Fed for Many critics contend that Bear In April 3, 2008, testimony to Stearns and AIG were “bailed out.” Congress about the Fed’s intervention in creating moral hazard with Former Treasury Secretary Paul O’Neill Bear Stearns, New York Fed President refuted this notion in a New York described the adverse Bear Stearns declared that Times exchange on Bear Stearns:12 consequence the Fed sought to avoid: Times: Do you think it was “Asset price declines … led to a reduc- moral hazard should have appropriate for the Federal Reserve to tion in the willingness to bear risk lend a helping hand to Bear Stearns and to margin calls … [resulting in] a been disregarded in the case and save a private investment com- self-reinforcing downward spiral of … pany from its own bad decisions? forced sales, lower prices, higher vola- of Lehman. O’Neill: I would say they didn’t tility and still lower prices.” save Bear Stearns. They saved the Geithner cataloged the possible financial system from a panic collapse. spillover effects from Bear Stearns’ col- I reject the notion they helped Bear lapse—protracted damage to the finan- Stearns. Bear Stearns was destroyed. cial system, widespread insolvencies [Emphasis added] and ultimately higher unemployment Times: No it wasn’t. It was pur- and borrowing costs, and a lower chased by J.P. Morgan, which will standard of living because of losses to keep it alive. retirement . O’Neill: They’re going to keep Why didn’t similar arguments per- the book alive. But the institution suade the Fed to prevent the collapse of Bear Stearns has been destroyed. of Lehman, an investment bank and They’ve gone from $158 to $2 of equi- primary dealer comparable to Bear ty. It’s wallpaper. It’s not even good Stearns in size and importance? The wallpaper. It’s butcher paper. answer, according to Fed Chairman Ben Bernanke and Treasury Secretary The Lehman Decision Henry Paulson, came down to unten- Roughly six months after the Bear able taxpayer losses and doubts about Stearns intervention and amid AIG’s the legal authority to intervene in this unraveling, another Wall Street invest- particular case. ment bank and primary dealer found A few weeks after Lehman’s bank- itself on the brink. Round-the-clock ruptcy, Bernanke addressed the issue: efforts by the Fed and Treasury to find “Facilitating the sale of Lehman … a buyer for Lehman Brothers Holdings would have required a very sizeable over the weekend of Sept. 13–14 fell injection of public funds … and would apart. On Monday, Lehman became the have involved the assumption by tax- largest bankruptcy in U.S. history, list- payers of billions of dollars of expect- ing liabilities of $613 billion in its filing. ed losses…. Neither the Treasury nor

EconomicLetter 10 Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas EconomicLetter the Federal Reserve had the authority demise? In particular, should moral to commit public money in that way; hazard be categorically and systemati- in particular, the Federal Reserve’s cally avoided? With the interconnect- loans must be sufficiently secured to edness of the global economic and provide reasonable assurance that the financial systems, it’s clear that fire loan will be fully repaid. Such collat- sales can spread to distant places and eral was not available in this case.”13 impact economic entities far removed Lehman had months to find from the initial calamity. It took the private buyers for all or parts of its collateral damage from Lehman’s bank- enterprise. None could be found, not ruptcy for this to be widely appreci- even with the help of the Fed and the ated by those who have invoked moral Treasury. And the firm’s condition had hazard to argue against Fed interven- deteriorated to the point where the tions. Moral hazard has its costs, but it Fed couldn’t find sufficient collateral also has its benefits. for a primary dealer credit facility loan. Like it or not, central Within hours of Lehman’s bank- The Fed’s Hippocratic Oath ruptcy filing, the negative consequenc- A basic precept taught in medi- bankers face the reality that es contemplated by Geithner in Bear cal schools is first, do no harm. All Stearns’ case began to unfold. Losses interventions—whether they involve managing moral hazard tied to holdings of Lehman debt forced medicine or finance—have potential one of the oldest funds costs, benefits and unintended conse- is an inescapable part of to sink below the purchase price of quences. These are often difficult to $1 a share, financial markets seized anticipate, especially in the financial their job description. Seeking up, stock markets around the world realm, where crises occur infrequently plunged, and governments were even- and each differs from its predecessors to minimize micro moral tually forced to inject capital directly in important ways. into their banking systems and extend In keeping with the principle of hazard during tumultuous deposit insurance safety nets. doing no harm, it is ideal to leave In some ways, the Lehman epi- markets to work their magic. When times is as far as they sode was as close as possible to a the Fed does intervene, it tries to do controlled experiment in the realm of what’s necessary—but as little as nec- can go. economics. By not intervening, the Fed essary—to achieve financial stability. created no moral hazard. Interestingly, This is as it should be. some critics who chastised the Fed Unfortunately, defining “as little as for creating moral hazard with Bear necessary” is rarely easy. In turbulent Stearns declared that moral hazard times, the challenge regulators face is should have been disregarded in the that maps charted during past crises are case of Lehman. all but irrelevant. Each crisis requires Little will be gained by debating judgment calls that must be executed the what-ifs surrounding Lehman. By in real time, often using incomplete the time Lehman filed for bankruptcy, and partly accurate information. the cost to insure the debt of other In the current financial crisis’ first investment banks had also skyrocketed. year, the Fed’s response has been A prohibitively expensive Lehman res- measured, reflecting the commitment cue would have merely forestalled one to doing only what’s necessary. The failure, but many other at-risk invest- central bank began with the hope that ment banks would have remained as the routine tools of monetary policy the financial system buckled under would be sufficient to lessen the intense leverage. What Lehman danger to the markets and the econ- revealed was the need to give authori- omy. The Fed turned to unorthodox ties better tools to manage the threats solutions—the new lending facilities to firms considered key to the nation’s and direct intervention—only when and the world’s financial infrastructure.14 faced with a deepening crisis. Direct What are the lessons of Lehman’s intervention has been rare, taken only

EconomicLetter Federal Reserve Bank of Dallas Federal Reserve Bank of Dallas 11 EconomicLetter EconomicLetter is published monthly by the Federal Reserve Bank of Dallas. The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the the “whole alphabet soup of levered up non-bank when stakes were high and other Federal Reserve System. options were exhausted. investment conduits, vehicles, and structures.” Articles may be reprinted on the condition that Intervention in the financial mar- See “Teton Reflections,” Global Central Bank the source is credited and a copy is provided to the kets in general, or in the affairs of a Focus, August/September 2007. Research Department of the Federal Reserve Bank of Dallas. single financial institution, remains a 5 , testimony before the House Economic Letter is available free of charge red-button option, reserved solely for Committee on Banking and Financial Services, by writing the Public Affairs Department, Federal tangible threats to the Fed’s primary Oct. 1, 1998. One solution to the problem of so- Reserve Bank of Dallas, P.O. Box 655906, Dallas, TX goals. The Fed prefers to rely on the called too-big-to-fail banks would be forced recap- 75265-5906; by fax at 214-922-5268; or by telephone at 214-922-5254. This publication is available on the self-correcting mechanisms of market italization by competitors. See “What Reforms Dallas Fed website, www.dallasfed.org. forces. This discipline flows from a Are Needed to Improve the Safety and Soundness guiding principle: No one entity is too of the Banking System?” by Harvey Rosenblum, big to fail; only the financial system is Federal Reserve Bank of Atlanta Economic Review, . Some entities may be First and Second Quarters, 2007. so caught in the intricate weave of the 6 “Taking Stock in America: Resiliency, financial system that their problems Redundancy and Recovery in the U.S. Economy,” can’t be resolved quickly. Using this by W. Michael Cox and Richard Alm, Federal metaphor, Bear Stearns and AIG were single threads that, if pulled, could have Reserve Bank of Dallas 2001 Annual Report. 7 unraveled the entire financial system. The Dow suffered its worst one-day point loss As ideal as it would be to on Sept. 29, 2008, when it lost 777.68 points. 8 eliminate moral hazard, the Fed—the For more on this, see “From Complacency to central bank for the world’s largest Crisis: Taking in the Early 21st economy—can’t do that and fulfill its Century,” by Danielle DiMartino, John V. Duca legal mandates. Like it or not, central and Harvey Rosenblum, Federal Reserve Bank of bankers face the reality that managing Dallas Economic Letter, December 2007. moral hazard is an inescapable part of 9 One of these cuts, made at the depth of the Richard W. Fisher their job description. Seeking to mini- crisis on Oct. 8, was unprecedented in that the President and Chief Executive Officer mize micro moral hazard during tumul- FOMC acted in coordination with five other cen- Helen E. Holcomb tuous times is as far as they can go. tral banks. The FOMC cut the fed funds rate by a First Vice President and Chief Operating Officer half point—from 2.25 percent to 1.75 percent. Harvey Rosenblum Rosenblum is executive vice president and direc- 10 “The History of a Powerful Paragraph,” tor of research, DiMartino is a financial analyst, Executive Vice President and Director of Research by David Fettig, Federal Reserve Bank of Renier is a research analyst and Alm is senior Minneapolis The Region, June 2008. W. Michael Cox economics writer in the Research Department at Senior Vice President and Chief Economist 11 The Fed and U.S. Treasury later modified the the Federal Reserve Bank of Dallas. terms of the government’s financial support for Robert D. Hankins Notes AIG. The new terms included a lower interest Senior Vice President, Banking Supervision 1 The Fed has worked closely with the Treasury rate at 3 percent over Libor and reduced fees on Executive Editor Department to mitigate the financial crisis. undrawn funds. They also included a lengthening W. Michael Cox In early September, for example, Treasury of the lending facility from two to five years. 12 Editor took control of the Federal National Mortgage “Market Leader,” New York Times Magazine, Richard Alm Association and Federal Home Mortgage Corp., March 30, 2008. 13 two federally sponsored investors in the housing “Current Economic and Financial Conditions,” Associate Editor sector. Ben Bernanke speech to the National Association Monica Reeves 2 for Business Economics 50th Annual Meeting, For more on this subject, see “Fed Policy and Graphic Designer Moral Hazard,” by Harvey Rosenblum, Wall Washington, D.C., Oct. 7, 2008. Gene Autry 14 Street Journal, Oct. 18, 2007. “Reducing Systemic Risk,” Ben Bernanke 3 Timothy Geithner, testimony before the Senate speech at the Federal Reserve Bank of Kansas Committee on Banking, Housing and Urban City’s Annual Economic Symposium, Jackson Affairs, April 3, 2008. Hole, Wyo., Aug. 22, 2008. 4 See Geithner’s remarks in “Brokers Threatened Federal Reserve Bank of Dallas by Run on Shadow Bank System,” MarketWatch, 2200 N. Pearl St. June 20, 2008. The term shadow banking system Dallas, TX 75201 was coined by Paul McCulley, who used it for