Policymaking Through a Panic Mark M. Zandi November 3, 2008

anic has gripped the global In an effort to restart money and attract the private capital ultimately financial system, pushing the credit markets, the has needed to bolster the financial system. Pglobal economy into recession. vastly expanded its role. The central In practice, the may not go as The U.S., Europe, Canada and Japan are bank can now lend to whomever and well given the complexity of the assets contracting, while emerging economies buy whatever it deems necessary, to be purchased, but if so then the costs from Brazil to China that had been essentially without limit. The Fed has involved in trying will also be small. growing rapidly are now weakening. also engineered an unprecedented A much larger and comprehensive The proximate cause of the global crisis coordinated cut with other mitigation plan will almost is the collapse of the U.S. housing market, central banks, more than doubled certainly be needed. Millions of and the resulting surge in mortgage loan the size of its balance sheet to pump homeowners owe more than their home defaults. Hundreds of billions of dollars in liquidity into the financial system, and is worth, and unemployment is rising losses on these mortgages have undermined is buying commercial paper and other quickly; , already at record the financial institutions that originated and money-market instruments directly from high levels, are sure to mount. The Hope invested in them, including some of the issuers and money-market funds. for Homeowners program faces severe largest and most venerable in the world. Policymakers have also worked impediments, and even under the best of Many have failed and most are struggling to to directly shore up the housing circumstances will likely be overwhelmed survive. Banks are fearful about extending and mortgage markets and broader by the wave of foreclosures still coming. credit to each other, let alone to businesses economy. A number of efforts have No plan will keep house prices from and households. With the credit spigot been put in place to enable stressed falling further, but quick action could closing, the global economy is withering. homeowners to avoid foreclosure. These avoid the darker scenarios in which Global stock investors have dumped their include programs called FHA Secure, crashing house prices force millions holdings as they come to terms with the Hope Now, and most recently Hope more households from their homes, implications for corporate earnings. A for Homeowners, a plan that allows completely undermining the financial self-reinforcing adverse cycle has begun: mortgage owners to convert some of system and economy. the eroding financial system is upending their troubled loans into FHA-insured Additional monetary and fiscal the economy, putting further pressure on mortgages in exchange for taking write- stimulus is also necessary. With inflation the financial system as the performance of downs on the loans. Fiscal stimulus, receding and deflation concerns likely everything from credit cards to commercial including this summer’s tax rebates and to predominate soon, there are few mortgage loans sours. the investment tax incentives that remain impediments to further interest rate cuts This cycle can only be mitigated by in place through the end of the year, has by the Federal Reserve. The only issue is aggressive and consistent government provided some economic support. how close to zero the target action. In the U.S., the public policy Yet more needs to be done to quell rate can go before it begins to undermine response to the financial crisis is without the financial panic and mitigate what money-market funds, which need some precedent. The full faith and credit of the threatens to become the worst economic return on their investments to cover their government now effectively setback since the Great Depression. The operating costs. More importantly, with backstop the financial system; significant reverse auctions for mortgage assets the Fed’s new ability to pay interest on parts of which have been nationalized. initially envisaged for the TARP need bank reserves, there is no limit on how With the takeover of Fannie Mae and to go forward quickly. In theory, the much liquidity the Fed can provide to Freddie Mac, the government makes nearly auctions are an elegant way to determine the financial system. all the nation’s residential mortgage loans. market values for these currently The government’s next fiscal And as the $700 billion troubled asset impossible-to-price assets. With price stimulus package should both cut taxes relief fund is deployed, the government discovery will come clarity about which and increase spending beginning early is gaining sizable ownership stakes in the financial institutions are undercapitalized next year, when the economy is likely to nation’s largest financial institutions. and by how much. Clarity, in turn, will be at its most vulnerable. The stimulus

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 13 Chart 1: A Financial Panic the crisis deepened Credit markets remain badly shaken. Difference between three-month Libor and Treasury bills and continued Bond issuance has come to a standstill 3.0 on, those with no residential and commercial- worries hindered backed securities issuance in recent 2.5 policymakers far months and very little issuance of junk Subprime financial too long, allowing corporate bonds and emerging market 2.0 shock the current panic debt. Asset-backed issuance of credit to develop. With cards, vehicle and student loans and LTCM 1.5 Y2K so many suffering municipal bond issuance also remains S&L crisis so much financial severely disrupted. Investment-grade Peso Thai Tech 1.0 Bhat Orange crisis bust loss, moral hazard bond issuance has held up somewhat County is no longer an better, but even this all but dried up in 0.5 issue; debate over October. Credit spreads—the extra yield whether it is fair investors require to be compensated for 0.0 to help stressed the perceived added risk of investing in 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 households stay riskier bonds—also remain strikingly in their homes wide, as investors shun anything but appears quaint. risk-free Treasury bonds. The difference must be large, equal to at least 2% of Their problems are clearly everyone’s between yields on junk corporate GDP, as GDP seems set to decline by at problems. Only quick, overwhelming bond bonds and 10-year Treasuries least that much without it. Extending and consistent government action will has ballooned to some 1700 basis unemployment insurance benefits, food instill the confidence necessary to points, and between emerging debt and stamps, and aid to state governments restore financial stability and restart Treasuries to well over 1300 basis points. would be the most effective spurs to economic growth. Historically, yield spreads for both have economic growth, but even increased Economic backdrop. The need averaged closer to 500 basis points. infrastructure spending could be desirable for more policy action is evident in Commodity and foreign currency considering the economy’s problems are the increasingly dark financial and markets have been roiled. Oil prices likely to last for some time, giving such economic backdrop. The financial panic have fallen more than 50% from their spending enough time to be of help. that began in early September with the record peaks in early July, and prices for With government making so many nationalization of Fannie and Freddie commodities from copper to corn have monumental decisions in such a short may have passed its apex, but the plunged. Global commodity demand is period of time, there will surely be collective psyche remains frazzled. And weakening rapidly as the global recession unintended consequences. Some may even if the panic soon subsides, economic undercuts the financial demand that had already be evident: Nationalizing Fannie damage has been done. The collapse in sent prices surging this past summer. Mae and Freddie Mac while not rescuing confidence, the massive loss of wealth, Economies reliant on commodity Lehman Brothers from bankruptcy may and the intensifying ensure production have been hit hard and their very well have set off the current financial that the U.S. economy will struggle currencies have rapidly depreciated. The panic. And policymakers need to be wary through the remainder of the decade. Canadian dollar, which had been close of the costs of their actions, as global Money markets are improving, to parity with the U.S. dollar as recently investors will eventually demand higher thanks to massive intervention by global as this summer, has dropped below 80 interest rates on the soaring volume central banks, but remain far from cents, and the Brazilian real has fallen of U.S. Treasury debt. Any measurable normal. The difference between 3-month more than 40% against the dollar since increase in long-term interest rates Libor and 3-month Treasury bill rates—a the panic began.2 would be counterproductive; its effect good proxy for the angst in the banking Volatility in global stock markets on the housing market and the rest of system—is still an extraordinarily wide has been unprecedented, and the price the economy would offset the economic 275 basis points (see Chart 1).1 This is declines nerve-wracking. Since the benefits from the fiscal stimulus. down from the record spreads of mid- downdraft began a few weeks ago, global But policymakers’ most serious October, which topped 450 basis points, stock prices are off a stunning 30% in missteps so far have come from acting too but it is still stratospheric compared local currency terms and more than 40% slowly, too timidly, and in a seemingly with past financial crises, not to mention from their year-ago highs. No market has scattershot way. Early on in the crisis the average 50-basis point spread that been spared the collapse. The declines there were reasonable worries about prevails in normal times. The Fed’s have been so precipitous that U.S. and moral hazard and fairness. Bailing out program to purchase commercial paper those who took on, originated or invested directly from issuers has pushed those 2 Currency swings have been wild enough to prompt in untenable mortgage loans would only short-term rates down as well, but they discussion of coordinated government intervention. This seems encourage such bad behavior in the too are still very high. unlikely, in part because the currency moves until recently future. And it would certainly be unfair have been largely welcome. A stronger U.S. dollar means global investors still view the U.S. as a safe haven, which is important to those homeowners still managing to as the Treasury ramps up borrowing. Nations whose currencies make their mortgage payments. But as 1 The London Interbank Offered Rate is the interest rate at are falling against the dollar are hopeful that this will reduce which major banks lend to each other. pressures on their key export industries.

14 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 Chart 2: Recession Everywhere Chart 3: A Body Blow to Confidence Based on Moody’s Economy.com coincident indicator Net % of businesses responding positively 50

40

30

20

10

0

-10 Source: Moody’s Economy.com -20 Expansion At risk 03 04 05 06 07 08 Recovery Recession

European bourses have tried imposing years ago.5 This is all the more surprising being felt by all Americans, from lower- limits on short-selling, and Russia has given the plunge in gasoline prices during income households losing jobs to suspended trading for days at a time. All the month; cheaper motor fuel in times affluent households with diminished of this has been to no avail. Mutual fund, past has always provided a lift to household nest eggs. This is evident in the sharply 401k and hedge fund investors simply spirits. Business confidence as measured by weaker sales at high-end retailers such want out of stocks, regardless of the Moody’s Economy.com’s weekly survey also as Nordstrom, Neiman Marcus and losses and any associated penalties. collapsed to a record low in October (see Bergdorf Goodman. Generally the wealth Even if the global financial system Chart 3). The net percentage of responses effect is so small that it can only be stabilizes soon, substantial damage has to all nine questions asked in the survey has determined econometrically; now it is already been done. The U.S. economy turned sharply negative. Most disconcerting potent enough to be apparent visually. was struggling before the financial panic is the decline in firms’ intention to hire and Since the housing bubble began to burst, hit; it has likely been in recession for invest, both of which had been holding up the link between retail sales and house at least a year. Real GDP fell in the last relatively well prior to the panic. prices has been striking (see Chart 4). quarter of 2007 and again in the third Current events have so soured Falling house prices appear to impact quarter of 2008.3 Some 750,000 jobs sentiment that they are sure to have long- retailing with a lag of about six months, have already been lost so far on net, and lasting impacts on household spending as homeowners do not immediately the unemployment rate has risen by 1½ and saving choices, as well as on adjust their spending behavior to any percentage points to 6.1%. The downturn business decisions regarding payrolls and change in housing wealth. The current is broad-based across industries and investment. The pessimism will magnify declines in house prices suggest that this regions, with 30 states now in recession the effect of evaporating household Christmas will be as tough for retailers as (see Chart 2).4 Data since the panic hit wealth. Net worth has fallen close to $11 any since 1992. Moreover, if house prices have been uniformly bad, suggesting that trillion since peaking a year ago; of that, decline substantially further as expected, the downturn is intensifying. Retail sales, $4 trillion results from the 20% decline in then retailers’ troubles will last through vehicle sales and industrial production house prices, while the rest is due to the Christmas of 2009. fell sharply in September, and the increase 40% decline in stock prices. Over time, The financial panic is also affecting in unemployment insurance claims in every dollar loss in household net worth the availability and cost of credit. Credit October is consistent with monthly job reduces consumer spending by 5 cents growth was weakening rapidly even before losses topping 200,000. over the next two years.6 If sustained, the recent events. The Federal Reserve’s The panic’s most immediate fallout wealth lost over the past year could thus Flow of Funds shows debt owed by is the blow to confidence. Consumer cut $275 billion from consumer spending households and nonfinancial corporations confidence plunged in October to its in 2009 and a like amount in 2010. actually fell in the second quarter of lowest reading since the Conference More than in past recessions, 2008 after inflation, for the first time Board began its survey more than 40 the financial pain of this recession is since the S&L crisis of the early 1990s. To date, the weakening in credit growth is largely due to disruptions in the bond 5 The University of Michigan consumer sentiment survey fell and money markets. Lending by banks, more between September and early October than between 3 When all the GDP revisions are in, it is expected to show any month since the university began monthly surveys in S&Ls and credit unions has remained that real GDP also fell in the first quarter of 2008. Second the late 1970s. sturdy. But this is probably only because quarter growth was supported by the tax rebate checks as 6 For a more thorough discussion of the wealth effect, see nervous borrowers have pulled down part of the first fiscal stimulus package. “MEW Matters,” Zandi and Pozsar, Regional Financial 4 State recessions are determined using a methodology similar Review, April 2006. In this article, the housing wealth effect available credit lines, and with banks to that used by the business cycle dating committee of the is estimated to be closer to 7 cents while the stock wealth now battening down their underwriting National Bureau of Economic Research for national recessions. effect is nearer to 4 cents.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 15 Chart 4: Smaller Nest Eggs, Less Spending Chart 5: Banks Fight to Survive; Nervous to Make a Loan % of residential mortgage debt, $ Net % of lenders willing to make a consumer loan 20 9 80

8 60 15 7 40 10 Core retail sales growth 6 20 3 mo. MA (R) 5 5 0

4 -20 0 House-price growth 3 -40 6 mo. lead (L) -5 Source: Federal Reserve’s 2 -60 senior loan officer’s survey Sources: Census, Realtors -10 1 -80 05 06 07 08 66 72 78 84 90 96 02 08 standards and cutting lines this source per gallon, and have averaged closer to might follow. The Treasury Department of credit is drying up. According to the $3 over the past year. Every penny-per- was equally reticent in its response. Fed’s senior loan officer survey, lenders gallon decline in the cost of gasoline FHA Secure—a program that liberalized have tightened over the past year as saves U.S. consumers just over $1 billion traditional FHA lending requirements to aggressively as they ever have. The net a year; thus assuming gas remains at help distressed homeowners refinance percent of loan officers who say they are $2 per gallon through the coming year, into FHA insured loans—was unveiled willing to make a consumer loan is the Americans will save more than $100 in August 2007. Hope Now, which lowest ever, with the exception of 1980 billion in 2009 compared with the standardized voluntary loan modification when the Carter administration briefly fuel costs in 2008. There will also be efforts by mortgage servicers—was imposed credit controls (see Chart 5).7 measurable savings on home heating established in October. While laudable, The pernicious impact of a credit and food bills, as agricultural and these steps were quickly overwhelmed. crunch on the economy is difficult to transportation costs fall. Total savings Policymakers may have initially quantify, but the economy’s performance next year compared to this will thus thought the crisis was somewhat during the early 1980s and early 1990s approach $200 billion. therapeutic. Risk-taking in the financial suggest it can be substantial. The 1980s Summing the costs to the economy system had been overdone and some downturn was the most severe in the from the wealth and credit effects, less the reevaluation was warranted. Credit post-World War II period, and while benefits from lower commodity prices puts spreads had never been so thin; bond the 1990s downturn was not as bad, the net direct cost of the financial panic issuance and bank lending were soaring, the economy struggled long after the at around $300 billion in 2009. (A $275 and private equity deals were all the recession formally ended. Using these billion wealth effect plus $225 billion credit rage. It was only by the end of 2007, six two periods as a guide suggests that effect minus $200 billion in savings due months into the crisis, that policymakers for every one percentage point decline to lower commodity prices). This is 2% began to realize that the pull-back in risk in real credit growth, real GDP growth of GDP. Of course this is a very simplistic aversion had itself become overdone. weakens in the subsequent year by analysis; it does not account for all the They had misjudged the severity of events. approximately 30 basis points. Thus if indirect costs of the panic on the economy Moral hazard concerns—the real credit shrinks 5% by the end of this and the multipliers, but it highlights the worry that if policymakers helped year, which seems plausible, then this potential magnitude of the fallout. hard-pressed financial institutions or credit effect will cut some $225 billion Policy critique. While homeowners they would encourage from GDP in 2009. policymakers could not have forestalled even more undesirable risk-taking in There has been one significant the financial crisis, they made two the future—further slowed the policy positive for the U.S. economy coming significant mistakes responding to it. response. Indeed, an overly generous out of the financial panic: lower The first was a slow and halting early policy response to past financial crises energy and commodity prices. With oil reaction after the crisis hit in the summer may have contributed to the current currently trading below $70 per barrel, a of 2007. one. There was also a groundswell of gallon of regular unleaded should soon The Federal Reserve initially did not opposition against government help, cost no more than $2. Gasoline prices react at all, waiting until mid-September as many thought a bailout would be peaked during the summer above $4 before lowering rates. The central bank unfair. Most homeowners were still cut rates twice more by year’s end, making mortgage payments, though but with each quarter-point move they many were struggling to do so; any 7 This was part of a failed effort to rein in the double-digit inflation of the period. discouraged speculation that more bailout would reward some who did

16 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 Chart 6: Money-Market Funds Are Vital to CP Market Lehman’ difficulties rescue the financial system, but the plan Share of open market paper held by MMF had long been known, was viewed by many Americans as a Wall 45 providing ample Street bailout. Moral hazard and fairness Source: Federal Reserve Board opportunity for others concerns had faded at the Treasury and to prepare for the worst. Fed, but officials had failed to convince 40 There was Main Street that it would be saving itself. unforeseen collateral Evaporating nest eggs and the damage, however. An eroding job market have since helped institutional money- forge a consensus favoring a major 35 market fund with government response to the financial sizable investments crisis. Some still argue that policymakers in Lehman securities should step aside and allow the crisis to 30 ‘broke the buck’ as it run its course, but for the time being they wrote down the value are difficult to hear. of those investments. Le monetary deluge. The Federal 25 In other words, the Reserve will use all its resources to revive 90 92 94 96 98 00 02 04 06 08 value of the fund’s the financial system. This means even assets fell below what lower interest rates, but more importantly not deserve it. While moral hazard and investors had put in. A psychological it means that the Fed will continue to flood fairness are certainly vital considerations, barrier was broken; individual investors markets with liquidity, lending to whomever policymakers unfortunately clung to had thought money-market funds were and buying whatever is necessary. them too long. The financial system as safe as mattresses. Redemptions Another interest rate cut is coming: was suffering massive losses and had began immediately, forcing the $3.5 The Federal Open Market Committee is been severely chastened, while surging trillion money-market fund industry to expected to lower the federal funds rate foreclosures undermined the finances of start pulling away from the commercial at its December meeting to a record low those homeowners still trying hard to paper market, its traditional investment 0.5%. This comes after an unprecedented make good on their mortgages. destination (see Chart 6). The financial 50-basis point cut in early October that The second significant policy panic became a direct and imminent was coordinated with other global central mistake was a lack of consistency in how threat to the economy; commercial paper banks, and another 50-basis point cut policymakers addressed the rash of major is a vital source of short-term financing at the scheduled FOMC meeting in late financial failures in early September. If for big businesses to fund everything from October. Lowering the rate much below there is a proximate cause for the current inventories to payrolls. this may not be feasible, as it could create financial panic, it is the nationalization Worried households also began problems for already-stressed money- of Fannie Mae and Freddie Mac and the shifting deposits from commercial banks market mutual funds. Many funds could decision not to save Lehman Brothers rumored to be in trouble. The failures of be put in jeopardy at a lower funds rate from bankruptcy a week later. Washington Mutual and Wachovia were because their operating costs would be Nationalizing Fannie and Freddie precipitated in part by these silent runs. greater than the return on their short-term may have been necessary, as regulators With so many venerable global financial investments, which are closely tied to the concluded they were quickly headed institutions running aground so rapidly, funds rate. toward insolvency, but it also told global those still standing were left questioning However, such limits on the funds investors that no financial institution was the viability of all their counterparties. rate no longer determine the amount of too big to falter. Investors immediately Few want to do business with a firm that liquidity the Fed can provide, which is began to question the viability of Lehman will soon be out of business. Interbank what matters most. The Fed now has the Brothers. Unlike Bear Stearns—the lending, in which banks with excess funds power to pay interest on bank reserves, investment bank that failed in March— lend to those with a deficit, froze. a change included as part of the TARP Lehman did not have a liquidity problem. The turmoil in credit markets legislation.8 The central bank has set The Federal Reserve had established jumped to the stock market. If money this deposit rate just below the funds various credit facilities after the Bear and bond markets were not working rate target. This seemingly innocuous Stearns collapse that Lehman could use properly, businesses would not be able technical change is important: it allows to raise cash. Lehman’s problem was that to fund themselves, and corporate the Fed to increase liquidity to the its counterparties–commercial banks, profits were sure to fall. Stock investors financial system without limit. As the hedge funds, other investment banks and reacted violently when the House of private investors–became nervous about Representatives initially voted down its future. After failing to find a buyer legislation to establish the Troubled Asset 8 The Federal Reserve requires depository institutions to hold 10% of their deposits in reserve to meet depositors’ for Lehman, policymakers decided to Relief Program at the end of September. demand for funds. The Fed can increase or decrease the let it fail. They calculated that Lehman’s Treasury and Federal Reserve officials amount of reserves in the financial system by buying or collapse would not create problems for had finally decided that a massive selling Treasury and other securities from depositories. The federal funds rate is that rate which equates the demand for the entire financial system, reasoning that government response was needed to and supply of reserves.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 17 Chart 7: Fed Will Provide Unlimited Liquidity down commercial auctions would establish market prices, Bank reserves, $ bil paper rates, while which have not been available since trading 350 raising the volume of in these assets collapsed. The Treasury Source: Federal Reserve Board new issuance sharply. would be the buyer in these auctions, taking 300 The implications bids from the institutions that own the of this program assets. The lowest bids would set market 250 go far beyond the prices, so that institutions, and just as 200 commercial-paper importantly potential private investors, market; the Fed now could determine how much capital the 150 has a mechanism institutions need. to purchase just Financial institutions have 100 about anything it announced write-downs on their deems necessary. mortgage assets to date of close to $600 50 A hypothetical but billion. This equates to losses on some 0 plausible example six million mortgage loans going through 60 66 72 78 84 90 96 02 08 would be for the Fed to a foreclosure sale, with the mortgage to purchase municipal owner losing half the loan’s value in bonds if state and the process. This would be a reasonable Fed injects reserves into the system and the local fiscal conditions continue to erode, loss forecast assuming that house prices funds rate declines, it will not fall below the threatening a string on muni bond defaults. eventually fall about 30% peak to trough deposit rate, because financial institutions Such defaults would almost certainly and unemployment peaks at 7.5%. Things will choose to deposit their excess reserves reignite the financial panic, since most may well turn out worse than this; it may with the Fed rather than lend them out investors perceive muni bonds as super-safe. also be that many institutions have already overnight at a lower rate. The Fed has Although the Federal Reserve is marked down the value of their holdings aggressively used this new authority to literally doing all it can, its ability to revive appropriately. They may still need more pump massive amounts of reserves into the the economy has been severely hampered capital to cover the darker scenarios and system in recent weeks (see Chart 7). As a by the financial system’s problems. The the losses they are sure to suffer on their result, Libor is falling, which suggests that Fed can pump unlimited cash into the other assets, but the amount of private the is coming financial system, but it can not force capital needed to sufficiently recapitalize back to life. The sooner banks begin lending financial institutions to make more credit the financial system could be readily to each other, the sooner they will lend available to households and businesses, forthcoming. But that will not be known more freely to households and businesses. which is ultimately what is needed to until a price for their mortgage assets has To further get liquidity into the financial end the downturn. Fiscal policymakers been established. system, the Fed is ramping up lending to a must therefore become even more While the TARP auctions work well wide range of financial institutions through aggressive, pursuing three broad goals: in theory, they have yet to get going. credit facilities it has established over the past 1) Recapitalizing the financial system; 2) The Treasury’s initial vision of the year. (See addendum).9 These facilities allow Keeping homeowners out of foreclosure; TARP was overwhelmed by the financial financial institutions to borrow from the and 3) Shoring up the economy. panic. With markets unraveling, officials Fed, using securities they own as collateral. Recapitalization. Policymakers have had no time and thus no choice but The Fed has repeatedly lowered the bar on appropriately focused first on stabilizing to use the TARP to make direct equity the collateral it will accept, taking on less the financial system, by working to investments in financial institutions. progressively liquid securities to encourage increase its capital base. Without The Treasury is using the first $250 more borrowing. To bring overseas financial adequate capital, the financial system will billion of the $700 billion TARP fund to institutions into the mix, the Fed has greatly remain in disarray, exacerbating the credit purchase preferred shares in commercial expanded its swap lines with global central crunch and undermining all efforts to banks and thrifts. The institutions are banks. Foreign central banks can exchange stem foreclosures and layoffs. counting this investment as part of their U.S. dollars for their own currencies, rather When first proposed by the Treasury, regulatory Tier 1 capital; a measurable than buying up dollars in foreign exchange the $700 billion Troubled Asset Relief addition considering that there was $1.35 markets. Such swap lines have been set-up Program was envisaged as a way to entice trillion in such capital at the end of June, central banks of developed economies, and new private capital into the financial system. according to the FDIC. most recently also with central banks from The TARP fund would be used to purchase Almost immediately a number of emerging economies. distressed mortgage loans and securities thorny questions have been generated The Fed is also exercising its new through a reverse process.10 The by the Treasury’s ownership stake. Is ability to purchase commercial paper it appropriate for the Treasury to be directly from issuers. This has helped bring picking winners and losers? Who gets the

10 A description of how the TARP reverse auctions could capital and who does not? Commercial work is described in “A Troubled Asset ,” banks, but not insurance companies? Lawrence Ausbel and Peter Cramton, October 5, 2008. What about finance companies that 9 These include the Term Auction Facility, the Primary Dealer http://www.cramton.umd.edu/papers2005-2009/ausubel- Credit Facility, and the Term Security Lending Facility. cramton-troubled-asset-reverse-auction.pdf turn themselves into banks? Should the

18 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 Chart 8: Surging Mortgage Foreclosures Chart 9: Foreclosures Will Remain a Long-Term Problem First mortgage loan defaults, ths, SAAR Mortgage debt outstanding facing first payment reset, $ bil 3,000 30 Sources: Equifax, Moody’s Economy.com Sources: GSEs, First American LP

2,500 25

2,000 20

1,500 15

1,000 10

500 5

0 0 00 01 02 03 04 05 06 07 08 08 09 10 11 12 capital be used for acquisitions? PNC was which mortgage owners can refinance and foreclosures in 2009 threaten to dwarf the beneficiary of Treasury capital, but borrowers into FHA-insured loans if they anything experienced so far. National City was not; the latter thus had reduce the mortgage amount owed by Even under the best of little choice but to sell itself to PNC. Can the borrower, is just getting under way. circumstances, mortgage defaults are institutions receiving the Treasury’s help TARP could help advance the Hope for expected to remain elevated well into the use it to pay dividends or boost executive Homeowners plan if it conducts auctions next decade as a large number of option compensation? If the capital is to be used for second mortgages. Second-lien holders ARM loans hit their first payment resets to support more lending, how do we are a significant impediment to this in 2010 and 2011 (see Chart 9). These know that institutions are using the funds program, because they must subordinate loans are 5-25 loans–fixed for five years aggressively enough for this purpose? their interests before a refinancing can take and then adjustable rate loans thereafter. It seems clear that the sooner the place. Few are willing to do this for free, Most option ARMs originated in 2005 Treasury can cease being the largest but paying them off could be well worth and 2006 when house prices were at their shareholder in the nation’s financial system the effort. Second-lien holders could receive peaks will likely be underwater when the better. This process can only begin a couple pennies on the dollar for their they hit their reset, and thus will be good if private money comes in to replace the mortgages via a TARP auction on condition candidates for a credit problem. public capital, but that will not happen they do not block modifications to the loan. A much more substantial mortgage until there is clarity regarding the value If the Treasury purchased whole mortgage loan modification plan is needed. of the assets on bank balance sheets. The loans through the TARP auctions, then One potential plan, put forth by FDIC TARP reverse auctions are at least in theory these loans too could be modified. Chairman Sheila Bair, would have the an elegant way to obtain price discovery, These are laudable efforts, but they federal government guarantee some and even if they do not work that well are being overwhelmed by the size of proportion of any losses on loans that in practice it will not take long or cost the foreclosure problem. According to are sufficiently modified by mortgage taxpayers much to figure that out. data from credit bureau Equifax, first- servicers to establish a certain minimum Forestalling foreclosure. With mortgage loan defaults–the first step in level of affordability for stressed TARP underway, policymakers are the foreclosure process–are running at a homeowners. The guarantees will be appropriately refocusing their efforts on 3 million annualized pace (see Chart 8). large enough so that it is clear to the keeping homeowners out of foreclosure. In a good year, annual defaults are well servicer and the mortgage owner that Surging losses on defaulting mortgage below 1 million. Many more are coming; the costs involved in modifying loans assets are eroding the financial system’s there are now an estimated 12 million are less than the costs of not modifying capital base, resulting in the credit homeowners whose mortgage debt exceeds and risking that the loan will go through crunch that is undermining the economy. the value of their home. 11 While negative foreclosure. The servicer would have Stemming these defaults is thus an equity alone need not result in a default, to modify the loan by lowering its important policy objective. negative equity combined with surging interest rate, increasing its term and/or As mortgage defaults have mounted, unemployment often does. With house reducing the mortgage balance in order the policy response has intensified. It prices expected to fall at least another to sufficiently lower borrowers’ monthly began with FHA Secure and Hope Now 10%, and unemployment expected to rise payments. This plan provides a clear in late 2007. As more banks and thrifts to 8% during the coming year, defaults benefit to homeowners, and it could be have been put into FDIC receivership, designed to provide enough of a benefit to the FDIC has been working to modify mortgage servicers and mortgage owners the loans owned by these institutions. 11 Estimates of the number of underwater homeowners to gain their participation. The cost to the are based on credit file data from Equifax and house price The Hope for Homeowners program, in estimates using data from Census, Case-Shiller and Zillow. Treasury, however, could be sufficiently

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 19 Table 1: Fiscal Stimulus Bang for the Buck economy’s pump. Simulations of the Moody’s Economy. Bang for the Buck com macroeconomic model Tax Cuts show that every dollar spent Non-refundable Lump-Sum Tax Rebate 1.01 on UI benefits generates an Refundable Lump-Sum Tax Rebate 1.22 estimated $1.63 in near term GDP. Boosting food stamp Temporary Tax Cuts payments by $1 increases GDP Payroll Tax Holiday 1.28 by $1.73 (see Table 1). People Across the Board Tax Cut 1.03 who receive these benefits Accelerated Depreciation 0.25 are hard-pressed, and will spend any financial aid they Permanent Tax Cuts receive within a few weeks. Extend Alternative Minimum Tax Patch 0.49 Another advantage is that these Make Bush Income Tax Cuts Permanent 0.31 programs are already operating, Make Dividend and Capital Gains Tax Cuts Permanent 0.38 and can quickly deliver a benefit increase to recipients. Cut in Corporate Tax Rate 0.30 The virtue of extending UI benefits goes beyond Spending Increases simply providing financial Extending Unemployment Insurance Benefits 1.63 aid for the jobless, to more Temporary Increase in Food Stamps 1.73 broadly shoring up household General Aid to State Governments 1.38 confidence. Nothing is more Increased Infrastructure Spending 1.59 psychologically debilitating, even to those still employed, Note: The bang for the buck is estimated by the one year $ change in GDP for a given $ reduction than watching unemployed in federal tax revenue or increase in spending. friends and relatives lose their Source: Moody’s Economy.com sources of income support. The slump in consumer confidence after the 1990- limited so that several million loans could problems. The amount spent on the 1991 recession may have been due in part be guaranteed.12 stimulus should be large enough to to the first Bush administration’s initial Economic stimulus. Despite the provide a measurable boost, but not so opposition to extending UI benefits for policy efforts to date, the financial crisis large that it harms the nation’s long-term hundreds of thousands of workers. The has caused significant economic damage. fiscal condition. The likely severity and administration ultimately acceded and Credit will be impaired for a long time; length of the current recession means the benefits were extended, but only after confidence has been shattered; and more stimulus plan should be sizable: Given confidence had waned. The fledgling than $11 trillion in household wealth has that the direct costs of the financial panic recovery sputtered and the political evaporated. Unless policymakers quickly are estimated at around $300 billion, damage extended through the 1992 agree on another large economic stimulus this would be a good benchmark. Such a presidential election. Increasing food plan, the economy seems headed for the stimulus plan would double the amount stamp benefits also has the added virtue worst recession since 1980-1982, when provided earlier this year, and would of helping people ineligible for UI such as unemployment reached double digits. equal about 2% of GDP. part-time workers. It also helps those who The goal of any fiscal stimulus plan To be most economically effective, do not pay income tax and thus will not is to maximize the near-term boost to a fiscal stimulus plan should extend receive a rebate. economic growth without weakening the unemployment insurance benefits, Another economically potent federal economy’s longer-term prospects. This expand the food-stamp program, increase tool is aid to financially-pressed state requires that the plan be implemented aid to state and local governments, and governments. This could take the form of quickly and that its benefits go first even increase spending on infrastructure, general aid or a temporary increase in the to those hurt most by the economy’s if that can be done quickly enough to Medicaid matching rate, to help ease the help the economy next year. costs of health coverage. Such help appears Extra benefits for workers who unlikely in the stimulus plan currently 12 There are many good ideas to consider if the FDIC plan does not move forward, including Harvard Professor exhaust their regular 26 weeks of being discussed, but this could quickly Martin Feldstein’s plan for low-interest rate loans from the unemployment insurance benefits and change in coming weeks if the economy’s government to stressed homeowners; and my own Home expanded food stamp payments have problems grow more severe or widespread. Appreciation Mortgage plan. Temporarily changing the bankruptcy laws to allow for first-mortgage cramdowns in been part of the federal response to most Fiscal problems are already a Chapter 13 filing on loans originated during the housing recessions, and for good reason: They developing in more than half the 50 bubble may also be helpful. The argument that such a change would substantially raise future mortgage costs feels specious. are the most efficient ways to prime the states. Twenty-seven have already

20 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 Table 2: The Economic Benefit of Fiscal Stimulus

Real GDP, $ bil, 2000 Real GDP, % change No Stimulus Stimulus Difference No Stimulus Stimulus Difference 07 11,523.9 11,523.9 - 2.03 2.03 - 08 11,686.1 11,687.5 1.5 1.41 1.42 0.0 09 11,434.3 11,648.5 214.2 -2.15 -0.33 1.8 10 11,586.9 11,970.5 383.6 1.33 2.76 1.4 11 12,204.5 12,533.9 329.5 5.33 4.71 (0.6) 12 12,846.9 12,962.7 115.8 5.26 3.42 (1.8)

Unemployment Rate Payroll Employment, mil No Stimulus Stimulus Difference No Stimulus Stimulus Difference 07 4.64 4.64 - 137.6 137.6 - 08 5.63 5.62 (0.0) 137.5 137.6 0.0 09 7.85 7.39 (0.5) 134.9 136.4 1.6 10 8.94 7.71 (1.2) 134.8 137.1 2.3 11 7.93 6.37 (1.6) 138.8 140.5 1.7 12 6.13 5.42 (0.7) 142.5 143.5 1.0

Sources: BEA, BLS, Moody’s Economy.com announced budget shortfalls totaling economic activity and employment stimulus, the economy’s current problems $26 billion for fiscal year 2009, which than they were three decades ago. The could extend well into 2010; this weakens began this past July. Tax revenue growth contention that helping states today will the case against infrastructure spending in has slowed sharply with flagging retail encourage more profligacy in the future the current period. sales and corporate profits. Income tax also appears overdone. Apportioning To assess the economic consequences receipts are also sure to suffer as the job federal aid to states based on their size, of fiscal stimulus, Moody’s Economy.com market weakens. California and Florida rather than on the size of their budget simulated two scenarios: One with no are under the most financial pressure, but shortfalls, would substantially mitigate additional fiscal stimulus, and a second with others such as Arizona, Minnesota, and this concern. a $300 billion stimulus program beginning Maryland are also struggling. Increased infrastructure spending during the first half of 2009. The program As most state governments are is also a particularly effective way to involves in two rounds of spending; the required by their constitutions to quickly stimulate the economy. The boost to first, launched next January, includes $170 eliminate their deficits, most are already GDP from a dollar spent on building billion in increased aid to state governments, planning to cut programs ranging new bridges and schools is large, an greater infrastructure spending and an from healthcare to education to local estimated $1.59, and there is little doubt extension of various investment tax credits government grants. Local governments that major infrastructure investment for businesses that are set to expire at the end are having their own financial problems; is needed. The case against including of this year. Another $130 billion is spent most rely on property-tax revenues, which such spending as a part of a stimulus beginning in May, including extended UI are slumping with house prices. Cuts in plan, however, is that it generally takes a benefits, expanded food stamps and another state and local government outlays are substantial amount of time for funds to refundable tax rebate. sure to become a substantial drag on the flow to builders and contractors and into The $300 billion stimulus plan adds economy in 2009 and 2010. Additional the broader economy. It should be noted nearly 2 percentage points to annualized federal aid to state governments will fund that our the economic bang-for-the-buck real GDP growth in 2009. Even with the existing payrolls and programs, thus estimates measure the change in GDP stimulus, real GDP is expected to fall by providing a relatively quick economic one year after spending actually occurs; 0.3% next year, but without the stimulus boost. States that receive a check from it says nothing about how long it may GDP plunges a stunning 2.2% (see Table the federal government will quickly pass take to cut a check to a builder for a new 2). This would be the most severe decline the money on to workers, vendors, and school. Infrastructure projects can take in GDP since the Great Depression, even program beneficiaries. years from planning to completion. Even if worse than the 1.9% drop experienced Some argue that state governments the funds are only used to finance projects in 1982. Some 4 million jobs will be should be forced to cut spending that has that are well along in their planning, it is lost peak to trough without government grown bloated and irresponsible; these very difficult to know just when projects stimulus, pushing the unemployment arguments are strained at best. State will get under way and the money spent. rate above 9%. Even with the stimulus, government spending and employment While this is an important caveat on the some 1.8 million jobs will be lost, with are no larger today as a share of total use of infrastructure spending as economic unemployment peaking near 8%.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 21 Conclusions. A long history of public Despite all this, the panic that has loan modification program is needed to policy mistakes have contributed to the roiled financial markets might have been blunt further increases in foreclosures. current financial crisis. While there will surely avoided if policymakers had responded Finally, another very sizable economic be more missteps, only through further more aggressively to the crisis early on. stimulus plan will be needed early next aggressive and consistent government action Officials misjudged the severity of the year. The most economically efficient plan will the U.S. avoid the most severe economic situation, and allowed themselves to be would include aid to state governments downturn since the Great Depression. hung up by concerns about moral hazard and infrastructure spending, in addition In some respects, the current financial and fairness. Considering the widespread to another round of tax cuts. The crisis has its genesis in the long-held economic loss of wealth, it is now clear they waited economy’s problems are likely to continue policy objective of promoting homeownership. much too long to act, and their response long enough to make such spending Since the 1930s, policy has been geared to the financial failures in early September particularly helpful a year from now. toward increasing homeownership by was inconsistent and ad hoc. Nationalizing Each of these measures carries heavily subsidizing home purchases. While Fannie Mae and Freddie Mac but letting substantial costs. The federal budget homeownership is a worthy goal, fostering Lehman Brothers fail confused and spooked deficit, which topped $450 billion in the stable and successful communities, it was global investors. The shocking initial failure just-ended 2008 fiscal year, could easily carried too far, producing a bubble when of Congress to pass the TARP legislation exceed $750 billion in fiscal 2009 and millions of households became homeowners caused credit markets to freeze and sent go even higher in 2010. Borrowing by who probably should not have. These people stock and commodity prices crashing. the Treasury could top $2 trillion this are now losing their homes in foreclosure, Now, a new policy consensus has year. There will also be substantial long- undermining the viability of the financial been forged out of financial collapse. It term costs to extricating the government system and precipitating the current recession. is widely held that policymakers must from the financial system. Unintended Perhaps even more important has take aggressive and consistent action to consequences of all the actions taken been the lack of effective regulatory quell the panic and mitigate the resulting in such a short period of time will be oversight. The deregulation that began economic fallout. An unfettered Federal considerable. These are problems for during the Reagan administration fostered Reserve will pump an unprecedented another day, however. The financial system financial innovation and increased amount of liquidity into the financial is in disarray and the economy’s struggles the flow of credit to businesses and system to unlock money and credit are intensifying. Policymakers are working households. But deregulatory fervor markets. The TARP fund will be deployed hard to quell the panic and shore up went too far during the housing boom. more broadly, through direct equity the economy; but given the magnitude Mortgage lenders established corporate stakes in financial institutions and via of the crisis and the continuing risks, structures to avoid oversight, while at reverse auctions to give private investors policymakers must be aggressive. Whether the Federal Reserve, the nation’s most the information they need to make new from a natural disaster, a terrorist attack, important financial regulation, there was a investments in these institutions. Another or a financial calamity, crises only end with general distrust of regulation. much larger and comprehensive mortgage overwhelming government action.

22 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 Addendum: Federal Reserve Actions Addressing the Financial Crisis

August 17, 2007. Spread between discount and funds rate cut to 50 bps from 100 bps. Max term extended to 30 days from daily.

August 21, 2007. Fee charged primary dealers when they borrow from the Securities Lending Program lowered.

August 24, 2007. Fed affirmed its policy to accept investment grade asset-backed commercial paper as collateral. Wall Street Journal reported that Fed was “exempting [a bank] from statutory limits on how much its bank unit…can lend to its affiliated broker dealer” – allowing clients’ assets at a broker/dealer subsidiary to be used as collateral for borrowing.

December 12, 2007. New Term Auction Facility (TAF) announced–offering $40 billion in term loans (28- and 35-day) through an auction process to the depository institutions eligible for discount window borrowing.

December 12, 2007. New FX swap lines with the ECB and SNB announced–$24 billion in total.

January 4, 2008. TAF expanded to $60 billion from $40 billion.

March 7, 2008. TAF expanded to $100 billion. Also, Fed began a series of 28-day repos expected to cumulate to $100 billion.

March 11, 2008. A new $200 billion Term Securities Lending Facility (TSLF) announced–lending Treasury securities to dealers, secured for a term of 28 days by a pledge of other securities, including Treasuries, Federal Agency debt, Agency MBS and non-Agency AAA-rated private label residential MBS. (Non-agency collateral must not be on review for downgrade.)

March 11, 2008. Increased swap lines with the ECB and SNB–to $36 billion in total from $24 billion.

March 14, 2008. Emergency funding for Bear Stearns provided through JP Morgan, via a non-recourse 28-day discount window loan secured by Bear Stearns collateral.

March 16, 2008. Spread between discount and funds rate cut to 25 bps from 50 bps. Maximum term on primary credit (discount window) loans extended to 90 days from 30 days.

March 16, 2008. Primary Credit Dealer Facility (PCDF) established, extending discount-window-like lending to primary dealers–providing overnight loans “in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements…, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.”

May 2, 2008. TAF expanded to $150 billion from $100 billion.

May 2, 2008. Increased swap lines with the ECB and SNB–to $62 billion in total from $36 billion.

May 2, 2008. Allowed collateral for Schedule 2 TSLF auctions expanded to include AAA/Aaa-rated asset-backed securities, in addition to already eligible residential- and commercial-MBS and agency CMO. Treasury securities, agency securities, and agency mortgage-backed securities continued to be eligible as collateral in Schedule 1 TSLF auctions.

July 30, 2008. PDCF and TSLF extended through January 30, 2009.

July 30, 2008. Introduction of auctions of options on $50 billion of draws on the TSLF.

July 30, 2008. TAF adjusted to include 84-day as well as 28-day loans. Total program left at $150 billion.

July 30, 2008. ECB swap line raised to $55 billion from $50 billion of draws on the TSLF.

September 14, 2008. Collateral eligible for PDCF broadened to closely match the types of collateral in tri-party repo systems of the two major clearing banks (including equities). PDCF collateral had been limited to investment-grade debt securities.

September 14, 2008. TSLF expanded to $200 billion in total, from $175 billion. Collateral eligible for Schedule 2 auctions expanded to all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage- backed and asset-backed securities could be pledged.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 23 Addendum: Federal Reserve Actions Addressing the Financial Crisis (cont.)

September 14, 2008. Temporary (through January 30, 2009) relaxation of rules (section 23A of the Federal Reserve Act) on depository institutions (banks) providing funding for their nonbank affiliates.

September 16, 2008. Lend insurance company AIG up to $85 billion as part of an effective nationalization of the company.

September 18, 2008. Central bank swap lines increased to $247 billion from $67 billion, including new BOJ, BOE, and BOC lines.

September 19, 2008. Extension of non-recourse loans at the primary credit rate to U.S. depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from money-market mutual funds.

September 19, 2008. Expansion of outright purchases by the Fed’s open market desk to include short-term agency debt.

September 21, 2008. Approval of applications of Goldman Sachs and Morgan Stanley to become bank holding companies.

September 24, 2008. Central bank swap lines increased to $277 billion from $247 billion, including new lines with the Reserve Bank of Australia, the Sveriges Riksbank, the Danmarks Nationalbank, and the Norges Bank.

September 26, 2008. Central bank swap lines expanded to $290 billion from $277 billion.

September 29, 2008. TAF expanded to $300 billion from $150 billion.

September 29, 2008. Addition of two extra TAF auctions, totaling $150 billion, to provide funding at year-end (in addition to $300 billion in regular program, implying $450 billion in total at year-end).

September 29, 2008. Central bank swap lines increased to $620 billion from $290 billion.

October 6, 2008. Using new authority voted on by Congress (as part of the EESA), the Fed announced it will begin paying interest on depository institutions’ required and excess reserve balances. The interest rate paid on required reserve balances will be the average targeted federal funds rate over each reserve maintenance period less 10 bps. The rate paid on excess balances will be set initially as the lowest targeted federal funds rate over each reserve maintenance period less 75 bps. According to the Fed, the change “will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.” Effective date: October 9, 2008.

October 6, 2008. Regular TAF expanded to $600 billion from $300 billion. In addition, the extra TAF auctions providing funds at year-end were expanded to $300 billion from $150 billion, implying $900 billion in total at year-end.

October 6, 2008. The Fed published a letter granting a request by a depository institution for an exemption from the limits on transactions with affiliates under section 23A of the Federal Reserve Act and the Board’s Regulation W to allow the institution to purchase assets from affiliated money-market mutual funds under certain circumstances.

October 7, 2008. Creation of a Commercial Paper Funding Facility, providing a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers.

October 8, 2008. Fee charged primary dealers when they borrow from the Securities Lending Program lowered again.

October 8, 2008. Lend AIG up to an additional $37.8 billion, collateralized by investment-grade, fixed income securities.

October 13, 2008. Expansion of swap lines with foreign central banks, including the BoE, the ECB, the SNB and BoJ to provide as much dollar funding as is requested at specified lending rates; instead of auctioning a fixed amount of funds, with bids determining the interest rate, foreign central banks will now provide as much funding as is bid for at a preset interest rate.

October 16, 2008. Allows bank holding companies to include in their Tier 1 capital without restriction the senior perpetual preferred stock issued to the Treasury Department under the announced by the Treasury on October 14.

24 Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 Addendum: Federal Reserve Actions Addressing the Financial Crisis (cont.)

October 21, 2008. Creation of Money Market Investor Funding Facility. The Fed announces that it will create a series of private sector special purpose vehicles that will provide a source of secondary market liquidity for money-market instruments.

October 27, 2008. Fed begins to purchase three-month unsecured and asset-backed commercial paper directly from issuers through CPFF facility.

October 29, 2008. Establishes temporary swap lines with Brazil, Mexico, South Korea and Singapore. The expansion of the swap program to emerging economies expands the Fed’s role as a backstop to the global financial system.

Moody’s Economy.com • www.economy.com • [email protected] • Regional Financial Review / October 2008 25