September 18, 2007 1 of 188 Meeting of the Federal Open Market Committee on September 18, 2007 A joint meeting of the Federal Open Market Committee and the Board of Governors of the Federal Reserve System was held in the offices of the Board of Governors in Washington, D.C., on Tuesday, September 18, 2007, at 8:30 a.m. Those present were the following: Mr. Bernanke, Chairman Mr. Geithner, Vice Chairman Mr. Evans Mr. Hoenig Mr. Kohn Mr. Kroszner Mr. Mishkin Mr. Poole Mr. Rosengren Mr. Warsh Mr. Fisher, Ms. Pianalto, and Messrs. Plosser and Stern, Alternate Members of the Federal Open Market Committee Messrs. Lacker and Lockhart, and Ms. Yellen, Presidents of the Federal Reserve Banks of Richmond, Atlanta, and San Francisco, respectively Mr. Madigan, Secretary and Economist Ms. Danker, Deputy Secretary Ms. Smith, Assistant Secretary Mr. Skidmore, Assistant Secretary Mr. Alvarez, General Counsel Mr. Baxter, Deputy General Counsel Ms. K. Johnson, Economist Mr. Stockton, Economist Messrs. Clouse, Connors, Fuhrer, Kamin, Rasche, Slifman, and Wilcox, Associate Economists Mr. Dudley, Manager, System Open Market Account Ms. J. Johnson,¹ Secretary, Office of the Secretary, Board of Governors Mr. Frierson,¹ Deputy Secretary, Office of the Secretary, Board of Governors Ms. Bailey¹ and Mr. Roberts,¹ Deputy Directors, Division of Banking Supervision and Regulation, Board of Governors _______________ ¹ Attended portion of the meeting relating to the discussion of approaches to stabilizing money markets. September 18, 2007 2 of 188 Mr. English, Senior Associate Director, Division of Monetary Affairs, Board of Governors Ms. Liang and Mr. Reifschneider, Associate Directors, Division of Research and Statistics, Board of Governors Mr. Wright, Deputy Associate Director, Division of Monetary Affairs, Board of Governors Mr. G. Evans,¹ Assistant Director, Division of Reserve Bank Operations and Payment Systems, Board of Governors Mr. Blanchard, Assistant to the Board, Office of Board Members, Board of Governors Mr. Oliner, Senior Adviser, Division of Research and Statistics, Board of Governors Mr. Meyer, Visiting Reserve Bank Officer, Division of Monetary Affairs, Board of Governors Mr. Small, Project Manager, Division of Monetary Affairs, Board of Governors Mr. Natalucci, Senior Economist, Division of Monetary Affairs, Board of Governors Mr. Luecke, Senior Financial Analyst, Division of Monetary Affairs, Board of Governors Ms. Beattie,¹ Assistant to the Secretary, Office of the Secretary, Board of Governors Ms. Low, Open Market Secretariat Specialist, Division of Monetary Affairs, Board of Governors Ms. Holcomb, First Vice President, Federal Reserve Bank of Dallas Messrs. Judd, Rosenblum, and Sniderman, Executive Vice Presidents, Federal Reserve Banks of San Francisco, Dallas, and Cleveland, respectively Messrs. Dzina and Hakkio, Mses. Krieger¹ and Mester, and Messrs. Rolnick and Weinberg, Senior Vice Presidents, Federal Reserve Banks of New York, Kansas City, New York, Philadelphia, Minneapolis, and Richmond, respectively Messrs. Krane, Peach, and Robertson, Vice Presidents, Federal Reserve Banks of Chicago, New York, and Atlanta, respectively _______________ ¹ Attended portion of the meeting relating to the discussion of approaches to stabilizing money markets. September 18, 2007 3 of 188 Transcript of the Federal Open Market Committee Meeting of September 18, 2007 CHAIRMAN BERNANKE. Good morning, everybody. I’d like to welcome Charlie Evans to the table. Charlie is no stranger. He has been attending these meetings since February 1995, certainly ahead of me. So congratulations and welcome. MR. EVANS. Thank you very much. CHAIRMAN BERNANKE. I’d also like to thank Cathy Minehan in absentia [laughter] for being willing to postpone her celebratory lunch until the next meeting, but we will do that in October. The first item of business is to select associate economists. With Brian Madigan becoming the secretary and Mr. Evans taking on a new role, we need to appoint two associate economists: Jim Clouse from the Board and Dan Sullivan from Chicago have been nominated. Do I have a motion? SPEAKER. Moved. CHAIRMAN BERNANKE. Moved. Discussion? Thank you. All right. Let’s turn now to the Desk operations. Bill. MR. DUDLEY.1 Thank you, Mr. Chairman. I’ll be referring to the handout that you have in front of you. In my mind, there are three key questions. First, how did the problems in the subprime mortgage area—with losses that probably will ultimately turn out to be in a range of $100 billion to $200 billion—lead to such broad market distress? Second, what is the cause of the dysfunction in U.S. and European money markets? Third, how far along are we in terms of the adjustment process—in other words, when might we anticipate a resumption of normal market function? Turning to the first question, the losses in subprime mortgages had wide-ranging effects because the poor investment performance made investors much less willing to invest in structured-finance products more generally. Investors lost confidence because highly rated securities that referenced subprime assets performed poorly and because investors found it difficult to value complex structured-finance products. This loss of confidence triggered several broader developments: the inability of mortgage originators to securitize nonconforming mortgage loans; the rapid 1 Materials used by Mr. Dudley are appended to this transcript (appendix 1). September 18, 2007 4 of 188 contraction of the asset-backed commercial paper (ABCP) market; the virtual shutdown of the collateralized debt obligation (CDO) and collateralized loan obligation (CLO) markets; the sharp shifts we saw into and out of Treasury-only versus prime money market mutual funds, which in turn disrupted the Treasury bill market; and the anticipated pressure on bank balance sheets and the upward pressure on term funding rates. The pressure on bank balance sheets is coming from three major sources. First, investor demand for securitized non-agency mortgage-backed securities has dried up. Bank originators now have to hold such loans in their bank portfolios. Second, bank backstop liquidity facilities have been triggered as investor appetite for asset-backed commercial paper has fallen sharply. Third, banks are expected to have difficulty syndicating the bridge loans that they provided to finance leveraged buyouts. Of these three sources of pressure, the rollup of ABCP programs has been, in my view, the most important. The magnitude of the potential funding requirement is the largest, and how much will come back onto bank balance sheets is very uncertain. The constraint on mortgage loan origination can be seen most visibly in the widening of the spread between fixed-rate prime jumbo mortgage loan rates and conforming mortgage loan rates. As you can see in exhibit 1, the spread has widened from around 25 basis points to around 100 basis points in recent weeks. The sharp contraction in the ABCP market began when commercial paper investors became aware that their investments could be vulnerable to loss but were uncertain as to the extent of their exposure in particular programs. This fear of loss had a legitimate basis for those ABCP programs that finance mortgage-related assets without full bank credit enhancement. An inability to roll over these programs in the current market would force the liquidation of the assets. In the current market, that could lead to investor losses. The problem started in extendable commercial paper market programs, where the credit enhancement backstop by banks was typically either absent or less than 100 percent. The problem then quickly migrated to structured-investment vehicle (SIV) programs, which suffered from similar shortcomings. From there, the problem spread as risk-averse investors started to shun the entire asset class. Asset-backed commercial paper rates rose for those programs that were able to roll over their outstanding commercial paper. This is shown in exhibit 2, which compares unsecured and secured commercial paper rates. The volume of outstanding asset- backed commercial paper shrank sharply as some issuers were unable to roll over their maturing paper. Exhibit 3 illustrates the downtrend in the volume of outstanding ABCP. Exhibit 4 shows the maturity structure of outstanding asset-backed commercial paper and highlights the high proportion of paper that is now being rolled on an overnight basis. The pressure on the asset-backed commercial paper market was temporarily exacerbated by the behavior of money market mutual fund investors, who shifted funds last month from prime money market funds to Treasury-only money market funds (see exhibit 5). Because the total assets in money market mutual funds are nearly four times the size of outstanding Treasury bills, these flows led to a large, albeit mostly transitory fall in Treasury bill yields. That is shown in exhibit 6. September 18, 2007 5 of 188 The good news is that the money flows into the prime money mutual funds have stabilized. This reflects greater discernment among investors about the risks associated with different types of asset-backed commercial paper and the widening yield differentials between prime and Treasury-only money market funds. It is noteworthy that those areas of the asset-backed commercial paper market with underlying structural problems—primarily the extendable, SIV, and SIV-lite portions of the market—represent only a small proportion of total asset-backed commercial paper outstanding. For example, as shown in exhibit 7, SIV