Crisis & Response
Housing Bubble Burst - 2006
In 2006, the housing bubble burst as housing prices fell, mortgage defaults increased and lending dried up. This resulted in a shortfall of liquidity within the financial markets. These meant institutions were running out of liquid assets, or assets that could be readily sold. This relayed into liquidity shocks when asset owners began trying to recover the full value of their assets and were unable to.
Liquidity problems that started in the housing market spread to other credit markets and resulted in a worldwide “credit crunch” in August 2007. Loss of confidence in the market caused banks to become more protective of their liquidity and less willing to lend and risk default. As a result, many types of corporate and financial borrowers trouble obtaining credit to fund transactions or to refinance existing debt.
In such an illiquid financial condition, the banks were facing the risk of widespread insolvency that threatened to spread to other banks and intensify the crisis (“CRS Report for Congress”).
Initial Fed Response in August 2007
As an initial response to the shortage of credit in the financial markets, the U.S. Federal Reserve then injected about $24 billion into the money supply for banks to borrow at a low rate (Federalreserve.gov). It allowed collateralization of such loans and extended the use of the discount window rate to primary dealers, who as non-banks were previously unable to borrow from the Fed’s discount window. On August 17, 2007, the Fed extended its normal lending period from overnight to 30 days, and then later eventually extended the period to 90 days (Cecchetti).
In such an illiquid financial condition, the banks were facing the risk of widespread insolvency that threatened to spread to other banks and intensify the crisis (“CRS Report for Congress”).
Initial Fed Response in August 2007
As an initial response to the shortage of credit in the financial markets, the U.S. Federal Reserve then injected about $24 billion into the money supply for banks to borrow at a low rate (Federalreserve.gov). It allowed collateralization of such loans and extended the use of the discount window rate to primary dealers, who as non-banks were previously unable to borrow from the Fed’s discount window. On August 17, 2007, the Fed extended its normal lending period from overnight to 30 days, and then later eventually extended the period to 90 days (Cecchetti).
Key Terms
· Bubble: a continuing trend of growth and rising prices beyond the point of sustainability
· Default: failing to pay back a debt
· Liquidity: ready availability of monetary assets
· Shock: a sudden change to liquidity in the financial system—most often a shortage
· Collateralization: making an asset available in the event of default
· Commercial paper: A money market short-term note sold by banks to meet short term debt obligations
· Default: failing to pay back a debt
· Liquidity: ready availability of monetary assets
· Shock: a sudden change to liquidity in the financial system—most often a shortage
· Collateralization: making an asset available in the event of default
· Commercial paper: A money market short-term note sold by banks to meet short term debt obligations
"The Federal Reserve has responded aggressively to the financial crisis since its emergence in the summer of 2007. The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy. In addition, the Federal Reserve has implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These new programs have led to a significant change to the Federal Reserve’s balance sheet."
During the credit crunch, banks essentially quit lending money which greatly hurts multiple parts of the economy, especially investment. In order to keep financial markets functioning, banks have to be able to lend and they must have liquid assets to do so. Although they vary slightly, the following programs all have essentially the same goal: to promote liquidity in financial markets using a variety of tools.
Federal Funds Rate: The Fed followed with cuts to the federal funds rate starting on Sept. 18, 2007. The Federal funds rate was lowered from 5.25% to 2% and through 6 step actions. Since mid 2007, the target federal funds rate has gone from 5.25% to close to 0%, an unprecedented move to provide liquidity into the market. Given the severity of the crisis, the Fed has indicated that it will maintain its accommodative monetary stance.
Discount Window: The Federal Reserve also introduced new terms to the Discount Window Program that basically reduced the price of borrowing primary credit through discount window: The discount rate was lowered from 5.75% to 2.25% in an attempt to provide more liquidity to the markets. They were hoping the cut could help convince banks it was okay to keep lending to creditworthy companies or consumers.
Fed Programs
The Federal Reserve has designed a variety of new programs (the Fed calls them tools) beyond the traditional monetary policy tools in response to the current financial crisis. The Fed web site explains:
The Federal Reserve has designed a variety of new programs (the Fed calls them tools) beyond the traditional monetary policy tools in response to the current financial crisis. The Fed web site explains:
