Credit Crisis: How Did We Get Here, and What the Fed is

Doing To Get Us Out of Here?

Raymond W StoneStone & McCarthy Research

May 22, 2008

Too Easy for Too Long? (2003/2005)

Low Mortgage Rate, Especially Adjustable Rate Mortgages, Provide a Boost to Home Sales

In early August 2007 Structured Investment Vehicles were unable to roll over Commercial Paper

Problems that were especially acute in the subprime mortgage market, weighed on the prices of MBS, reducing the collateral value of these securities for issuers of ABCP

At the heart of the problem were falling home prices

So Who Is To Blame?• The Fed for Keeping Rates Too Low for too Long• Clearly Regulators Including the Fed Should

have been more proactive• Securitization of Mortgages, shifting risk from

direct lenders to a broad spectrum of investors• Rating Agencies• Risky Mortgage Instruments, and little discipline

on the part of Mortgage Brokers• Naïve Public—”If a bank is willing to make me a

load they must think I will be able to repay”

The inability of issuers to roll-over ABCP forced borrowers to show up at the doorsteps of banks

Banks faced with increased funding requirements, aggressively attempted to increase so-called “Managed-Liabilities”

Banking System

asset s liabilt ies

+ Bank Credit + m anaged liabilit ies including Large Tim e Dep

Term Fed Funds

Eurodollar / Libor Bor rowing

Banks’ sudden surge in assets triggered funding/liquidity requirements rendering strains in the inter-bank funding market

In response to funding strains and stress on bank capital positions, banks tightened lending standards

Not only was credit less available, but it also became more costly

Today the Fed’s duties fall into four general areas:

• Conducting Monetary Policy in pursuit of dual mandate

• Supervising and regulating banking institutions

• Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

• Providing financial services to banks, the US government and foreign official institutions

Why Should We Care About Financial Stability?

• Because financial market strains impact on both the cost of credit, and the availability of credit.

• Which can adversely influence the Fed’s ability to achieve maximum sustainable growth and employment

• Thereby worsening financial strains, creating an “Adverse Feedback Loop”

To Address Concerns Regarding Financial Market Stability and the Downside Risks to Economic Activity:

• The FOMC has cut the Federal Funds Target from 5-/14% last summer to only 2% now.

• Also the Fed has instituted a number of extraordinary measures to provide liquidity and insure an orderly functioning of the financial markets

The Federal Reserve has instituted a number of innovations to reduced strains in the inter-bank funding market

• Term Discount Window Program (August 17, 2007)• Term Auction Facility—TAF (Dec 12, 2007)• Single-Tranche OMO Program (March 7, 2008)• Term Security Lending Facility--TSLF (March 11, 2008)• Primary Dealer Credit Facility (March 16, 2008)• Lending Specific to Bear Stearns/JP Morgan Chase Deal

Effectively the Fed has used its Balance Sheet in a creative fashion

Has the Fed’s Balance Sheet Been Compromised?

I . Chgs Federa l Reserve Ba lance Sheet ( De c 5 , 2 0 0 7 to Ma y 7 )Weekly averages ($blns)

asset s liabilt ies

- $237.3 Outr ights $1.0 Re se r v e Ba la nce s$72.7 RPs

$100.0 TAF Cr e dit - $3.7 Cur r e ncy in Cir cula t ion$16.5 PDCF Cr e dit $0.3 Tr e a sur y De posits$11.3 Othe r Discount Adv a nce s

$2.7 Re v e r se RPs ( For e ign Off icia l)$0.0 Re v e r se RPs ( De a le r s)

- $0.7 Floa t $38.1 Othe r FR Asse ts (including SWAP drawings) $0.4 All Othe r Lia bil it ie s & Ca pita l

$0.7 Tota l Re se r v e Ba nk Cr e dit$0.0 Gold stock - $0.3 Fa ctor s Absor bing Re se r v e s$0.0 Special Drawing Rights$0.0 Treasury Currency Outstanding

$0.7 Tota l Fa ctor s Supply ing Re se r v e s $0.7 Tota l Lia bilit ie s & Ca pita l

After Lots of Easing and Much Twisting of the Fed’s Balance Sheet, What’s Next?