THE INTEREST-RATE THREAT AND THE FED’S ILLR ACTIONS
As the evidence indicates, stabilizing the US financial system was a fundamental motivation behind the Fed’s unprecedented ILLR actions in 20082009. Yet, another risk facing the US economy likely played a role in the Fed’s decision. Besides protecting banks and money market funds from foreign default, the swap program represented an indirect way ofbringing down rising interest rates that the Fed did not have direct control over. As domestic credit markets in the United States tightened during the panic, the Fed aggressively cut short-term interest rates in the hopes of stimulating the economy. Between October 31, 2007, and December 16, 2008, the central bank slashed the federal funds rate on nine separate occasions from a high of 4.5 percent to a target rate of 0.25 percent or below. Despite these unprecedented efforts, interest rates on many contracts were not falling. Indeed, some began climbing. This had to do with a trend that developed nearly 20 years prior to the crisis. Beginning in the early 1990s, a wide variety of financial products, including corporate and consumer loans, started to be linked to the London Interbank Offered Rate (Libor). Hence, if Libor rose, so did rates on any financial product linked to it. The Libor index is tallied daily by the British Bankers’ Association, which polls an elite group of 16 major banks to see at what rate a bank could borrow dollars from other banks. Unlike the federal funds rate, which is under the direct control of the Fed, Libor is more independent of the US monetary authority. What made the Libor link especially threatening during the financial crisis was the fact that the vast majority of adjustable-rate mortgages (ARMs) in the United States were also indexed to Libor. During the 2000s, it had become commonplace for banks to issue what are referred to as "hybrid ARMs”—mortgages that begin with a fixed interest rate for the first two or three years and then reset (monthly, semi-annually, or annually) based on the rate to which they were indexed.33 Libor is not a dollar swap line with the Reserve Bank of India. However, the Fed rebuffed the request, reportedly because the rupee was not a fully convertible currency (Agrawal and Goyal 2012). See Helleiner (2014, p. 46) and Prasad (2014, pp. 208-209) for brief discussions of other requests for swap deals that were reportedly rebuffed by the Fed.
33. Schweitzer and Venkatu 2009.
the only rate to which ARMs have been indexed. Indeed, there are three other indices that have been used. However, in the decade leading up to the crisis, Libor became the index of choice. At the time of the financial crisis, some 60 percent of prime hybrids and virtually all of subprime hybrids were indexed to Libor.
Libor began showing signs of strain as early as the summer of 2007; the trend continued and worsened after Lehman collapsed. As banks panicked, interbank lending sputtered to a halt and the rates banks charged one another for dollars rose rapidly. Since Libor reflects the rates banks are charging each other for credit, the financial market skittishness caused the index to spike. Between September 15 and October 15, 2008, the one- month dollar Libor rate nearly doubled from roughly 2.5 to 4.5 percent. Consequently, many US homeowners with prime ARMS and virtually all homeowners with subprime ARMs ready to reset during the fall of 2008 were about to experience a significant hike in their monthly payment. How significant is this? One report gives us a pretty good guess. The authors estimate the spread between monthly payments of ARMs linked to US Treasury rates—the second most popular index for ARMs at the time, and one more sensitive to changes in the federal funds rate—and those linked to Libor. They conclude that for a typical subprime borrower, having a Libor-indexed loan as opposed to a Treasury-indexed loan equaled a roughly $100 monthly payment increase for every $100,000 of remaining principal. For prime borrowers, the figure was about $50 per month. According to an internal Citibank report from October 6, 2008, the Libor spike was predicted to bring about a "10 [percent] increase in defaults for outstanding non-delinquent ARMs at reset, which translates to roughly 1.8 [percent] increase in cumulative loss.” And this was for Citibank alone. The trend was the same across other major banks as well. Libor was threatening to bring about a second wave of foreclosures as more ARMs prepared to reset at even higher and more unsustainable interest rates. As Figure 7.10 depicts, a vicious cycle was emerging where initial subprime losses caused interbank lending to seize up and Libor to rise, which was poised to cause more subprime losses and feedback into credit markets. The US monetary authority had a clear interest in doing whatever it could to indirectly bring Libor rates under control to prevent this vicious cycle from fully developing.
Libor/ARM Default Vicious Cycle
It was in this environment that the Fed opened and expanded its swap program, which I contend was partially aimed at bringing Libor rates back in line with Treasury rates. As stated previously, Libor first began showing strains in the summer of 2007. This was visible due to movements in the TED spread, which measures the difference between Libor and short-term Treasury rates. As discussed earlier, the TED spread, which typically averaged around 40 basis points, spiked several times during the crisis. The first spike was in August 2007, when it reached 240 basis points. That month the Fed first approached the ECB about the possibility of opening up a swap line between the two central banks. The second TED spread spike was on December 12, 2007, when it reached 220 basis points. On that same day, the Fed opened its first two swap arrangements with the ECB and SNB. The third spike was in March 2008, when the spread hit 203 basis points. That month marked the first wave of swap line increases. Then, when Lehman filed for bankruptcy, the spread peaked at an astounding 457 basis points. Again, this large spread meant that resetting Libor-linked AR Ms would experience substantial mortgage payment increases. Following Lehman’s collapse and the major TED spread spike, the Fed’s swap program entered its dramatic 40-day period of expansion.
How did the swaps function as a method for the Fed to rein in a wild Libor rate? Because Libor reflects risk and tension in the international interbank lending market—specifically lending in dollars—swaps provided an alternative means of getting dollars in the hands of foreign banks that needed them. A purely domestic injection of liquidity would only have had a marginal effect on Libor, since huge volumes of dollars are also lent outside of the United States. Indeed, of the 16 banks that were polled daily to determine the rate, 13 were non-US institutions. Consequently, easing the domestic interbank lending market would not have been sufficient to bring Libor rates, and hence ARM rates, down. Foreign banks had to be included as well, which is why the swap program was the perfect backdoor method to rein in Libor. Foreign central banks could now deliver liquidity to dollar-starved banks through auctions. This relieved demand in the frozen interbank market. As demand for dollars between banks shrank (because demand was now met via the swap lines) the rates banks charged each other for dollars fell. When the Fed made four of the swap lines unlimited in size and increased the total number of central banks participating to 14, Libor fell from its mid-October high faster than it had risen to that point. It dropped from roughly 4.5 to 1.5 percent by mid-November 2008. The TED spread, for its part, closed from 457 basis points to 210 basis points in the same period. And, although still elevated, these declines represent dramatic improvements in a very short period of time. The swaps had both a practical as well as a psychological effect on markets, helping to bring Libor under control. As Naohiko Baba and Frank Packer explain,
Financial markets reacted well to the announcements of both the increases in the absolute amounts of the swap lines and the increase in numbers. In particular, the approval of unlimited dollar swap facilities for selected central banks on October 13 was greatly welcomed. Many market participants reported that the expended swap facilities improved term funding conditions.
As Libor fell, resetting ARMs now faced rates considerably closer to the Treasury rates the Fed had more control over. Ifthe Fed viewed swap lines as a way to prevent Libor-indexed ARMs from experiencing significant monthly payment increases, they proved to be an effective tool.
-  Others indices include the one-year constant-maturity Treasury yield, the EleventhDistrict Cost-of-Funds Index, and the Federal Housing Finance Board national averagecontract interest rate.
-  Parulekar et al. 2008, p. 1.
-  Ibid., p. 1.
-  Spread according to Bloomberg Financial, available at http://www.bloomberg.com/apps/ cbuilder? ticker1=.TEDSP:IND, on July 21, 2010.
-  Baba and Packer 2009, p. 11.