Incremental Expansion of Liquidity Facilities, March 2008-August 2008

In March 2008, as the New York investment bank Bear Stearns flirted with bankruptcy due to its exposure to bad mortgage investments, conditions in the wholesale markets significantly worsened. Vice Chairman Timothy Geithner provided a colorful label for what was happening: an "adverse dynamic margin-spiral-downward-self-feeding thing.”[1] The cause of the spiral, Bernanke concluded, was the continued withdrawal of money market funds and "other, less sophisticated investors” from credit markets as fears about exposures to vulnerable banks like Bear grew.[2] Of course, the very decision by money market funds to pull out of the market only pushed the vulnerable financial institutions closer to the edge. This point was echoed by one governor whose "real concern” was that many of the money markets "that hold between $3 trillion and $4 trillion will just walk away.”[3] Foreign banks were especially susceptible to tightening credit conditions. At one meeting, a Fed researcher informed committee members of the unfolding problem facing European banks backing "conduits” (like Ormand Quay discussed above) that had financed billions of dollars in MBS investments by selling ABCP to US money market funds:

As the conduits that issued the ABCP encountered difficulty rolling their paper over, many of these banks, fearful of damage to their reputations, elected to purchase assets from the conduits or extend credit to them, which proved in many cases to be a significant source of balance sheet pressures. This list is dominated by European banks.[4]

One member observed that as credit dried up in London and across Europe, there was a growing possibility that a major financial institution would fail as "liquidity and solvency [were] becoming intertwined.” Dudley echoed this sentiment, warning that "if the vicious circle were to continue unabated, the liquidity issues could become solvency issues, and major financial intermediaries could conceivably fail.”[5]

As the committee worried about the exposure of US institutions to increasingly illiquid European counterparts, it also lamented that the dollar shortage was blunting the stimulative impact of aggressive rate cuts. Members recognized that the liquidity crisis "impairs the monetary policy transmission mechanism” such that "mortgage rates have risen ... even with Treasury rates going down.”[6] The Fed was clearly aware of the "ominous” link between Libor and ARMs. One member explained to the group, "The LIBOR-OIS spread has widened, so borrowers tied to LIBOR rates have seen those rates rise more than 25 basis points since the last meeting.”[7] At another meeting, an FRB president relayed concerns from his district about a "second wave of foreclosures” among option ARM mortgage borrowers.[8] By the end ofApril, it is clear the committee understood that the swap lines and other liquidity facilities were "associated with a decline in ... LIBOR.”[9] Consequently, Geithner lobbied other members to vote in favor of expanding the swap lines and TAF in order to

[take] another shot at trying to get [Libor] down . . because—to use a technical term—[it is] screwing up the transmission mechanism of US monetary policy now. We’re not sure how much effect we can have. There is a plausible case that increasing the size of the swaps will help on that front.[10]

It was within the context of these discussions that the FOMC voted unanimously to renew (once) and expand the size of its swap lines (three times) with the ECB and SNB. At the same time, the Fed increased the size and lengthened the maturity on TAF loans, and it introduced several additional domestic liquidity facilities that also began to lend to foreign banks operating within the United States.

  • [1] FOMC 2008d, p. 15.
  • [2] Ibid., p. 17.
  • [3] Ibid., p. 83.
  • [4] FOMC 2008A, p. 161. Emphasis added. Materials presented at that FOMC meetingidentify the following three foreign banks as being most exposed to the liquidity strainsfacing ABCP conduits: HBOS (United Kingdom), HSBC (United Kingdom), and Fortis(Belgium), responsible for $42, $33, and $26 billion in outstanding ABCP, respectively(FOMC materials 2008, 240).
  • [5] FOMC 2008b, pp. 22, 7.
  • [6] FOMC 2008b, p. 5; FOMC 2008c, p. 57.
  • [7] FOMC 2008d, p. 56. Emphasis added. Fed staff materials during the crisis also echoedthis concern: "Amid poor liquidity, rates on six-month and one-year Libor—reference ratesfor a wide variety of contracts, including floating-rate mortgages—rose over the intermeeting period” (Blue Book 2008, p. 11). OIS stands for "overnight indexed swap.” The Libor-OISspread is similar to the Libor-TED spread. Both are used to measure stress in money markets.
  • [8] FOMC 2008e, p. 37.
  • [9] FOMC 2008d, p. 7.
  • [10] Ibid., p. 15.
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