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Steve Cecchetti's Recent Federal Reserve Actions FAQ

They aren't "frequently" asked questions, but they are good questions--and very good answers:

Subprime ‘crisis’: FAQs: Federal Reserve policy actions in August 2007: Here are the basic how's and why's of what the Fed has been doing to calm financial markets.

Let’s start with the facts: On Thursday 9 August 2007 the Federal Reserve’s Open Market Trading Desk (the “Desk”) injected $24 billion into the U.S. banking system. This was done in two equal size operations, one at 8:25am and a second 70 minutes later at 9:35am.1 On Friday 10 August 2007, the Desk was in the market three times (8:25am, 10:55am, and 1:50pm) putting in a total of $38 billion.

The Fed’s operations came on the heels of two even larger injections by the ECB in Frankfurt. On Thursday morning the European Central Bank (ECB) in Frankfurt, Germany had put nearly €95 billion ($130 billion) into European financial institutions, followed by a somewhat smaller operation of €61 billion ($83.6 billion) on Friday.

How is this actually done? What are the mechanics of the transactions? In all of these cases, the funds were put into the banking system using what are called “repurchase agreements” or “repos”... a short-term collateralised loan in which a security is exchanged for cash, with the agreement that the parties will reverse the transaction on a specific future date at an agreed-upon price.... The Federal Reserve Bank of New York’s Open Market Desk engages in repurchase agreements every morning (the exact time varies). The quantities normally range from $2 billion to $20 billion. Most of them are overnight, but it is standard to engage in repos that are as long as 14 days. The $35 billion on Friday 10 August 2007 was the largest since those in the aftermath of the 9/11 terrorist attacks. (The record is $81.25 billion on 14 September 2001.)

What happens if the bonds used in the repo fall in value overnight? When the Fed engages in a repo, the... “counterparty” agrees to repurchase the security at a fixed price regardless of what happens.... The only risk the Fed faces is that the counterparty in a repo goes bankrupt....

If the Fed has $35 billion to help the financial system, why can’t they use some of their money to help the poor? The Fed isn’t spending the money on bailing out banks, hedge funds, or helping rich people. It is making fully-collateralised loans that will be repaid the next day (or week). So, while it’s putting the funds in today, it’s taking them out almost immediately....

What is liquidity and why is it so important? The publicly stated rationale for these large interventions is that liquidity dried up.... I define liquidity as “the ease with which an asset can be turned into a means of payment such as money.” That is, when an asset is liquid it is easy to sell large quantities without moving market prices. When something is illiquid, it is hard to sell. People don’t want to buy things that they can’t sell easily.... For financial markets to function well, it must be cheap and easy to both buy and sell securities. When market liquidity dries up, the financial markets stop functioning.... Fall 1998 was the last time market liquidity dried up to a greater extent than we observe today....

$35 billion seems like quite a bit of money. Is it? When the Fed injects “money” into the financial system, what it does is create balances in something called “reserve accounts”.... Those are the bank’s checking accounts, with the exception that they don’t pay interest. Because there is no interest paid on reserve balances, banks try to economise on the quantities.... Total reserves in the US banking system for the two weeks ending 1 August 2007 averaged $45 billion, of which roughly $12 billion was held as deposits in reserve accounts at the Federal Reserve.... Excess reserves, those above what the Fed requires banks to hold, usually total less than $2 billion.... [T]he increase in reserves on Friday increased banking system reserves by more than 75%. More importantly, it increased the size of reserve accounts by a factor of 4... the increase was more than 10 times the normal level of excess reserves.... $35 billion is a very big number...

Why did the banks need this money? It is easy to explain why the Fed used open market operations to add $81.25 billion on 14 September 2001 in the aftermath of the 9/11 terrorist attacks. People’s inability to reach their offices in downtown New York had closed some very large banks. Though those banks could still receive payments from other banks, they couldn’t make any payments.... Funds were flowing into a few huge reserve accounts, but nothing was coming out. Some banks were sucking up the lifeblood of the financial system.

Last week the trigger seems to have been the continued fall in the value of certain mortgage-backed securities.... [U]p to now, the problems in the subprime mortgage market are relatively small. Currently, losses are estimated to be at most $35 billion – equivalent to a stock market decline of about 0.2%.... When people see that they have underestimated the risks in one place, they start to question their ability to accurately evaluate risks everywhere else. Then... prices of risky financial assets fall... people flee risky stuff that they find it hard to evaluate and put their money in safe assets – what’s called a “flight to quality”... an increase in prices of U.S. Treasury securities and an influx of funds into the banking system... bankers... become less willing to lend their reserves to other banks... [in] overnight loans.... Keeping the federal funds rate at its target level of 5.25% [on Friday] – that’s what the Open Market Desk at the Federal Reserve Bank of New York is supposed to do every day – meant engaging in huge operations.

I’ve heard that the Fed’s operation had something to do with mortgages. Did it? Yes.... On Friday 10 August the Fed accepted mortgage-backed securities as collateral for the entirety of the $35 billion in repos.... My speculation is that the Fed did this to demonstrate to the markets that they believe mortgage-backed securities are good as collateral. They were trying get financial market participants to value mortgage pools sensibly.

Who decides to do this? A number of people are involved in deciding the quantity of a daily open market operation. On a normal day there isn’t much to decide. The Desk staff makes a recommendation in a conference call and the participants agree.... Last week was obviously not normal. While I doubt that the entire Federal Open Market Committee decided on the action, they may have been consulted through a conference call. My guess is that Chairman Bernanke and New York Fed President Geithner had a say. What I can be sure of is that the decision was made by the Federal Reserve....

Why is this happening now? It is natural to ask whether there is some specific reason for these events to occur right now. Can we identify a specific trigger? While we can see something that has happened, as I suggested earlier there has been no fundamental deterioration.... Instead, what happened was analogous to a bank run.... [T]wo events... may have precipitated this... on 2 August... the German bank, IKB Deutsche Industriebank AG, was in trouble because of investment in US subprime loans. And then, on Wednesday, that one of Europe’s largest banks, BNP Paribas, had three funds with similar problems....

Does this have anything to do with discount lending? For those of you who have seen (and heard) Jim Cramer’s diatribe... you may be wondering about discount lending. Here’s the deal. The Fed has a standing offer to lend to banks (so long as they have collateral to pledge for the loan) at a rate that is 1 percentage point above the federal funds rate target of 5.25%.... [I]t seems unlikely that discount lending increased much last week... banks always have the option of borrowing from other banks at the federal funds rate, and the Federal Reserve Bank of New York reports that the highest rate charged for an overnight interbank loan late last week was 6%. I seriously doubt that a bank would borrow from the Fed at 6.25% when they can borrow more cheaply from another bank. I would guess that Cramer was really arguing for an interest rate cut....

The European Central Bank’s operation was much larger than the Fed’s. Is there a reason? The details of the European Central Bank’s (ECB) operating procedures are very different from those of the Fed.... When the ECB announced its intention to provide funds on Thursday 9 August 2007... they said that they would accept all bids at or above their 4% target. The result was that banks asked for and received €95 billion ($130 billion).... [I]n Europe a bank that has excess can redeposit it at the ECB at a 3% interest rate. That makes it far cheaper for European banks to err on the holding of too high a level of reserve balances. Now, put yourself in the position of a European bank.... [W]hen the ECB says that they are going to give you as much as you want on a day when they normally do nothing, you have to wonder what they know that you don’t.

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