I showed you at the beginning of this lecture that long list of different kinds of lending facilities, okay? And here they all are, here they all are, okay? as because this is the asset side of the balance sheet of the Fed, so all of these things are loans, these are loans that the Fed is making. And here's how it's financing these loans. by expanding the liability side, by expanding, by expanding it's deposits. I remind you that this is Bear Stearns, this vertical line here and this is [UNKNOWN] here. And you can see the stages of the crisis, okay? Before Bear Stearns, if you look at what the fed was doing, it was just moving the fed foundry. In the months since Oct, in, in since August, it moved the Fed funds rate from 5% down to 2%, okay? So the first thing it tried to do was it, it responded with elasticity, right? It's lowering, it's lowering the Fed funds rate, it's trying to, to make it more make it more profitable for, for banks to take on the equity risk and, and, and so forth. It's trying to support asset prices indirectly by lowering, by lowering the fed funds rate. But then Bear Stearns failed, okay? And that wasn't enough anymore. And so then they got a little more aggressive. They sold off these treasury bills. This is about a trillion dollars of the treasury bills. They sold of 500 billion of them. And lent the proceeds to brokers, dealers and, and, and everyone else who was in need. and that was the second attempt, okay? And then came Lieman AIG and things got worse, worse still. and they took the, the money market unto their own balance sheet, okay? They created their own, you know, two trillion more of, of deposit fed and two trillion more of lending on, on, on the fed. The inter bank market broke down and the fed became the inter bank market, okay. If you, you, you didn't, nobody trusted each other, they all trusted the fed. So any new money that was flowing was flowing through the fed. You deposited surplus, surplus entities deposited at the fed and deficit entities borrowed from the fed. This aqua thing is is mortgage backed securities. That's a later stage where it starts to intervene in the capital market itself and buy mortgage backed securities. we'll leave that out for the moment. I now want to just do imbalance sheets and show you what the Fed did. How to understand these different stages of response to crisis, okay? So I, I had, I started the lecture by saying that the Citi SIV look like this. There was residential mortgage backed securities here and there was asset backed commercial paper here as the funding source, okay? And there are shares here, okay? So there are international investors or something that are, that's holding here. And all of this is fine. Citi, Citi's not in there, this is off balance sheet for Citi, it's not anywhere in the Fed's balance sheet or anything like that, okay? So the first stage of the crisis it looked maybe like a normal crisis, okay? That money market mutual funds started to worry about the value of the underlying asset, Residential Mortgage Bank Securities. And they said I would just assume, you know, not renew this and get some other kind of funding going. if you don't mind, okay? And so Citi did this, and they thought this was good business. They thought they were going to make money doing this. Remember dealers are not in this. You know, to, to make the world a nice place, the're trying to make, the're trying to make profits, okay? And, and what did they think they where, how did they think they were going to make a profit? They thought they could make a profit by letting, by replacing. I'm not going to do all these subtractions, I'm just going to cross them out. Okay. When this matured, they replaced that funding with, with a loan from Citibank. So Citibank said, we think those are really good securities, we're happy to take them as security ourselves, okay? Against a loan, okay? And then we will fund that loan on our own balance sheet let's say even with a repurchase agreement. Okay? The point being so that goes away and now its a repurchase agreement. Well, there's still this underlying security here is, is the collateral for this. But on the other hand now this repurchase agreement is a liability of Citibank. And so you have further recourse. That if this asset turns out not to be worth enough to pay this back then you have recourse against Citibank. And Citibank has a big balance shake and so it's, it's, you have a little more security and and so it's fine, okay? But then you start to worry a little bit more about that security you say, you know what Citibank, I don't really like, you know. You're going to say you might say to me okay fine you keep the mortgage back security and we're done I don't really want that to be so, okay? I would rather actually have commercial paper from you that's that's your unsecured liability, okay? Of Citibank, that is based on your whole asset book, everything, okay? Commercial paper. Lets just call this maybe Leiman too, because remember you're talking about Leiman issuing all this unsecured commercial paper that was bought by the primary reserve fund, right? So a number of these big banks were in this business, okay? And when their off-balance sheet deals started to come unwound they saw profit opportunity. They said, let us take this off the balance sheet of the customers that don't want to hold it anymore and hold it ourselves and charge for that. And this will wind up, we're going to make money, we want to do this, okay? and so no one was holding a gun to their head, they said this is good business, let's do this, unsecured commercial paper here. and or if you are a, another possibility might be the euro-dollar market if you are a foreigner. [SOUND] Because money market mutual funds also invest in paper, that's issued by foreign banks, here in your dollar market. All of this stuff happened. If yo look at the flow of funds, you see that this was, this was happening. There was a replacement of, of a certain kind of funding, with. And then you got the traditional banking system sort of involved. Now, these traditional banks are of course backstopped by the Fed and the FDIC, okay? In ways that these SIVs were not. So the collapse of the shadow banking system happened in stages, it happened first, it collapsed onto the traditional banking system. And the money market mutual funds said, well that's fine, I'm happy to do business with you because you have a backstop, okay. And that makes me happy. Except that wasn't the end of the story, okay? It continued, it continued to get get worse. And it particularly continued to get worse for the European banks that were doing these sorts of, these sorts sivs. Because they didn't have at all the kinds of backstops that domestic banks in the US have. They don't have as much access to the Fed. When they, and so when, when, when the money market mutual fund said you know what, I know I lent you that Euro money dollar for a week but now the week is up and I would like not to roll that over anymore. The European banks are in trouble. Where are they going to get dollar funding? Where are they going to get dollars, okay? And this is where the Fed stepped in, okay? With the Treasury too, okay? And what they did was liquidity swaps to, for with foreign central banks. So we should have foreign central banks here too. And and they, and they, the Treasury got involved, holding treasury bills. So that the money market mutual fund could replace all of this, dodgy stuff with treasury bills. That's what they wanted anyway. Okay fine. We've got treasury bills and now this is a liquidity swap that is a loan from the ECB, lets say. So there are very, there are various stages here, and they. So now, let me return to here. So you, you can sort of see these stages happen. This, this element here, this sort of orange bit, that's $600 billion of liquidity swaps, that's at, at, at the peak of the, of the crisis, that's what's happening. And this brown thing here, what is that? Treasury supplemental account, That's basically there was a treasure, the Treasury had deposited the Fed. And then they issued T-bills out the other side. So I'm consolidating the Fed and the Treasury balances here. Because otherwise we'd have, we'd have, you know, the whole length of the room here. the point was to give money market mutual funds what they wanted Treasury bills, okay? And to give your PN banks the funding they needed, which was dollar funding that was channeled through Central Bank channels, because the money markets were closed down. So this is a sequence, from a normal crisis and an attempt to absorb this crisis in a normal way. By just letting the crisis move a little bit in order to have an incentive for the normal banking system to take over, okay? But it wasn't enough. The crisis got worse and it, and it, and it exceeded their ability to absorb this. the fed tried to help them in the way that the fed normally tries to help them by lowering the fed funds rate, okay? That wasn't enough. The Fed started then to intervene in this way, okay? To enter into the term funding market, okay? That's what you're seeing there, okay? With the liquidity swaps and, and lending directly to dealers. This, all the term facitlities, all of that is acting as a backstop to this market. Not just this market, okay? So they're moving, they're moving up. Are moving down the hierarchy if you will, okay? From the best money to now back stopping directly the banks, not just lending them money but being the value investor, okay? And, eventually they backstop the mortgage banks security market which is that aquamarine thing there. So they, they, as the crisis kept getting worse They moved farther and farther, and they moved more and more of the financial system on to their balance sheet, okay? At no point, I, I, I, I'm sure this is right. At no point did they want to do any of this. Central bankers are a conservative lot. Okay. They certainly don't want to take any credit risk, okay? They don't want to take any interest rate risk, they don' want to take any risk. Risk. You know? That, that's why their money is the best money, okay? They, they're not in general, taking risks. In a crisis though, lend freely, okay? At a high rate against what would be good security in a normal time. That's basically what they, what they did. There's a little bit of a difference because you're dealing with asset markets that are long term. which budget was, sort of, sort of, not. I've, I started this lecture by talking about normal monetary policy, just messing with the Fed funds rate and having some effects on asset prices indirectly. that you, what the Fed does gets transmitted to the rest of the economy by these profit maximizing dealers and markets and arbitrage and all of this. So the Fed is, sort of, at a distance from the market. It's messing with the overnight Fed funds rate. And all, everything else just, sort of, happens with, with, with other people interacting with each other. The Fed is, sort of, at a distance. Normally that's enough because these, the, the rest of the system has enough elasticity in it that if there's fluctuations and demand and so forth. They, they cause fluctuations and prices and, and people behaved in a way to absorb those fluctuations and everything is fine. This is the way the system works in normal, in normal times. But when it gets out of control, okay? When it, when the, when the fluctuations are too large, the imbalances are too large. The imbalances that had built up over decades of the fed keeping interest rates too low, perhaps. Or not allowing crises to wipe out the tinder that was, that was building up in the forest, okay? When the crisis starts, it doesn't just, it's not just temporary it continues to get worse. And as it continues to get worse, the Feds responsibility as the ultimate backstop causes it, forces it, okay? To do more. To do more and more and more, okay? Until it has put a floor on the system. The reason it can put a floor on the system is because its own liabilities are the best money in the system. Ultimately it could put the entire system on its own balance sheet. If people didn't want to hold any risky security at all, the Fed could buy them all and give them all cash for it, okay? Ultimately. Now that's the end of the market system, really, okay? but you this is at least you know feasible, you could do this, you could do this. But the Fed doesn't want to do this and it certainly doesn't want to do this just at the first indication of trouble, it want, it keeps hoping. It keeps hoping that, you know, we don't really have to do that much, do we? Maybe if we just do this, that will be enough, okay? This is this is what the ECB is doing now, right? Let's do just enough and maybe that will cause enough pressure because of the disequilibrium to cause politicians to do the right thing. And maybe it won't and if doesn't then we'll do more okay? And that's where we, that's where we are. So we are living today through a slow motion collapse, possibly, okay? If of, of the European system which, you know, keep in mind what happens in these slow motion collapses. Nothing happens, every now and then there's a lot of excitement, you know, like bars, okay? but they are preceded by building up stresses and, and that doesn't and, and the crisis doesn't necessarily resolve itself for a long time. So, this is, this is the nature of the system that we're, that we're dealing with. [BLANK_AUDIO]
