Financial crisis Summary

Throughout this current financial crisis, the Federal Reserve Bank has developed and implemented several new policy tools. Each tool has a different function, but all together the main focus is to provide liquidity in the market and prevent a more severe recession or even depression within the country and the world. Although the effects of each tool and the effects of this crisis cannot be completely measured yet due to the fact that we aren’t sure if the recession is over or when it will be over, there are two tools that seemed to have worked better than the rest and two that haven’t worked so well.

The term auction facility, also known as TAF, is an auction which banks place bids for funds. The term auction facility allows depository institutions to borrow from the FED in order to provide liquidity and strengthen the balance sheet of these banks. The banks could have borrowed from the discount window, which is essentially the same funds provided by TAF, but the stigma associated with borrowing from the discount window has prevented these institutions from doing so. When an institution borrows from the discount window, these transactions are published which shows that they could be having trouble.

This prevents banks from participating in discount window transactions because they don’t want stakeholders to think they are hurting financially. TAF has been successful for many reasons. Other than eliminating the stigma, TAF has been extremely popular among financial institutions. Although in recent months it has slowed down, it has done its job efficiently. Besides using open market operations and just placing funds throughout the economy, TAF has injected money more precisely where it is needed while easing stress within the interbank market.

Banks are more willing to lend out funds because TAF has provided more liquidity. This is easily understood in Exhibit 1, where the TED spread and the results of TAF are presented. The TED spread is an indicator of credit risk within the economy. It is the spread between United States T-Bills and LIBOR, which is essentially the spread between U. S. debt and the rate at which commercial banks lend to each other. When lenders believe that the risk of default on interbank loans is probable, the TED spread increases.

Vice versa when the TED spread decreases the risk of interbank loans isn’t considered probable. As presented in Exhibit 1, on August 9, 2007 BNP, a French bank reported they were having trouble valuing certain mortgage backed securities and worried they had a serious risk of liquidity. This prompted other institutions to worry about liquidity as well. Exhibit 1 shows the difference between the observed TED spread and an alternative TED spread, which is what would have happened had TAF not been implemented.

The difference shows how well TAF worked the first several months. Until the fall of Lehman Brothers which caused a radical spike in the spread because institutions and consumers feared the FED and the government wasn’t going to help anyone out. The difference between the observed and alternative TED spreads shows the expansion of TAF after September 15, 2008 was also extremely successful. Another successful policy tool is the Term Securities Lending Facility, also known as TSLF.

TSLF is also an anonymous auction, like the TAF, but instead of auctioning off funds, it auctions of treasuries. It is also different because TSLF auctions these treasuries off to primary dealers to also help provide liquidity. Using other mortgage backed securities, treasuries, agencies, and all investment grade debt as collateral, dealers were able to participate in these treasury auctions. TSLF was prompted by secured funding becoming impaired early in 2008, which causes dealers to try to seek alternative funding, liquidate positions, or worse, file for bankruptcy.