The easiest way to watch the crisis develop through these transcripts is to read the market summary delivered to the committee at the beginning of each meeting by New York Fed official William Dudley, who would soon become president of the New York Fed, in January 2009.
No need to wade through hundreds of pages of transcripts. Dudley’s remarks at the start of each meeting are an efficient update of market conditions.
Reading them is like watching a horror movie in slow motion.
January 9, 2008: While market function has improved and contagion risks have diminished somewhat, the underlying strains on financial markets remain severe and may even have intensified.
January 21, 2008: We started to see a step backward last week—especially late in the week—when we viewed the asset-backed commercial paper market beginning to deteriorate again.
January 30, 2008: The bigger story remains the continued pressure on bank balance sheets, the tightening of credit availability, and the impact of this tightening, on the outlook for economic activity.
March 10, 2008: Financial conditions have worsened considerably in recent days. Credit spreads have widened, equity prices have declined, and market functioning has deteriorated sharply.
And so on.
Dudley reels off story after story of multiple financial markets failing, undone by lenders’ and investors’ loss of confidence, and he tells of the Fed creating one program after another to plug the latest hole in the dike.
As the transcripts make clear, at the heart of the chaos was the wounded repurchase market.
From the March 10, 2008, meeting:
Although there are many factors that can be cited to explain what we are seeing—including the acute weakness in the U.S. housing sector, a deteriorating macroeconomic outlook, and the loss of faith in credit ratings and structured-finance products—we may have entered a new, dangerous phase of the crisis. Major financial intermediaries are pulling back more sharply and along more margins than previously—shrinking their collateral lending books and raising the haircuts they assess against repo collateral.
For a time, this adjustment was occurring in a relatively orderly way, but we appear to have passed that point about ten days ago. The failure of Peloton—a major hedge fund—and the well-publicized problems of Thornburg Mortgage and Carlyle Capital Corporation in meeting margin calls have triggered a dangerous dynamic.
Dudley then describes the fire sales:
That dynamic goes something like this: Asset price declines—say, triggered by deterioration in the outlook—lead to margin calls. Some highly leveraged firms are unable to meet these calls. Dealers respond by liquidating collateral. This puts downward pressure on asset prices and increases price volatility. Dealers raise haircuts further to compensate for the heightened volatility and the reduced liquidity in the market. This, in turn, puts more pressure on other leveraged investors.
A vicious circle ensues of higher haircuts, fire sales, lower prices, higher volatility, and still lower prices, and financial intermediaries start to break as a liquidity crisis potentially leads to insolvency when assets are sold at fire sale prices.
This dynamic poses significant risks.
First, it impairs the monetary policy transmission mechanism. We have seen that in recent weeks in the sharp widening between mortgage rates on an option-adjusted basis and Treasury bond rates.
Second, as hinted at above, there is a systemic issue. If the vicious circle were to continue unabated, the liquidity issues could become solvency issues, and major financial intermediaries could conceivably fail.
I don’t want to be alarmist, but even today we saw double-digit stock price declines for Fannie Mae and Freddie Mac. (RepoWatch note: In six months, the federal government will have to take over these two companies.) There were rumors today that Bear Stearns was having funding difficulties: At one point today, its stock was down 14 percent before recovering a bit. (RepoWatch note: In four days, Bear Stearns will collapse and be absorbed by JPMorgan Chase.)
Third, the problems in one financial market disturb others. We have seen the problems move from subprime to alt-A mortgages to jumbo prime mortgages and now even agency mortgage-backed securities. Commercial-mortgage-backed security spreads and corporate credit spreads have also widened, and we have seen considerable distortions in the municipal market.
In four days, on March 14, Bear Stearns will fail, abandoned by its repo lenders. On March 16, the Federal Reserve will set up the Primary Dealer Credit Facility, an overnight loan window for primary dealers like Bear who are having a tough time financing their operations through the tri-party repo market, where transactions are routed through a clearing bank, either The Bank of New York Mellon or JPMorgan Chase.
Dudley will report on the status of this critical program at many open market committee meetings throughout 2008. The facility will operate until February 1, 2010.
From the March 18, 2008, meeting:
The PDCF should help to restore confidence among repo investors. It essentially creates a tri-party repo customer of last resort — us.
When investors have concerns about the ability of a dealer to fund itself, they are reluctant to roll over their own repo transactions. The reason is the fear that the clearing bank may not send their cash back the next morning when the overnight repos mature. This fear may not be misplaced. If the clearing bank is worried about whether investors will stay put, the clearing bank may decide to keep the cash. In that case, the investors would be stuck with the securities that collateralize the repo transactions.
The PDCF should break that chain of worry by reassuring the clearing bank that the Fed will be there as a lender to fund the repo transactions. The repo investors are reassured that the clearing bank will send back their cash the next day and thus are willing to roll over their repo transactions.
At least that’s the theory.
As noted, the PDCF should provide some comfort to the counterparties of these firms that these firms will, in fact, be able to fund their obligations. Yesterday, the major money market mutual fund complexes did roll their outstanding repos with the major investment banks.
However, the jury is still out on whether the PDCF will be sufficient to stabilize confidence.
In this meeting, Dudley describes the run on repo:
I’m going to talk a bit about the Bear Stearns situation. In my view, an old-fashioned bank run is what really led to Bear Stearns’s demise.
But in this case it wasn’t depositors lining up to make withdrawals; it was customers moving their business elsewhere and investors’ unwillingness to roll over their collateralized loans to Bear.
The rapidity of the Bear Stearns collapse has had significant contagion effects to the other major U.S. broker–dealers for two reasons.
First, these firms also are dependent on the repo market to finance a significant portion of their balance sheets.
Second, the $2 per share purchase price for Bear Stearns was a shock given the firm’s $70 per share price a week earlier and its stated book value of $84 per share at the end of the last fiscal year. The disparity between book value and the purchase price caused investors to question the accuracy of investment banks’ financial statements more generally.
By the April 30, 2008, meeting, the situation appears to be improving:
The introduction of the primary dealer credit facility seems to have helped to stabilize the repo markets. That improvement, in turn, has caused the equity prices of the four remaining large investment banks to recover somewhat and their credit default swap spreads to fall sharply. (RepoWatch note: All four will have to be bailed out by October.)
The PDCF backstop facility also appears to have helped break the negative dynamic of higher haircuts, forced asset sales, lower prices, higher volatility, and still higher haircuts that was in place in the weeks leading up to the Bear Stearns liquidity crisis. … Over the past few weeks, haircuts have stabilized.
At the June 25, 2008, meeting, Dudley is still cautiously optimistic:
Financial markets have become more resilient to bad news in recent weeks. … the share prices of the four remaining independent U.S. investment banks remain depressed … In contrast to this poor equity-price performance, credit default swap spreads remain much narrower than at the time of Bear Stearns’s demise in mid-March. The establishment of the Primary Dealer Credit Facility and the Federal Reserve’s role in the acquisition of Bear Stearns by JPMorgan Chase are undoubtedly both important factors behind the divergence of equity prices and credit default swap spreads.
Lehman Brothers, which reported a second-quarter loss that was considerably larger than expected, has been under the most stress. However, in contrast to Bear Stearns’s experience in mid-March, Lehman’s short-term financing counterparties have generally proved to be patient.
The financing backstop provided by the Primary Dealer Credit Facility has been cited by many counterparties as a critical element that has encouraged them to keep their financing lines to Lehman in place.
The investment banks have begun to rapidly deleverage their balance sheets … the gross leverage ratios for Lehman Brothers, Goldman Sachs, and Morgan Stanley all fell sharply in the second quarter. This stands in marked contrast to the rise in leverage ratios that persisted through the first quarter of this year.
Finally, a few words about the Primary Dealer Credit Facility. We have been actively managing our counterparty risk in this facility and have made it clear to market participants that this should be viewed as a backstop facility rather than as a core source of funding. By the end of next week, borrowing from this facility is likely to drop sharply because of two events.
The first is this week’s closing of the Bear Stearns–JPMorgan Chase transaction, which will result in the elimination of Bear Stearns’s PDCF borrowing.
The second is the anticipated closing next week of the Bank of America acquisition of Countrywide, which is expected to eliminate Countrywide’s PDCF borrowing.
In the absence of new financial shocks that could provoke renewed funding difficulties, we would anticipate little persistent PDCF borrowing after these mergers are completed.
But by the September 16, 2008, meeting, the situation has changed violently. The federal government seized Freddie Mac and Fannie Mae on September 7. Bank of America said September 15 it would acquire Merrill Lynch in a shotgun wedding. Lehman Brothers filed bankruptcy September 15.
From the September 16, 2008, meeting:
Now, the Lehman filing has also intensified the pressure on Morgan Stanley and Goldman Sachs in a number of respects. The Lehman failure means that investors now view the debt of Morgan Stanley and Goldman Sachs as having much more risk than it did on Sunday. This means that these firms need bigger liquidity buffers than they had before, and it does have implications for long-term profitability. As a consequence, their share prices fell very sharply yesterday. Morgan Stanley was down about $5 a share, to $32, and Goldman Sachs’s stock was off 18 points, to $135. Morgan Stanley experienced a modest, but not insignificant, pulling back of their counterparties and ate into their liquidity buffer by a measurable degree.
The Lehman problems also were evident in some other areas. This is very incomplete, but the ones that came to my attention were money market funds—especially, the Reserve Fund that had large withdrawals, and they encountered a significant liquidity problem. I am actually not sure how that was resolved, but I think that State Street was in the situation of having to cover a very large shortfall of the Reserve Fund last night.
The risk here, of course, is that, if AIG were to fail, money funds have even a broader exposure to them than to Lehman, and so breaking the buck on the money market funds is a real risk. The capital resources of the entities that are associated with the money market funds often are quite modest, so their ability to top up the money funds and keep them whole is quite limited. Thus the money market funds are definitely one important issue in how this contagion could be broader.
Finally, let me talk a bit about the facilities that we introduced over the weekend. Basically, we did two things. We broadened the Primary Dealer Credit Facility significantly in terms of collateral eligibility. Whereas, before, the PDCF took investment-grade securities only, we broadened it to include basically everything that is in the tri-party repo system.
We felt that, by backstopping the tri-party repo system completely, we would reassure tri-party investors that they didn’t face rollover risk, and so we would keep tri-party investors investing with the banks. That seems to be mostly what happened, at least yesterday.
We did get quite a bit of PDCF borrowing yesterday evening, but it was predominantly Lehman. It was about $28 billion of Lehman borrowing. I think the total borrowing was something on the order of $42 billion. That is telling you that most of the borrowing we had was associated with Lehman’s not being able to roll over their tri-party repo positions with their investors.
We don’t really know the reasons for the other borrowing, but it probably was mostly to test the facility as opposed to actual need. So broadening the PDCF collateral eligibility does seem to be working, so far at least, in keeping tri-party investors in the game and continuing to provide funds to the other primary dealers.
The second thing we did was to the Term Securities Lending Facility … We broadened that collateral so the terms are now the same as the old Primary Dealer Credit Facility. …
So that is where things stand.
On this day, September 16, the Federal Reserve will inject $85 billion into a stumbling AIG, and the Reserve Primary money market fund will trade below $1 a share. In three days the U.S. Treasury Department will have to temporarily guarantee investments in money market mutual funds, to stop a rising flood of withdrawals. In five days Morgan Stanley and Goldman Sachs will have to become commercial bank holding companies to survive, ending more than a century of financial-market dominance by the nation’s large investment banks.
In the coming months, the Fed and other regulators will try many initiatives to keep cash flowing into the vulnerable areas of the financial markets.
(See the Federal Reserve Bank of St. Louis for a timeline of events during the 2007-2009 Financial Crisis. See “The Flight from Maturity” by Gary Gorton, Andrew Metrick and Lei Xie for a timeline of trouble in the financial markets, which they say started in the repurchase market on July 23, 2007. )