Highlights:

  • This two-part post looks at the steps the Federal Reserve is taking to unwind the “Quantitative Easing” program it initiated in response to the 2008-2009 financial crisis and “The Great Recession”.
  • Part I looks back at the onset of the Great Recession and the Fed’s decision to pump massive amounts of money (“liquidity”) into the financial system in an effort to prevent a full-blown depression.
  • Part II will discuss the Fed’s decision to begin draining the liquidity it injected into the financial system and whether fears of unintended adverse consequences are justified.

Growing up, my family had a swimming pool in our backyard.  My sister, four brothers and I spent countless hours in the pool rough housing, playing Marco-Polo and generally having loads of fun.  But when fall arrived, my dad would drain our pool in preparation for the change of seasons.  To me, the emptying of the pool signaled the end of summer and the approach of another long, cold, Wisconsin winter.  I remember thinking, “Can’t we wait just a bit longer before pulling the plug on the fun, Dad?”

Flash forward to 2006-2007, when things were going swimmingly for the U.S. economy.  Housing prices were rising, the economy was expanding and on October 9, 2007 the Dow Jones Industrial Average exceeded 14,000 for the first time in history.  Over the next 18 months, however, the financial season turned and the Dow lost more than half its value.

A collapse in the market for subprime mortgage loans is commonly blamed as the principal cause of The Great Recession of 2008-2009.  A combination of a desire by bankers to increase profits and political pressure to bring private home ownership within the reach of lower-income Americans resulted in mortgage loans being given to people whose ability to repay was questionable at best.  The banks then sold these mortgages to brokerage firms, who in turn repackaged them in trusts (referred to as “mortgage pools”) that issued securities for sale to investors.  Because mortgages had a history of low default rates, credit rating agencies, such as Standard and Poors and Moody’s, gave these securities their stamp of approval.

Lax lending standards resulted in rampant speculation in the housing market — speculation that created a glut of new homes on the market.  The consequence was all too predictable: housing prices across the country began to fall.  Soon, millions of homeowners were suddenly “underwater,” meaning that their homes were valued for less than what they owed.  As a result, borrowers began defaulting on their mortgage obligations at a record clip.  The increased default rates began draining the mortgage pools.

In February 2007, the Federal Home Loan Mortgage Corporation (Freddie Mac) announced that it would no longer purchase risky subprime mortgages or mortgage-related securities. Then, in April, subprime mortgage lender New Century Financial declared bankruptcy.  Shortly thereafter, American Home Mortgage Investment Corp. collapsed. 

In March 2008, investment banking giant Bear Stearns went underwater as a result of losses brought on by its investment in subprime mortgages.  A few months later, Lehman Brothers followed suit, in what was the largest bankruptcy filing in U.S. history.  Facing its biggest financial crisis since the Great Depression, the Federal Reserve decided it needed to take action. 

Within days of Lehman Brothers’ bankruptcy announcement, the Fed agreed to lend insurance and investment company giant AIG $85 billion so that it could remain afloat.  The Federal Reserve then began injecting trillions of dollars (“liquidity”) into the financial system.  The goal was to stimulate the economy by making money more available to consumers and businesses, and thereby increase investment and spending (albeit on borrowed funds).

The Fed used a two-prong approach to bolster liquidity.  First it lowered interest rates.  In September 2007, lending rates were 5.25%.  By the end of 2008, the Fed had slashed the rate it charged on overnight loans to banks to zero for the first time in its history.

Second, the Federal Reserve went on a buying spree.  On November 25, 2008, the Federal Reserve announced that it would purchase up to $600 billion in agency mortgage-backed securities (MBS) and agency debt.  Then, on November 3, 2010, the Fed announced that it would purchase $600 billion of longer-dated Treasuries, at a rate of $75 billion per month.  On September 13, 2012, the Federal Reserve announced that it would purchase an additional $40 billion of mortgage-backed securities per month until the labor market improved “substantially”.  This was followed by a decision to buy another $40 billion of mortgage-backed securities per month and an additional $45 billion of Treasury securities as well.  The end result: the Fed’s balance sheet (the securities it owns less liabilities) grew from about $870 billion in August 2007 to $4.5 trillion in September 2017.

Just as a change of seasons led to the draining of our family swimming pool every autumn, the slow but steady economic recovery has led the Federal Reserve to scale back its efforts to bolster the economy.  In 2017, the Fed began to gradually pull liquidity from the financial system to prevent the economy from overheating.  The Fed has done this by gradually raising interest rates and by unwinding its post-recession security purchases. 

More specifically, the Fed has raised rates nine times since 2015 to a current range of 2.25% to 2.50%.  In addition, the Fed has begun reducing its balance sheet by not reinvesting the dollars it receives when the securities it bought as part of the QE program are repaid.

In our next post we will look at concerns that the Fed is draining the fiscal system’s liquidity too quickly.  These concerns have been a major contributor to recent stock market volatility as some investors fear that the Fed’s latest plan could lead to a new recession.  Others take a more sanguine view towards the Fed’s recent course of action.  It makes for an interesting – and important – debate, so please stay tuned. 

In the meantime, you might enjoy this swimming pool scene from The Sandlot.  We can only hope that the Fed’s plan turns out as well as Squints’ adventure did!

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