03 December 2008

Counting the Cost: the Financial Crisis

Disclaimer: I am not an expert in this field; these are my notes as I research these topics using the usual internet/public library resources. In many cases, links have been added to subsequent posts in this blog. Apologies in advance for any mistakes of interpretation.

How much will the financial crisis cost the US taxpayer? Most of the attention has focused on the Troubled Asset Relief Program (TARP), a $700 billion package initially designed to restore financial markets by buying up troubled assets. That's understandable, but it mainly reflects Congressional debate over a smallish share of the overall government response. According to Barry Ritholtz, et al., that government response was predominantly administered by the Federal Reserve System, and is measured by capital stakes.

An additional component of the bailout, also far surpassing the TARP agreement, is outlays by the Federal Deposit Insurance Corporation (FDIC). The FDIC approved the Temporary Liquidity Guarantee Program (TLGP) in October; it provides a guarantee of non-interest bearing deposits up to $250,000 instead of the usual $100,000.

TARP and the FHA "Hope for Homeowners" programs were designed mainly to inject a stream of payments into the huge pool of obligations taken on by federally guaranteed agencies.

Here follows a review of the items on Ritholtz's list.

Federal Reserve System

The Federal Reserve System took on potentially $5.8 trillion in liabilities in response to the initial wave of banking failures. Here are the programs it has created for coping with the catastrophe.

  • Commercial Paper Funding Facility: created 7 October 2008, shortly after a disastrous meltdown of the commercial paper markets (Bloomberg; see chart). Accepts newly issued 3-month unsecured and asset-backed CP from eligible issuers as collateral in exchange for funds (3 months).
  • Term Auction Facility: created 12 December 2007. Up to 90 loans to depository institutions (thrifts, savings banks, credit unions) for emergency reserves, supplementing the usual interbank reserve lending. Not a permanent institution, but a series of auctions of funds held every two weeks. The banks successfully bidding must provide suitable securities as collateral.
  • Money Market Investor Funding Facility: created 21 October 2008 to provide liquidity to money market funds; object to prevent sales of assets in falling market (debt deflation).
  • MBS Purchase Program: created November 2008 to buy mortgage-backed securities from FNMA, and FHLMA (Fannie Mae, and Freddie Mac; known collectively as the GSEs). This was intended take the place of the suddenly-defunct market for MBS collateralized debt obligations (CDOs). This is not the same thing as the project of re-absorbing the GSEs themselves. In terms of financial risk, this is probably qualitatively riskier than the other programs.
  • Term Securities Lending Facility (TSLF): created 11 March 2008 & renewed 3 December; lends Federal Reserve holdings of US Treasury securities to NY Fed primary dealers.
  • Term ABS Lending Facility (TALF): created 25 November 2008; loans to entities buying asset-backed securities (ABS); borrowers required to not be originators of the ABS.
  • Credit Extensions (mostly AIG): large number of different interventions to salvage network of CDS counterparty liabilities; includes at least $122 billion (apparently, not the same money as the $150 billion of TARP funds authorized as of 9 November specifically for AIG). Most money ever directed by the USG to any single enterprise (NY Times).

Federal Deposit Insurance Corporation

The Temporary Liquidity Guarantee Program (TLGP) was rated at costing potentially $1.4 trillion, although so far it has not cost anything yet--it is an extremely new program, and we don't know how many banks are likely to default on their largest deposits.

The FDIC also provided Citigroup with $306 billion in loan guarantees (Bloomberg), with Citigroup required to absorb the first $29 billion in losses, and 10% of losses after that--for a potential maximum liability to the FDIC of $249.3 billion. The FDIC provided a similar loan guarantee of $139 billion to General Electric (Bloomberg). Ritholtz lists the current amount for this line item as 100% of the maximum, which presumes an implausibly disastrous collapse of Citigroup and General Electric asset value.

US Treasury

It may come as a surprise to learn that the Treasury Department's role in the federal government response to the financial crisis was small potatoes. There are two main programs, the Troubled Asset Recovery Program (TARP) and the GSE bailout (separate and distinct from the MBS purchase program).


This is where I was supposed to carefully review all of the programs and their interplay, and make some assessments. One meta-assessment is that James Hamilton of Econbrowser (7 October) was unable to say, and he really is an expert (I'm just trying to learn about this). The reason is that the financial system has certain metaphysical obstacles to consequential analysis: there's no agreement on what this relationship of debt to economic output really means.

Having examined several of the programs set up by the Federal Reserve and the Treasury, I think I can understand why the approach taken was so complex: each industry had to be treated differently. For example, while money market funds usually rely on commercial paper markets for investor return, they have constraints and problems that are distinct enough to need different approaches. But the complicated arrangement of credit triage supplied by the Fed to its [still more] complicated patient means unpredictable results and unpredictable market response.

When I was studying theories of monetary policy, like the debate over "commitment versus discretion" (see Dotsey 2008), the papers and textbooks described a world of macroeconomic stability. A bad monetary policy might lead to a monotonic increase in bond yields, but it was a well-behaved catastrophe. I understood that this was an introduction to the idea, and meant to help students understand the basic terms of the debate, but it did not occur to me that the real controversy would erupt during a multi-dimensional crisis in which many different financial markets were flying apart. Here, there were no rules to commit to: the contribution of economic theory to debate in this crisis has been to grumble about moral hazard.

What we are really discussing here is something that economic theories do not describe in any meaningful sense of the word "describe," and something more akin to a turbofan engine. Except that a turbofan engine was designed and produced by a single firm, and its operating principles are well known to the designers or mechanics. The financial system was designed by no single entity, and its relationship with the real economy is mired in doubt.

Having said that, it seems to me that a big part of the rescue program sketched above is multiple layers of liability. A homeowner borrows money from a mortgage originator, who sells the mortgage to an investment bank. The investment bank creates an SIV and sells the mortgage to it, in exchange for a stream of payments to depositors. The mortgage may be insured against default with a credit default swap, whose counterparty is a hedge fund. The hedge fund may hedge its CDS liabilities with put options on the same CDO, and the counterparty to the puts may be another investment bank that finances with commercial paper. That commercial paper, finally, finances the original homeowner's money market fund. The same liability is repackaged, leveraged, and perhaps even multiplied through options and credit default swaps.

The Fed's program, in effect, rescues each layer. Party A uses some federal funds to repay B, who uses that plus more federal funds to repay C, and so on. This increases the Fed's exposure but reduces the unit risk of that exposure.

However, it seems clear that this post can never be more than a bookmark, which I will need to revisit as the situation unfolds.

Sources & Additional Reading

Barry Ritholtz, "Calculating the Total Bailout Costs" and "$7.8 Trillion Total Bailout Commitment," The Big Picture (November 2008)
Econbrowser (James Hamilton's blog)Federal Reserve System sites:
Marco Arnone & George Iden, "Primary Dealers in Government Securities: Policy Issues and Selected Government's Experience" Working Paper, International Monetary Fund (March 2003)

"Financial Crisis – News and Resources" page at Morrison & Foerster, LLP website (outstanding!)

Andrew Ross Sorkin & Mary Williams Walsh, "AIG May Get More in Bailout," New York Times (9 Nov 2008)

Joe Weisenthal, "Explaining The AIG Black Hole," Business Insider (30 October 2008)

Neil Irwin, "Fed Prepared to Prop Up Money-Market Funds," Washington Post (22 October 2008)

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