Thank you, Mr. Chairman. To start, I just want to update people on what happened overnight in markets. Equities rebounded a bit in both Asia and Europe, and bond yields reversed some of the decline that they saw on Monday. The dollar was slightly weaker against the yen and the euro but still in the range that it established. It did not go back below the lows that it reached early on Monday. I would say that generally the markets’ function was okay. The big issue was bank funding pressures in Europe were evident for dollar funding. The funds rate bid as high as 3¾ percent, which is quite surprising on the eve of a meeting in which we are likely to reduce the federal funds rate target. Term funding pressures, if you look at the one- month or three-month LIBOR–OIS spread, are basically unchanged from Monday, when they were up quite sharply from last Friday.
Before talking about what markets have been doing over the six weeks since the last FOMC meeting, 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.
The contrast in the behavior of investment bank equity prices versus credit default swap (CDS) spreads is revealing. Share prices fell sharply, but the CDS spreads narrowed a bit, indicating a lower risk of default. For example, Lehman’s stock price fell 19 percent, but its CDS narrowed by 20 basis points, to 450 basis points, yesterday. This underscores the difference between the $2 per share buyout price for Bear Stearns—less value than people thought—and the introduction of the Primary Dealer Credit Facility (PDCF)—a reduction in the risk that a liquidity problem could drive a firm into insolvency.
I have a few words about the PDCF, before moving to a discussion of market developments since the January FOMC 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.
High use of the PDCF would result in a large increase in the amount of reserves added to the banking system. I think it is important to go on record on that because, if that were to occur, over the short run the New York Desk might not be able to drain reserves sufficiently quickly to keep the federal funds rate from trading extremely soft to the target. We will make all efforts to make the “short run” as short as possible. But realistically, there is a good chance that the federal funds rate could trade soft relative to the target, especially through the end of the current reserve maintenance period. In fact, yesterday we saw that, although it started the day quite firm, the funds rate crashed at the end of the day, and the effective fed funds rate for the day was 2.69 percent. It depends, in large part, on the volume of use of the PDCF.
Stepping back from developments of the past few days, recent weeks have been marked by rapid and, at times, disorderly deleveraging of financial holdings within the global financial system. As I discussed last week, the most pernicious part of this unwinding has been the dynamic of higher haircuts, missed margin calls, forced selling, lower prices, higher volatility, and still higher haircuts, with this dynamic particularly evident in the mortgage-backed securities market.
I’ll be referring to the handout from here. Over the past six weeks, we have surveyed a number of hedge funds and one REIT about the haircuts they face for financing different types of collateral. As shown in exhibit 1, the rise in haircuts has been most pronounced in non-agency mortgage-backed securities. But even agency MBS have seen a significant widening of haircuts in recent weeks. The collateral funding pressures have been particularly evident for residential-mortgage-backed securities collateral. This is due to several factors including very unfavorable fundamentals for housing, a high level of uncertainty about the ultimate level of losses, and an overhang of product for sale, both currently and prospectively. In our discussions with market participants, unleveraged players have been unwilling to step in to buy “cheap” assets for several reasons. First, there are few signs that housing is close to a bottom. Second, a significant amount of product sits in weak hands and, thus, could be dumped on the market. Third, this particular asset class has characteristics that exacerbate price volatility and, therefore, risk. For example, when spreads widen and yields climb, prepayment speeds slow. This extends duration. When the yield curve is upward sloping for longer maturities, the rise in duration generates an increase in yields. The rise in yields also reduces housing affordability, which puts further downward pressure on home prices, increasing prospective losses on the mortgage loans that underpin the securities.
Signs of distress in this market include the following. First, a sharp widening in option-adjusted mortgage spreads—as shown in exhibit 2, option-adjusted spreads for conforming fixed-rate mortgages have widened considerably since the January 30-31 FOMC meeting, though they have come in quite a bit over the past couple of days. That’s good news. Second, jumbo mortgage spreads relative to conforming mortgages rates remain very wide. As shown in exhibit 3, this spread has averaged more than 100 basis points this year. The current yield on prime jumbo loans is around 7 percent, a margin of about 3½ percentage points over ten-year Treasury note yields. Third, mortgage securities prices continue to fall. For example, as shown in exhibit 4, the prices for AAA-rated tranches of the ABX 07-01 vintage continue to decline. Fourth, Fannie Mae and Freddie Mac reported large fourth-quarter losses, and their stock prices and CDS spreads have performed accordingly (exhibit 5). The sharp decline in the equity prices has made the companies reluctant to raise new capital, despite the prospects of higher-margin new business, because additional share issuance at the current share prices would lead to massive dilution for existing shareholders. Fifth, the yield levels on many mortgage-backed securities have climbed significantly above the yield on the underlying mortgages that underpin the securities. This is the opposite of how securitization is supposed to work. This phenomenon reflects the glut of supply of such securities on the market and the added risk premium attached to assets that are typically held on a mark-to-market basis.
Although the residential mortgage market is the epicenter of the crisis, distress has been evident much more broadly—with the municipal market fully implicated in the period since the January meeting. The deleveraging process evident among financial intermediaries operating outside the commercial banking system has led to a widespread repricing of financial assets. When available leverage drops, risk- adjusted spreads have to rise for leveraged investors to earn the same targeted rate of return as before. This helps explain why the problems in the residential mortgage market have infected financial markets more generally, leading to wider credit spreads (exhibits 6 and 7) and lower equity prices (exhibit 8) both in the United States and abroad. As leverage is reduced and spreads widen, financial arbitrage implies that all assets should reprice. The risk-adjusted returns from holding different asset types should converge—recognizing that the degree of leverage that is available in markets may differ across asset classes in accordance with divergences in price volatility, liquidity, transparency, and other characteristics.
Of course, the notion of convergence to equivalent risk-adjusted returns is an equilibrium concept, and we are not in equilibrium. The events of the past week underscore that point. But there are plenty of other examples of disequilibrium at work. For example, for mortgage-backed securities, the losses implied by the prices of the AAA-rated ABX index tranches appear to be high even relative to the darkest macroeconomic scenarios. The municipal bond market is also a good example of how market valuations can become unusually depressed when supply increases rapidly. Then the value inherent in the securities becomes broadly known, this mobilizes new money, and risk-adjusted returns come back down relatively quickly. Term funding spreads also indicate greater stress within the financial system. As shown in exhibits 9 and 10, the spreads between one-month and three-month LIBOR– OIS spreads have widened sharply in recent weeks, even before Bear Stearns’s demise. We are sitting today at 56 basis points for the one-month LIBOR–OIS spread and 77 basis points for the three-month LIBOR–OIS spread, about the same as yesterday morning.
As you are all aware, we have been active in responding to the growing market illiquidity. Exhibit 11 illustrates the results of the TAF auctions. Note how propositions and the number of bidders have increased recently and the spread between the stop-out rate and the OIS rate has risen over the past few weeks. Even before the Primary Dealer Credit Facility was implemented this weekend, we were in the middle of a historic transformation in the Federal Reserve System’s balance sheet. We are increasing the supply of Treasuries held by the public (either outright or borrowed) and reducing the supply of more-illiquid collateral held by the private sector. Even excluding the uncertain impact of PDCF borrowing, this shift will speed up noticeably over the next month or two. Our current plans are to increase the size of the TAF to $100 billion, scale up the single-tranche RP book to $100 billion, renew and increase the size of the foreign currency swaps with the ECB and the SNB to $36 billion outstanding (if fully subscribed), and implement a $200 billion TSLF program. Exhibit 12 shows how these programs are likely to change the composition of the Federal Reserve’s SOMA portfolio. As can be seen, when all the current programs are fully phased in by May, Treasury holdings will have shrunk to about 45 percent of the total portfolio, down from about 97 percent last July.
At the same time that financial markets have been under severe stress and the macroeconomic growth outlook has deteriorated, the inflation news has also been disturbing. Several market-based indicators are adding to investors’ concerns about the inflation outlook. First, commodity prices have increased sharply. As shown in exhibit 13, the increases have been concentrated in both energy and agricultural prices. Of course, subsidies to stimulate the production of ethanol from corn have been an important factor. By diverting corn production to this purpose, the linkage between energy and grain prices has been significantly strengthened. Second, the dollar, after a period of stability that lasted from mid-December into February, has begun to weaken anew (exhibit 14). This has gotten considerable attention in the press and abroad as the dollar has hit new lows against the euro and has fallen below 100 against the yen. Up to now, the decline has generally been orderly, and the downward slope of the broad real trade-weighted dollar trajectory shown in exhibit 14 has not changed much.
The foreign exchange markets are clearly very skittish. In particular, there has been considerable focus on China and the Gulf Cooperation Council (GCC) countries and their willingness to maintain their pegs against the dollar. For China, investors expect its crawling peg to move faster. As shown in exhibit 15, the Chinese yuan is now expected to appreciate about 11 percent against the dollar over the next year, up from an 8 percent pace at the beginning of the year. For the GCC countries, there is speculation that some of these countries might decouple from the dollar. However, on a one-year-forward basis, market participants are currently building in only a couple of percentage points of expected appreciation.
Breakeven rates of inflation have continued to widen. As shown in exhibit 16, both the Board staff’s and the Barclays measures have broken out above the ranges evident in recent years. It is difficult to differentiate how much this widening reflects a higher risk premium due to greater uncertainty about the inflation outlook versus higher expected inflation. But either way, it is probably fair to say that inflation expectations have become less well anchored over the intermeeting period. I will say, however, that yesterday breakeven rates of inflation came down very sharply—the move was 15 to 20 basis points. Today, we are back in the range we were in, but that is only today. Short-term rate expectations continue to move lower. As shown in exhibit 17, federal funds rate futures now anticipate a trough in yields a bit below 1.5 percent. The yields implied by Eurodollar futures prices have also shifted sharply lower, as shown in exhibit 18. The trough in yields is expected to be reached in late summer or early fall.
Our formal survey of primary dealers, which we normally show you, was conducted more than a week ago, and it is clearly out of date (these exhibits are included in the appendix to the handout). So let me focus on what the dealers’ expectations were as of yesterday. They changed quite a bit over the past week. Most dealers expect either a cut of 75 or 100 basis points: There are eight for 100 basis points, ten for 75 basis points, and two for 50 basis points. This compares with the slightly more than 100 basis points built into the April federal funds rate contract (yesterday the April fed funds contract implied a 1.95 percent effective fed funds rate for the month).
There were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the January 30-31 FOMC meeting. Of course, I am very happy to take questions.