Thank you, Mr. Chairman. Today my attention will be narrower than usual, given the briefings by Bill Bassett and Linda Kole that will follow covering the broader developments in the equity, fixed income, and foreign exchange markets in the United States and abroad, which have been considerable over the past six weeks. I will focus on three topics: (1) the impact of our new facilities and other government initiatives on market function, (2) the consequences of the expansion of these facilities on our balance sheet and our ability to hit the federal funds rate target over time, and (3) the travails of the hedge fund community and how this could potentially add to market dysfunction. I will be referring to the chart package that should be in front of you.
As you all know, the Lehman bankruptcy led to sharp outflows from prime money market mutual funds into Treasury-only funds (exhibit 1). The result was a collapse in Treasury bill yields (exhibit 2). At the same time, the cost of financing Treasury securities via repo fell sharply—this is illustrated in exhibit 3 by the drop in the overnight general collateral (GC) repo rate. This increased the incentive for Treasury traders to short Treasury securities that were already hard to obtain because the effective cost of borrowing such securities is determined by the level of the GC repo rate. As a result, Treasury fails, which represent Treasury securities that are not delivered as promised to their buyers, soared. Treasury fails were also exacerbated by the withdrawal from the securities lending market of some large holders of Treasuries, including some major foreign central banks. Although Treasury yields fell sharply and Treasury bills were in great demand, the rise in fails resulted in a sharp diminution of trading and liquidity in the Treasury securities market. The fact that there are severe market-functioning problems in the asset class that is in greatest demand—Treasuries—underscores the scope and severity of the markets’ broader dysfunction.
At the same time, the outflows from prime money market funds led to a sharp drop in the demand for commercial paper, a significant rise in commercial paper rates, and a shortening of commercial paper maturities (exhibits 4 and 5). Term bank funding spreads rose sharply, with the one-month and three-month LIBOR–OIS spreads increasing to levels that make the earlier peaks look like modest speed bumps (exhibits 6 and 7). The Lehman bankruptcy caused counterparty risk concerns to intensify. Moreover, the Lehman bankruptcy disrupted a number of markets because participants in these markets were uncertain how to adjust their long- and short- position exposures that offset their open positions with Lehman. The result was a sharp drop in the willingness of counterparties to engage with one another, especially at term. Essentially, the result was a massive coordination problem that has led to a very unattractive equilibrium. I would put it this way: “I won’t lend to you even though I think you’re okay because I am not sure others will lend to you either. I need some assurance that others will lend to you in order to have some assurance I can get my money back if I need it.” Even though it has been in the interest of all parties to engage, no party has been willing to go first.
In response, the Federal Reserve dramatically expanded its programs of liquidity support. The size of each TAF auction has been raised to $150 billion—the same size as the entire TAF program just six weeks ago. Fixed-rate tender dollar auctions were implemented by the BoE, the BoJ, the ECB, and the SNB. The asset-backed commercial paper money market mutual fund liquidity facility (AMLF) and the commercial paper funding facility (CPFF) were implemented, and plans for a money market investor funding facility (MMIFF) were announced. The Federal Reserve and other central banks stepped forward to engage in transactions with a broad range of bank and, in the case of the Fed, nonbank counterparties. The hope, of course, is that this willingness to engage will reduce rollover risk and therefore encourage others to re-engage with their counterparties.
At least for now, the escalation in the size of the TAF auctions appears to have been sufficient to satisfy the demand for dollar funds in the United States. As shown in exhibit 8, the first two auctions of $150 billion have been slightly undersubscribed. Currently, about $300 billion of TAF credit is outstanding. Demand for dollar funding in Europe has increased sharply even though the cost is much higher than in our TAF auctions. Whereas the two most recent TAF auctions were stopped out at the OIS rate, which is the minimum bid rate, the foreign fixed-rate tender operations have been conducted at a rate of OIS plus 100 basis points. As shown in exhibits 9 and 10, swap outstandings have grown to nearly $500 billion currently. The ECB swap size is currently about $280 billion, more than half the total amount of swaps outstanding. The amount of outstanding swaps is likely to climb sharply when the first 84-day fixed-rate tender operations are conducted in Europe next week.
The CPFF facility is another important element in the Fed’s program of liquidity escalation. As you know, this facility provides a backstop for domestic issuers of A1/P1-rated commercial paper. Issuers can sell commercial paper to the facility at three-month term for an effective cost of OIS plus 200 basis points for nonfinancial and financial issuers and OIS plus 300 basis points for asset-backed commercial paper (ABCP). This facility complements the AMLF, which lends funds to banks at the primary credit facility rate against the ABCP purchased from money market mutual funds. Yesterday was the first day that the CPFF was open for business, and a number of borrowers issued commercial paper to the facility totaling more than $50 billion. At the close of business last week, 79 issuers had registered to use the facility, paying 10 basis points, or $580 million, to cover the potential issuance of commercial paper. The 10 basis point fee provides a little equity to get the program off and running.
Finally, the most recent facility, the money market investor funding facility, was announced last week. This facility will provide liquidity to five conduits that will purchase commercial paper and certificates of deposit of designated issuers from 2a-7 money market mutual funds. It will likely be several more weeks before this facility is operational.
The escalation in the provision of liquidity and some of the other initiatives I will discuss shortly have led to a grudging improvement in the interbank funding markets and in the commercial paper market. Reviewing the earlier exhibits, most term funding spreads have narrowed, but the improvement is modest relative to the earlier deterioration. It is unclear at this stage whether the modest extent of improvement reflects the limited ability of additional capacity and breadth in terms of liquidity provision to restore confidence, especially at a time that the macroeconomic outlook has deteriorated globally, or whether it will just take time for these liquidity facilities to restore confidence and some semblance of normality to the money markets.
The expansion of the Fed’s liquidity provisions has been accompanied by escalations on two other fronts. First, the FDIC announced a bank funding guarantee program. Although the terms and conditions of this program have not yet been finalized, the program is likely to guarantee most of the new senior debt obligations of participating depository institutions and their associated holding companies up to a cap of 125 percent of the maturing obligations through June 30, 2009. Importantly, new interbank funding will be covered. How this affects the federal funds market remains to be seen. Second, the Treasury has committed $250 billion of funds from the TARP program to inject as preferred stock into the banking system. Nine large banks announced two weeks ago that they will accept $125 billion of preferred stock investment from the Treasury. Over the past few days, the Treasury announced that an additional $35 billion of capital has been committed. The FDIC guarantee announcement and the TARP capital infusion have been effective in shoring up confidence in the major U.S. banks. As shown in exhibits 11 and 12, credit default swap spreads for most major U.S. financial institutions have narrowed sharply.
But the guarantee of the senior debt of depository institutions and their associated holding companies has generated some unintended consequences for those firms not covered by these guarantees. In particular, the credit default swap spreads for major nonbank financials have narrowed less than those for the banks (exhibit 13). Moreover, the funding costs for the GSEs have climbed, especially for short-term discount note issuance. The funding costs for Fannie and Freddie for both long-term and short-term debt are shown in exhibits 14, 15, and 16. However, the fear that funds would flow out of prime money market funds back into bank assets guaranteed by the FDIC has not been realized—at least not yet.
The expansion of the Fed’s facilities and the open-ended nature of the fixed-rate tender dollar operations by the foreign central banks that we are funding by swaps have led to rapid expansion of our balance sheet. Exhibit 17 provides a snapshot of the Federal Reserve’s balance sheet at different times before and during the crisis. During the first 13 months, the size of our balance sheet was little changed. We accommodated our liquidity programs mainly by selling Treasury securities. During the next stage, which began around the time of the Lehman bankruptcy filing, we expanded our balance sheet but drained the reserve additions primarily by having the Treasury issue supplemental financing program bills and placing the proceeds on our balance sheet. However, the capacity to continue to drain reserves via SFP bills was unlikely to be a long-term solution because the Treasury would ultimately be constrained by the debt limit ceiling.
The passage of the Emergency Economic Stabilization Act of 2008 granted the Federal Reserve the authority to pay interest on reserves immediately. This was very important because it meant that we could expand our balance sheet size by unsterilized reserve additions but at the same time keep the federal funds rate from crashing to zero by paying a positive interest rate on holdings of excess reserves. Further rapid balance sheet expansion appears inevitable as the takedown from the TAF auctions and the fixed-rate tenders expands further and as our new facilities, such as the CPFF and MMIFF, begin operation. Although the estimates shown for year-end in exhibit 17 are indicative—the actual size will be driven by the use of our various liquidity facilities—it does seem likely that the Federal Reserve System’s balance sheet will grow very rapidly through year-end. We are now nearly three weeks into the new interest-on-reserves regime, which was implemented on October 9. As you know, the Board of Governors initially set the spread between the target federal funds rate and the rate paid on excess reserves at 75 basis points. Policymakers erred on the size of a wide margin given unsettled market conditions and the lack of experience with the new regime, recognizing that the spread could be reduced if the federal funds rate traded soft relative to the target.
As shown in exhibit 18, despite the payment of interest on reserves, the federal funds rate has continued to trade soft relative to the target. As a result, the Board narrowed the spread to 35 basis points with the start last Thursday of the second reserve maintenance period under the interest-on-reserves regime. It is too soon to assess the effect of the narrower spread on our ability to push the federal funds rate back up to the target because the interest rate paid on reserves is based upon the lowest target federal funds rate during the reserve maintenance period. So currently it is hard to separate the impact of the narrower spread on the effective federal funds rate from the expectations for further cuts in the target federal funds rate that might occur at this meeting. There are two complications in fixing the interest-on-reserves spread at a level consistent with the target. First, some of the GSEs, which hold balances at the Fed, are not allowed to earn interest on their balances. Thus they have to sell federal funds to banks that, in turn, hold the funds and are paid the interest-on- reserves rate. Second, some banks have also been selling federal funds below the interest-on-reserves rate. We expect this to diminish over time as they gain more experience with the new regime. However, other factors, such as concern with their overall leverage ratios, could cause this phenomenon to persist. As a result, there has been a significant amount of federal funds rate trading below the interest-on-reserves rate. This is illustrated in exhibit 19, in which the circles are sized to reflect the amount of trading at a particular rate level.
This trading of fed funds below the interest-on-reserves rate has two consequences. First, it blurs the meaning of the effective federal funds rate with respect to its relationship to the stance of monetary policy. Conceptually, the interest- on-reserves rate, rather than the effective federal funds rate, could be viewed as representing the default risk-free investment rate for banks. Second, it implies that we may have to narrow considerably further the spread between the target federal funds rate and the interest rate paid on excess reserves in order to push the effective federal funds rate up to the target. In principle, if fed funds sales were to continue in large volume below the interest-on-reserves rate, the interest-on-reserves rate might need to be set right at the federal funds rate target in order to support the federal funds rate close to that level.
Before turning to a discussion of monetary policy and inflation expectations, I want to make a few comments about the hedge fund industry. Before this crisis began, most of the fears about a market meltdown were focused on hedge funds. Until now, these fears have been mostly misplaced. However, the risks that hedge fund problems will now exacerbate the crisis have increased substantially recently. The underlying problem is that the recent performance of the hedge fund industry has been very poor and hedge fund viability is not very robust when net asset values slip considerably below their high-water marks in individual funds. September was the poorest month in the past 10 years, and so far October returns are on pace to be even worse. Net asset value for the entire hedge fund industry is down more than 10 percent year-to-date. The average performance, shown in exhibit 20, masks substantial dispersion in returns and particularly poor performance for certain strategies. In particular, convertible arbitrage, emerging market arbitrage, and fixed- income arbitrage strategies suffered double-digit losses in the month of September, and further losses are likely in October.
Poor hedge fund performance has been exacerbated by several factors. First, policy shifts such as the short sales ban have caused big problems for convertible arbitrage, statistical arbitrage, and long/short equity strategies. This has been an important factor behind Citadel’s travails. Second, prime brokers continue to pull back in their willingness to provide financing by raising their haircuts assessed against hedge fund assets as market volatility rises (exhibit 21). Third, investors are pulling funds out of hedge funds because of their poor performance and a generalized increase in risk aversion. As a result, hedge funds are raising cash to meet actual and potential redemptions, and many hedge funds are either hitting or approaching their net asset value trigger points.
Let me say a few words about net asset value triggers. Hedge funds often negotiate agreements with each of their prime brokers that set the terms for their access to financing. These contracts give the prime brokers the option to seize and liquidate collateral if the hedge fund net asset value falls by more than a certain magnitude—say, a 30 percent decline in assets under management over a three-month period; that’s a very common trigger. Obviously, if only a few hedge funds are close to these triggers, there is little problem as there is no potential flood of asset sales into the market. But when so many hedge funds are under pressure at the same time, the risk of broader asset liquidation increases. The prime broker may have a lessened incentive to waive its right to liquidate collateral when a greater proportion of the industry is troubled because the first-mover advantage of selling collateral likely becomes more important under such circumstances.
I anticipate that the pressure from the liquidation of hedge fund assets will continue to weigh on financial markets over the next few months. Some major fund of fund managers anticipate redemptions between now and early 2009 of at least 25 percent of the total industry, or about $500 billion based upon the estimated $2 trillion size of the global hedge fund business.
Market participants continue to price in additional cuts in the federal funds rate target. Of course, it is a little harder than usual to tell what they are expecting based on futures prices because the federal funds rate has traded soft relative to the target and those expectations are also embedded in the near-term rates for fed funds futures contracts. Regardless of the cause, if you look at exhibits 22 and 23, there has been a fairly sharp downward shift in the federal funds rate curve and the Eurodollar futures curve—they have shifted downward about 100 basis points. Moreover, the curves are considerably flatter than they were a few months ago, indicating that market participants expect that the FOMC will be slow to raise the federal funds target in 2009. Our primary dealer survey indicates that most survey respondents expect the Committee to lower the target federal funds rate over the next two meetings to around 1 percent and keep it there through most of 2009. This also represents a downward shift of about 100 basis points from the survey conducted before the September 16 meeting (exhibits 24 and 25). When the survey was conducted more than a week ago, the majority of respondents anticipated a 25 basis point cut. Since then, the consensus has flipped, with most now anticipating a 50 basis point rate cut at this meeting.
On the inflation expectations front, normal relationships between TIPS and nominal Treasuries have been distorted by the illiquidity of TIPS relative to nominal Treasuries and the high level of chronic fails in the five-year sector of the nominal Treasury market. As a result, TIPS yields have climbed sharply relatively to nominal Treasuries, leading to a sharp fall in breakeven inflation measures (exhibit 26). The fact that breakeven inflation rates have fallen more sharply in the five-year sector than in the ten-year sector has generated a rise in five-year, five-year-forward measures of inflation (exhibit 27). The distortions in the U.S. Treasury market suggest considerable caution in interpreting the rise in these measures. Interestingly, our Desk survey of primary dealers shows a slight drop in long-term inflation expectations since the September survey (exhibit 28).
Before concluding, let me note that the staff recommends approval of a $15 billion foreign exchange swap line with the Reserve Bank of New Zealand to help satisfy the dollar funding needs of banks that operate in New Zealand. As noted in the memo to the Committee from Nathan Sheets and myself that was distributed on Friday, this would complement the swap agreements that we have already enacted with other advanced economies and would have the same technical features as those with the smaller advanced countries (that is, Australia, Denmark, Norway, and Sweden) with fixed swap line limits. Nathan will be discussing the potential for additional swap line authorizations for four emerging market countries recommended by the staff that were discussed in a second memo to the Committee on Friday.
There were no foreign operations during this period. I request a vote to ratify the operations of the System Open Market Account that have been undertaken since the September 16 FOMC meeting. Nathan will continue our presentation.