Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

It is better than the time I found out I had to discuss a Stiglitz paper in grad school about 12 hours ahead of time. That was harder. I read the Stiglitz paper three times, and then I started to understand it. [Laughter] What I thought I would do, if I could, is invert the order and start with the balance sheet issues and then go into the TALF because I think that there is a broader question of our exit from all our liquidity programs. That is a very legitimate issue. You can imagine a circumstance that sometime in the future we still have an inflated balance sheet, and we actually want to raise the federal funds rate target. The question is, Would we be able to do so?

The good news, of course, is that a lot of our facilities are going to go away pretty naturally—the swaps, the CPFF, and the TAF. We may have to give it a bit of a nudge, but those programs should downsize pretty automatically. Even after that, we are still going to have on our books a lot more agency debt and a lot more agency mortgage-backed securities. We’re going to have loans outstanding that are associated with Bear Stearns and AIG. We are going to have longer-term Treasuries. We have potentially a very large funding obligation to Citigroup, if its losses go through the FDIC and TARP money. Then, of course, the TALF could also still be on our balance sheet, depending on what the terms of those TALF loans are. I am going to come back to that a little later.

Generally, I am not worried about our ability to raise the level of interest rates, even if our balance sheet is still inflated at the time, for a number of reasons. First, I think the interest rate on excess reserves does work, just not quite as well as we had hoped. The gap between the interest on excess reserves and the effective funds rate has been running in the 40 to 50 basis point range. That means that, if we were to raise the interest rate on excess reserves, we would raise the whole complex of interest rates, including the effective fed funds rate. The gap is as large as it is because, when balance sheet capacity is scarce, people have to be paid to use their balance sheet to arbitrage that difference. But I think that gap today is pretty stable, and we can expect that, as the balance sheets return to a more normal condition, over time that gap might actually narrow as people say, “Well, gee, I have more balance sheet capacity to do this arbitrage.” So that would be point number 1.

Point number 2 is that we can probably take active steps that reduce the cost of that arbitrage to banks today. We can limit the GSEs in terms of their fed funds sales, and we can also reduce the balance sheet consequence of the arbitrage by potentially removing those purchases from the leverage ratio, giving them a little regulatory relief, which actually makes some sense because there is really no risk to a bank that is buying fed funds from another bank and putting them on deposit with the Fed. There is no interest rate risk overnight. So that is something that we might want to consider.

Another thing that I think is important to recognize is that there may be other means of addressing our excess reserves problems. The first point is that interest on excess reserves is probably good enough to do a reasonable, if somewhat sloppy, job in pushing up interest rates. In addition to that, we have other ways of addressing excess reserves in the system. We have the ability to change our monetary policy framework. We had a meeting earlier this year in which we discussed some of the potential places we might want to go. To drain excess reserves, if we decided that was necessary to get better control of the federal funds rate, we could do reverse repos with a broader set of counterparties, like money market mutual funds. We could do that using the agency debt on our balance sheet and using the Treasury debt on our balance sheet, and we could probably do that in size, since the money market funds would be very happy to be our counterparts.

Second, we could also change the monetary framework in a more radical way. One can imagine a system by which we set voluntary reserve targets for banks at pretty high levels, where the rate they got if they were above the target dropped off considerably and the rate they got below the target dropped off considerably. So we could basically give the banks incentives to hold the amount of their excess reserves that actually are in the banking system.

Third, the Treasury could help us, as it was helping us for a while. The SFP bills actually did work. The problem was that, as the Treasury’s borrowing needs skyrocketed, it started to worry about running into the debt limit. What actually happened—it was a political issue—it didn’t want to notify the Congress 60 days ahead of time that it might hit the debt limit, and that is really why it started backing away from the SFPs. Now, we could resolve this in a couple of different ways. One, if the debt limit were raised enough, you would have plenty of room. Or you could potentially exempt the SFPs from the debt limit, and you could argue that doing so makes sense because there is debt here and there is cash on the Federal Reserve balance sheet, so no real net debt is created.

Last, you could gain legislative authority to issue Fed bills, which I think is actually a little more radical step. But the attractiveness of that, of course, is then we have complete control over our destiny, and you don’t have the mushing together of church and state, where we are at least somewhat dependent on the Treasury for managing our monetary policy. So the bottom line for me is that I don’t think we should be concerned about the large size of our balance sheet constraining our ability to manage our interest rate policy going forward. That should not be a driver of what we decide about our liquidity facilities.

So why is this important? Well, the TALF, just to recap, is a program in which we would basically lend funds against AAA-rated consumer asset-backed securities on a nonrecourse basis to basically anyone—not quite anyone, not foreigners, but pretty much anyone who wants to do it—and we would conduct these transactions through the dealer community. In the TALF program we would be offering three things to investors. First, they would be offered more leverage than they can get today because the haircuts that we would put on the securities would not be the 50 percent type of haircuts that the market is putting in place today. They might be 10 percent, 20 percent, or 30 percent. We are still negotiating, determining that. So investors could get a lot more leverage than they can get today. The second thing that would be offered is protection against tail risk, and that is something that investors very definitely can’t get today. Because the loan would be nonrecourse, the investor could lose only the amount of the haircut, and that is really important in a world where prices are very volatile. So that would significantly reduce the mark-to-market risk of investing in the securities from the perspective of investors. Finally, probably the most important thing, we would be providing term funding. People could buy these securities, which are of relatively long duration. It depends on what security you are looking at, but the securities probably range in duration from two years to seven or eight years, if you are looking at student loans. So this facility would not work if the term were very, very short.

We have been in the process of going out and talking quite extensively to issuers and investors over the past couple of weeks. The Board staff has been involved. The New York Fed staff has been involved. Basically what we found out is that they like the program. The leverage is not quite as important as we thought. They said they could live with less leverage rather than more leverage. They like the protection against the tail risk. The nonrecourse nature of the loans, of course, is very attractive. But the main thing on which they focused and that they said was most important for the success of the program was the length of the term of the loans. When we went forward with the initial term sheet, we were talking about a one-year term, and the investors have come back quite forcefully and said that a one-year term is not sufficient. The program will not work with a one-year term. Now, maybe they are exaggerating the degree to which it wouldn’t work, but it does seem fairly credible that there is no reassurance that one year from now we are going to be completely out of the situation that we are in today. So, certainly, it is completely legitimate to be worried as an investor about the rollover risk one year from now, given that these are assets of longer durations.

Where I come out on all of this is that I think we really do need to be attentive to that concern, and we should try to make the term of the TALF loans as long as possible, subject to protecting the Fed, obviously, from credit losses. If we were to make it short term, I think there is a high probability that the program would fail. I think that would be a huge blow to our credibility. Up to now we have done pretty well in wheeling out programs that have done what we said they were going to do. I think this is a particularly important program because of its ability to be expanded in multiple directions. The Treasury is very, very interested in this program as a way of using TARP capital efficiently. So to wheel this out on terms that are too short and that make the program unattractive would be very, very damaging to our credibility. My view is that we should be willing to offer these loans at term. I would favor three years. I think if we do that, this program will be successful. Obviously, if we do that, we are going to have more balances on our books. This program was originally conceived of as about a $200 billion program. That is probably as big as it would get for consumer ABS, but obviously, if we expand it to CMBS and other things, it could be considerably larger than that. So that is sort of where we are. Pat, do you have anything you want to add?

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