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

Thank you, Nathan. I will be referring to the exhibits labeled in red, “Staff Presentation on Financial Developments.” The intermeeting period was characterized by persistent strains in financial markets and a sharp drop in asset prices. Although some markets have improved in recent days, the ongoing disruptions have generated intense pressures on financial institutions and have contributed to a significant further tightening of credit conditions for households and businesses. As Bill Dudley noted, spreads on credit default swaps (CDS) for financial institutions have been quite volatile. As shown by the top left panel of your first exhibit, median spreads for large bank holding companies (the black line) and regional commercial banks (the red line) declined substantially after the announcement of the Treasury’s capital purchase program and the FDIC’s temporary liquidity guarantee program on October 14; they ended the period almost 70 basis points lower, on balance. The median CDS spread for insurance companies (the blue line) increased substantially over the latter part of the intermeeting period amid concerns about the financial condition of these firms. Judging from the wide range of dealers’ price quotes on CDS for the same firms (shown in the top right panel), liquidity and price discovery in the CDS market remain strained.

The functioning of markets for corporate debt is also impaired. As shown by the blue line in the middle left panel, the staff’s proxy for the bid-asked spread on high- yield bonds spiked to more than 4 percent before partially reversing course over the past week. This spread is also unusually elevated for investment-grade bonds (the black line). As shown to the right, the average bid-asked spread on syndicated loans traded in the secondary market (the black line) jumped up over the intermeeting period. Secondary market prices for syndicated loans (the blue line) dropped to unprecedented levels, reportedly reflecting heavy sales by hedge funds that were forced to meet investor redemptions as well as the unwinding of some types of structured investments.

Municipal finance, the subject of the bottom two panels, was significantly disrupted by dislocations in money market mutual funds in September and record withdrawals from long-term municipal bond funds in early October. Markets for structured products, such as tender-option bonds, that issued short-term variable-rate debt backed by longer-term municipal bonds were particularly affected. Yields on those short-term instruments (shown by the black line in the bottom left panel) jumped for a time, and the sales of the underlying long-term bonds as the structures unwound boosted long-term municipal bond yields (the blue line). As shown to the right, issuance slowed substantially until mid-October, when a few states—notably California—placed a sizable amount of new debt, though they paid fairly elevated interest rates to do so. In recent days, however, liquidity conditions have shown signs of improvement, yields have decreased somewhat, and issuance has moved back up from the extremely slow pace seen in the second half of September and the first half of this month.

Please turn to exhibit 2. As noted by Bill Dudley, prime money market funds suffered a wave of redemptions in mid-September, shown by the red bars in the top left panel. Although the flows diminished after the Federal Reserve and the Treasury announced steps to support money funds on September 19, prime funds lost about one-fifth of their assets, on net, over the intermeeting period. As a result, prime funds have dramatically reduced their holdings of commercial paper, generating significant disruptions in that market. As shown by the black line in the top right panel, unsecured financial commercial paper outstanding has declined sharply since mid- September, and the ongoing contraction in ABCP (the blue line) has continued. In contrast, the amount of unsecured commercial paper placed by nonfinancial firms (the yellow line) was little changed, on net, over the period. As shown in the middle left panel, broad equity prices (the black line) dropped about 30 percent over the intermeeting period as the outlook for both economic growth and earnings dimmed, and implied volatility increased to record levels. As depicted by the red bars to the right, those developments were accompanied by record outflows of about $60 billion from equity mutual funds in September. Weekly data indicate that, over the first half of October, investors withdrew more than $100 billion from long-term mutual funds, including about $70 billion from equity funds, but outflows have slowed in recent days.

As shown in line 1 in the bottom left panel, M2 expanded rapidly in September and early October as some firms and households shifted toward safer assets. Liquid deposits (line 2) increased significantly in September and stayed about flat in October. In contrast, retail money funds (line 3) were little changed in September but have grown briskly this month. The sizable increases in small time deposits in both months (line 4) were widespread, in contrast to the more concentrated gains seen over the summer in response to elevated yields at a few financial institutions. Currency (line 5) began increasing rapidly in recent weeks, apparently supported by higher demand from both foreign and domestic holders.

As a result of the disruptions in short-term funding markets, a range of borrowers turned to banks for funding. The “other loans” category (the blue line in the bottom right panel) rose sharply beginning in mid-September as a result of both unplanned overdrafts and draws on existing credit lines by nonfinancial businesses, money market mutual fund complexes, foreign banks, nonbank financial institutions, and municipalities. C&I loans at banks (the black line) have also increased significantly in recent weeks, as a broad spectrum of nonfinancial firms tapped existing credit lines. According to the October Senior Loan Officer Opinion Survey, however, about 25 percent of the largest banks and 35 percent of other banks surveyed indicated that C&I loans not made under previous commitment accounted for some of the recent increase.

Additional results from the survey are the subject of your next exhibit. Large net fractions of institutions reported having continued to tighten their lending standards and terms on all major loan categories over the previous three months, with some banks reporting that they had tightened lending policies considerably. As shown by the black line in the top left panel, about 80 percent of domestic respondents tightened their lending standards on C&I loans since July, and all but one of the 54 banks surveyed reported charging higher spreads over their cost of funds on such loans (the red line). As noted to the right, nearly all the banks that tightened standards or terms did so in response to a more uncertain or less favorable economic outlook and a reduced tolerance for risk. Almost 40 percent of domestic banks tightened in part because of concerns about their capital or liquidity position, somewhat more than had cited those pressures in July. As indicated in the middle left panel, a large fraction of domestic banks again reported tightening standards on commercial real estate loans over the past three months.

Moving to loans to households, almost 70 percent of respondents tightened standards on residential mortgages to prime borrowers (the red line in the middle right panel). As shown by the blue line, nearly 90 percent of the institutions that originated nontraditional mortgages tightened standards on such loans. As shown by the short black line in the bottom left panel, about 75 percent of the respondents tightened lending standards on home equity lines of credit, and about 60 percent tightened standards on both credit cards (the blue line) and other consumer loans (the red line). As noted to the right, almost 25 percent of banks, on net, reported reducing the credit limits on existing credit card accounts of some prime customers over the past three months, and about 60 percent of banks reported cutting existing lines of some of their nonprime borrowers. Banks that had trimmed the limits on existing credit card accounts most often cited the more uncertain economic outlook as a very important reason followed, in turn, by a reduced tolerance for risk and deterioration in the credit quality of individual customers.

Business finance is the subject of your next exhibit. The spread on BBB-rated bonds issued by nonfinancial corporations (the blue line in the top left panel) rose about 275 basis points over the intermeeting period, to more than 600 basis points, whereas that on bonds of financial firms (the black line) reached nearly 1,000 basis points before easing some in recent days. As spreads spiked and volatility increased, bond issuance by both nonfinancial and financial corporations (shown in the table to the right) dropped appreciably in the third quarter (row 3) relative to the pace seen in the first half of the year (row 2). As shown in the last row, there has been no high- yield issuance by nonfinancial firms so far this month, and bond issuance by financial firms has come to a near halt.

In commercial mortgage markets, secondary market spreads on AAA-rated commercial mortgage-backed securities (CMBS), shown in the middle left panel, continued to increase on net, and no new CMBS have been issued for several months. As noted to the right, using announced earnings for about 200 firms and analysts’ estimates for the rest, the staff expects third-quarter S&P 500 earnings to come in about 10 percent below the level posted in the third quarter of last year. Losses at financial companies account for the drop. Bank holding companies reported further substantial write-downs on mortgage-related and other securities as well as higher loan-loss provisions necessitated by widespread deterioration in credit quality. In contrast, earnings of nonfinancial companies are projected to have risen about 12 percent from a year earlier, but increased profits of energy companies account for virtually all of those gains. As indicated in the bottom left panel, analysts have revised down significantly their expectations for earnings of nonfinancial firms (the red line) over the next year, likely in response to the worsening economic outlook. Expected earnings for financial firms (the black line) also have been cut further this month. A rough estimate of the equity premium (shown in the bottom right panel) stands at an extremely high level.

The household sector is the subject of your last exhibit. As shown by the top left panel, interest rates on conforming residential mortgages have been volatile—partly in response to the renewed pressures on GSE debt noted by Bill Dudley—but ended the period only slightly higher at around 6 percent. The staff expects home prices (the black line to the right) to decline significantly further through the end of 2010 and mortgage debt (the red line) to be about flat over that period. Both paths have been marked down from the September forecast to reflect a weaker economic outlook and tighter credit conditions. Spreads on asset-backed securities backed by credit card loans (the black line in the middle left panel) and auto loans (the red line) have risen more than 150 basis points since mid-September, moving well above their spring peaks. The cumulative increase in spreads since midyear has hindered issuance of such securities, and the volume of new deals, shown to the right, dropped more than 50 percent in the third quarter. The latest data, available through October 17, suggest that very little issuance has occurred this month. As shown in the bottom left panel, consumer credit has decelerated recently. With lending conditions likely to remain tight and with spending on durables expected to be soft, the staff sees significant further weakness in consumer credit in coming quarters.

Summing up, although there has been modest improvement in several financial markets recently, the worsening of the global financial crisis sharply increased pressures on financial firms and markets over the intermeeting period as a whole. Those pressures have led to further deleveraging, diminished liquidity, increased concerns among investors about the economic outlook, and a reduced tolerance for risk-taking. The resulting sharp fall in asset prices and the further tightening of credit conditions have had substantial adverse effects on nonfinancial businesses and households. That concludes my prepared remarks.

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