Sunday, March 16, 2008, was not a peaceful day for the Board of Governors. Over the prior week, one of Wall Street s most famous investment houses, Bear Stearns, had gone into full collapse. Although Bears Stearns had roughly $17 billion in readily available assets, it appeared this was not enough to satisfy the market. Other investment firms believed Bear Stearns had made so many poor investments that it was not financially viable. They rapidly began pulling out their funds from the firm.
The Fed feared that a complete collapse of Bear Stearns would devastate the financial system and cause a global panic as investors would want to pull out their funds from all financial institutions, effectively causing a run in the financial markets. During the week the Fed began to search for ways to deal with this crisis. One solution was to try to convince another financial institution to take over Bear Stearns and keep the financial markets open. The problem, however, was that no one had a clear idea precisely what quality of assets Bears Stearns had on its balance sheet, and thus no firm wanted to be exposed to the risk of purchasing them. Finally, the Fed convinced the investment firm JPMorgan Chase & Co. to buy Bear Stearns but only after the Fed agreed to loan Chase $30 billion. The Fed had successfully averted a major financial crisis but had put U.S. taxpayers at risk by lending such a large amount to a private investment house.
Unfortunately, Bear Stearns was only an early symptom of a problem that increased in severity over the coming months. As we discussed in Chapter 12, by September and October of 2008 the mortgage crisis had effectively spilled over into the world s financial markets. Banks and other financial institutions were afraid to lend to one another because they were not sure whether or not their loans would be repaid. The world s financial markets were freezing up, stock markets were in sharp decline, and there was growing panic.
The panic was brought to a head when the Fed and Treasury decided not to arrange a bailout for Lehman Brothers, another major financial institution, as they had done for Bear Stearns. The markets worldwide reacted adversely to this decision. The Fed and Treasury quickly changed tactics, however, and authorized an $85 billion loan to the American International Group (AIG) and took an 80 percent ownership stake in the company. The Fed had thought that the failure of AIG would trigger massive failures of other institutions whose assets were insured by AIG. As the crisis continued, the Fed continued to develop new programs, such as purchasing the short-term debt of corporation’s commercial paper so that it effectively spread its lender of last resort function beyond financial institutions. It also began a program to extend loans to money market funds, some of which had come under financial pressure, and it started to make purchases of securities backed by mortgages in order to keep funds flowing to the housing sector. Finally, it began to pay interest on deposits held at the Fed, a move designed to induce banks to hold more reserves and increase the Fed s own ability to make critical loans.
Taken together, these were sweeping changes to the Fed s role in the financial system. The Fed has now abandoned its efforts to support the commercial paper market and money market funds, but has maintained the other programs. Only time will tell whether the remaining changes, adopted during a two-month period, will become permanent tools of the Fed or will fade away when the economy eventually recovers.