ECON102: Principles of Macroeconomics (2021.A.01)

Well before most of the public became aware of the precarious state of the U.S. financial system, the Fed began to see signs of growing financial strains and to act on reducing them. In particular, the Fed saw that short-term interest rates that are often quite close to the federal funds rate began to rise markedly above it. The widening spread was alarming, because it suggested that lender confidence was declining, even for what are generally considered low-risk loans. Commercial paper, in which large companies borrow funds for a period of about a month to manage their cash flow, is an example. Even companies with high credit ratings were having to pay unusually high interest rate premiums in order to get funding, or in some cases could not get funding at all.

To deal with the drying up of credit markets, in late 2007 the Fed began to create an alphabet soup of new credit facilities. Some of these were offered in conjunction with the Department of the Treasury, which had more latitude in terms of accepting some credit risk. The facilities differed in terms of collateral used, the duration of the loan, which institutions were eligible to borrow, and the cost to the borrower. For example, the Primary Dealer Credit Facility (PDCF) allowed primary dealers (i.e., those financial institutions that normally handle the Fed's open market operations) to obtain overnight loans. The Term Asset-Backed Securities Loan Facility (TALF) allowed a wide range of companies to borrow, using the primary dealers as conduits, based on qualified asset-backed securities related to student, auto, credit card, and small business debt, for a three-year period. Most of these new facilities were designed to be temporary. Starting in 2009 and 2010, the Fed began closing a number of them or at least preventing them from issuing new loans.

The common goal of all of these various credit facilities was to increase liquidity in order to stimulate private spending. For example, these credit facilities encouraged banks to pare down their excess reserves (which grew enormously as the financial crisis unfolded and the economy deteriorated) and to make more loans. In the words of Fed Chairman Ben Bernanke:

"Liquidity provision by the central bank reduces systemic risk by assuring market participants that, should short-term investors begin to lose confidence, financial institutions will be able to meet the resulting demands for cash without resorting to potentially destabilizing fire sales of assets. Moreover, backstopping the liquidity needs of financial institutions reduces funding stresses and, all else equal, should increase the willingness of those institutions to lend and make markets".

The legal authority for most of these new credit facilities came from a particular section of the Federal Reserve Act that allows the Board of Governors "in unusual and exigent circumstances" to extend credit to a wide range of market players.