Wednesday, October 31, 2012

A visual review of the lending facilities created by the Fed during the credit crisis

I'm currently updating my History of the Fed chart. As a side project, here's what's happened to the various Federal Reserve credit programs initiated during the crisis. Most of them have rolled off the Fed's balance sheet. Even the most toxic of them - Maiden Lane I and III - seem set to be paid off.

Go to scribd to see a higher resolution pdf. Alternatively, my public gallery has a high-res GIF.

This chart illustrates one role of a central bank, that of lender of last resort role. A central banking facing a crisis is supposed to lend to everyone on any sort of collateral and buy all sorts of assets. If you read through the fine print of the chart, you'll see that the Fed's new facilities accepted a broad range of assets - from commercial paper to CDOs to RMBS, and opened themselves up to a fairly wide array of counterparties.

What is really happening here is that the Fed is providing liquidity insurance. Liquidity insurance is like any other form of insurance - home insurance, car insurance, credit default insurance, whatever. Given the possibility of a fire, people buy house insurance to compensate  for that outcome. Given the possibility that one might be required to do a fire-sale into a thin market, it might be a good idea to purchase liquidity insurance ahead of time. Both are products that can be provided by insurance companies competing in the market.

Unfortunately the Fed can never know if it is providing liquidity insurance at the right price because it is the monopoly provider and has no competition. During the credit crisis, a lot of firms were extended liquidity insurance by the Fed even though they never paid for it ahead of time. In the future, one would hope that the free market takes over the Fed's role of liquidity insurance provider, leaving the Fed to operate the clearing system and set a few interest rates.

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