captioning performed by vitac which has liquid assets like long term loans but liquid short term liabilities like deposits. in a classic bank panic, if bank depositors lose faith in the quality of the assets held by the bank they run, pull out their money, the bank can't pay off everybody because they can't change their loans into cash fast enough. and so the run on the bank is self-fulfill, the bank will either fail or dump all of its long term assets quickly in the market and take big losses. that's what a panic basically is

in the context of a banking system. the priccrisis of 2008-2009 was financial panic. but in a broader financial market setting. in particular as house prices fell in 2006 and 2007 for the reasons i described when house prices falling people who borrowed on a subprime mortgage were not able to make payments, more and more of them would be delinquent or default and impose losses on the financial firms, the investment vehicles they created and also on credit insurers like aig. unfortunately, the securities were so complex and the monitoring of the financial firms of their own risks was not sufficiently strong that there was -- it wasn't just the losses. a very striking fact is that if you took all the subprime mortgages in the united states

and put them all together and assumed they were all worthless the total losses to the financial system would be about the size of one bad day in the stock market. they just weren't that big. but what the problem was is that they were distributed throughout different securities and different places and nobody you know where they were and who would bear the losses. there was a lot of uncertainty created in the financial markets. as a result, where you had short term funding whether commercial paper or other type of short term fund weg had all kind of funding that was not deposit insured, it was wholesale funding, came from other financial firms, whenever there was a doubt about a firm just like in a standard bank run the investors, the lenders, the counter parties would pull back their money quickly because the same reason that a d out of a

bank that would thought to be having trouble. there s s which generated pressures on key financial firms as they lost their funding, forced to sell assets quickly and many more financial markets were badly disrupted. now, in the depression of the '30s this were thousands of bank failures, but almost all of the banks had failed in the '30s at least in the united states were small banks. and there were some larger banks that failed in europe. the difference in 2008 was there were many small banks that failed in the united states but there were also intense pressures on quite a few of the largest financial institutions in the united states. and the next two pages are just a short list of some of the firms that came under intense pressure. bear stearns sway broker dealer came under very intense pressure in the short term funding markets, in march of 2008. it was sold to jpmorgan with fed

assistance in march. things calmed down a bit after that and over the summer there was some hope that the financial crisis would moderate but then in late summer things really began to pick up. in september 7th of 2008, fannie mae and freddie mac clearly were insolvent, they didn't have enough capital to pay the losses on their mortgage guarantees, the federal reserving worked with fannie mae and freddie mac's regulator and treasury to determine the size of the short fall and over the weekend the treasury with the fed's assistance came in and took those firms and put them into a form of a limited bankruptcy called a conservatorship and the treasury got authorization from congress to of the fannie mae and freddie mac obligations andeld fannie mae and freddie mac mortgage backed security the company itself was now sort of in a partial bankruptcy but the

u.s. government now guaranteed. so that protected those investors. that had to be done or else there would have been an enormous intensification of the crisis because investors all over the world held literally hundreds of billions of those securities. famously in the mid. september, lehman brothers a broker dealer, and i'll talk more about this, i have a case study on this coming up. had severe losses. came under great pressure. couldn't find either anybody to buy it or provide capital for it. so on september 15th it filed for bankruptcy. on the same day merrill lynch was acquired by bank of america. again, basically saving the firm from potential collapse. on september 16th the next day aig, the largest multidimensional insurance

company in the world had, if you remember, had been selling the credit insurance, came under enormous attack from the people demanding cash either through margin requirements or short term funding. the fed provide emergency liquidity assistance for aig and prevented the firm from failing. again, i'll again as well. washington mutual was one of the biggest thrift companies. a big provider of subprime mortgages, was closed by regulators later in september after parts of the company were taken off, jpmorgan acquired this company as well. october 3rd, wachovia, one in t united states, again, came under serious pressure and acquired by wells fargo, another large mortgage provider. these firms i'm talking about were among the top 10, 15

financial firms in the united states. similar things were happening in europe. not only small banks were being affected. that was a problem. but here we had the biggest, hagerstownest, most complex international financial institutions at the break of failure. now, the lessons from the great depression going back are two. first, if you remember the fed did not do enough to stabilize the banking system in the 1930s so the lesson there is that in a financial panic the central bank has to lend freely according to the rules toncial system. and the second lesson of the great depression the fed did not do enough to prevent deflation and contraction of the money supply so second lesson of the great depression you need monetary policy to help the economy avoid a deep depression. so, in heeding those lessons the

federal government and federal reserve topped the financial panic p.m. worked with other agencies and worked internationally with foreign central banks and governments. now one aspect of the crisis that i think maybe doesn't get quite enough attention is the fact that this really was first of all a global crisis, in particular europe as well as the u.s. was suffering very severely from the crisis. but it was also a very impressive example of international cooperation. and one particular date that i've singed out here is october 10th, 2008. as it happened on that day there was a previously scheduled ndus countries. it happened to take place here in washington. the g7 are the seven largest industrial countries. and the central bank governors and the finance ministers of met in washington.

now, i'll tell you a deep dark secret these big i had profile international meetings are a terrible bore because much of the work is done in advance by the staff, and we have a discussion but there's a communique which has been written by the staff and it's simply fairly routine in most cases. this was not one of those meetings. we essentially tore up the agenda and sat down and talked about what are we going to do? how are we going to work together to stop this crisis which was threatening the global financial system. and in the end we came up with a statement that was written from scratched, based actually on some fed proposals and circulated and there were a number of statements involved in that but among those were first we would work together to prevent the failure of any more simmically important financial

institutions, this was after lehman brothers failed. we would make sure banks and other financial institutions had access to funding from central banks anpivernments. we would work to restore depositor confidence and investor confidence. then we were going cooperate as much as possible to normalize credit markets. this was a global agreement and subsequent to this agreement just in the following week the uk was the first to announce a comprehensive program to stabilize its banking system, the u.s. announced major steps to put capital into our banks and so on. so a lot really happened in just the next couple of days after this meeting. now just to show you that this worked. this graph show us the interest rate charged on loans between banks. this is the interbank interest rate. so bank a lend to bank b overnight this was the interest rate that was charged. now zbloormly the overnight

interest rate between banks is way less than 1%. because banks, you know, they need some place to park their money overnight and they have a lot of confidence it's safe to tloend another largek n see sta 2007, banks lost confidence in each other. and that's shown by the inhe ra each other to make loans. so, for example, in 2007 you begin to see the pressures as house prices began to fall and there were increasing concerns about the quality of the mortgage securities and the quality of the firms. in march of 2008 you can see another little peek there around bear stearns and it doesn't look like much in comparison but that was a pretty tough period, it was a period of quite sharp moments in financial markets and in funding markets. now look what happened when bear stearns happened.

there was just an enormous spike in these intermarket bank rates and probably not much lending was taking place even at those high rates. what this was indicative was there was no trust whatsoever even between the largest financial institutions because nobody knew who would be next, who was going to fail, who was going to come under funding pressure. look what happened after the international announcements? within a few days you began to see a reduction in the pressure, and by the end the year early january there was an enormous improvement in the funding pressures in the banking system. so this is a great example of international cooperation and illustrates the point that this was not just a u.s. phenomenon, not just u.s. policy, was not just the federal reserve, it was a global cooperative effort particularly between the united states and europe.

now, the fed played an important role, however in providing that the panic was controlled. let me just talk briefly about this in general and then i'll do case studies that will illustrate some of the issues. now, the federal reserve has a facility called the discount window, which it uses routinely from vied short term funding to banks, maybe a bank finds itself short of funding at the end of the day, it wants to borrow overnight, it has collateral with the fed based on that collateral it can borrow overnight which is called the discount rate which is the rate that the fed charges. the discount window which allows the fed to grow banks. no extraordinary steps were needed to lend to barngs. the fed always tloend banks. we made some modifications in order to reassure banks by the

availability of credit, and to get more liquidity into the system, we extended the maturity discount window loans which were normally overnight loans, we made them longer term and auction ever discount funds where firms bid on how much they would pay. by having a fixed amount we would assure ourselves we got a lot of cash into the system. the point here is that the discount window which is the fed's usual lender last resort facility was used aggressively to make sure banks had access to ca but our financial system is a lot more complicated than the one that exists created in 1913. we have many other different kinds of financial institutions and markets now, and as i the crisis was like an old time bank crisis but appearing in all

different kinds of firms and institutional context. fed had to go beyond the discount window. create other p, special credit facilities that allowed us to make loans to other kinds of financial on the principle that firms suffering from loves funding is the best way to calm a panic. now all these loans were secured by collateral. we western taking chances with taxpayer money and i'll talk about that when i come back. but the cash was going not just to banks but more broadly into the system. again, the purpose of this the office enhance the stability of the financial system and get credit flows moving again. and just to emphasize, this is the traditional lender of last resort of central banks that's been around for hundreds of years. what was different is it took place in a different institutional context than just

the traditional banking context. here's some of the institutions and markets that we addressed through our special programs. banks, of course, were covered by the discount window but another class of institutions, broker dealers which are financial firms that deal in securities and derivatives were facing other problems. we provided cash or lent short term lending to those terms on a collateralized basis as well. as i'll talk about commercial paper borrowers received assistance as did money market funds. i'll come back and do a little case study on those two. finally the asset backed securities market. in the modern economy, modern financial system, a lot of the funding that you get for not just mortgages but auto loans,

credit cards, all kind of consumer credit are funned through the securitization process. that is a bank might take all of its credit card receivables, bundle them together into a security and then sell them in the market to investors, much the same way that mortgages were sold and that's called the asset backed securities market. the asset backed securities marktd dried up during the crisis and the fed created some new programs. i should mention that lending t discount window this was totally standard lending through the normal discount window these other types of lending required us to invoke emergency authorities. there is a clause in the federal reserve act called 13-3 which says that under unusual and exogent circumstances, basically in an emergency the fed can lend

to other types of entities othe authority had not been used by ths. e otulr problems emerging in differentrkets we i authority and used it to help stabilize a variety of different markets. so let me giveyot of a case stu will help you one, you know, what we did and how it helped the economy. so i want to talk a little bit . now money market funds are basically investment funds in which you can buy shares and money market funds take your money and invest it in short term liquid assets. money market funds historically almost always maintained a $1 share price. so they are very much like a bank, actually. and they are used frequently by institutional investors like

pension funds. so a pension fund with $30 million in cash probably wouldn't put that into a bank bee insured, there's a limit to how much deposit insurance co pensi instead of putting a cash in the bank is put the money in a money market fund which promise $1 for each dollar put in plus a little bit of interest on top and invest in very short term safely quid type d so it's a pretty good way to manage your cash if you're an institutional investors of some kind. so this investors putting their money into money market funds. now, as i said, money market shares are not insured. they do not have deposit insurance. but the investors who put their money into a money market fund expect that they can take their money out at any time, dollar for dollar. they treat it like a bank

account, basically. the money market funds in turn have to invest in something and they tend to invest in safe short term assets like commercial paper. commercial paper is a short term debt instrument issued typically by corporations. short term in that it's 90 days or less typically. a nonfinancial corporation may issue paper to allow it to manage its cash flow. it may need short term known meet payroll or cover inventories. ordering manufacturing companies like gm or caterpillar would issue commercial paper to issue cash to manage their daily operation. banks would issue commercial paper to get fund that they then can use to manage their liquidity positions and they can use, again, to make loans to the private economy. here's the pic

more completely. on the left you see the investor investing their excess cash in a money market fund. the money market fund buys commercial paper which is basically a funding source for both nonfinancial businesslike manufacturers and for financial companies who would lend it on to other borrowers. now what happened to this very nice arrangement. lehman brothers was created a huge shock wave as i'll describe. lehman brothers was an investment bank. it was a global financial services firm. it was not a bank. so it was not overseen by the fed. it was an investment company. it held lots of securities. it did business in security

markets. it couldn't take deposits not being a bank. instead it funded itself in short term funding markets including the commercial paper market. lehman invested heavily in mortgage securities and commercial real estate during the 2000s. as house prices fell, lehman's position got worse and they were losing money in real estate. lehman was becoming insolvent. it was losing money in all of its investments. and it was coming under a lot of pressure. indeed as lehman's creditors lost confidence they with drew fug refused to roll over lehman's paper and other business partners said we're not going to do business you because we're afraid you won't be here next week. lehman was increasingly losing money and increasingly finding

it unable to fund itself. they to find somebody put more capital into the firm. it was unable to do that. on september 15th it filed for bankruptcy. this was an enormous shock that affected the whole global financial system. now in particular, one of the many implications of the failure of lehman brothersas money market funds. there was one particular fairly large money market fund that held among its other a bys lehman. when lehman failed that commercial paper was either worthless or completely illliquid for a long time. this money market fund could no longer pay off its depositors at a $1 per share. it lost money. now, suppose you're an investor in a money market fund and you

know if you go there and ask for a dollar back you can get it but you also know they don't have enough money there to pay everybody off a dollar. what your going to do? same thing that a 19th-century bank depositor would do if they heard their bank lost money. investors in this fund and in other money market funds began to pull out their money just like a standard bank run. i'll show you the data on that in just a second b ut very intense bank run or in this case money market fund run in which investors in these funds began to pull out their money just as quick as they could. the fed and treasury respond very quickly to the situation. the treasury provide temporary guarantee which said we guarantee that you'll get your money back if you just don't pull it out right now. and the fed created a backstop liquidity program under which we lent money to banks who in turn used that money to buy some of

the assets of the money market funds. that gave the money market funds the liquidity they needed to pay off their depositors and helped to calm the panic. and just to show you a sense of what was happening here, this is the money outflows from the money market funds. this is a $2 trillion industry. this is daily data. so you see the lehman bankruptcy, couple days later you see the money market fund breaking the buck, unjablg to pay its investors a dollar a share. following that announcement you see that for about two days there about $100 billion a day was flowing out of these funds. within two days the treasury announced a guarantee program, the fed came in to support the liquidity of these funds and as you can see the run ended pretty quickly.

so absolutely classic, classic bank run, classic response, providing liquidity to help the institution being run provide the cash to its investors, providing the guarantees and that successfully ending the run. but that wasn't the end of the story. remember the money market funds were also holding commercial paper. and as they began to face runs, they in turn began to dump commercial paper as quickly as they could. and as a result, the commercial paper market went into shock. this is a nice example how financial crises can spread. we had lehman failing, that cau to experience a run which toledo a shock in the commercial paper. everything is connected to everything else, and it's really hard to try to keep the system stable.

so, there was, as the money market funds with drew from the commercial paper market there was a sharp increase in rates in the commercial paper market and lenders were unwilling to lend for more than one day to commercial paper borrowers which in turnhe ability of those companies to function and the ability of those financial institutions to fund themselves. once again the federal reserve responding in a way that badgett would have us respond, establish special programs, basically we stood as backstop lenders. we said make your loans to these companies and we'll be here ready to backstop you if there's a problem rolling over these funds. and that restored confidence in the commercial paper market. and there's the picture here. this is commercial paper rates. again, once again you can see

the panic phenomenon, a sharp, sharp increase in rates, which really understates this pressure because it doesn't also include the fact that for many companies there was no price they could get fund organize if they got funding it was only for overnight or very short term periods. the fed's actions restored confidence in that market and you can see the response, rates came back down in the beginning of 2009. one other type of activity which is the last thing i want to cover, so a lot of what i've been talking about is stuff you didn't hear too much about when you read the papers. working with these critical markets and work with these -- providing broad based liquidity to financial institutions to bring the panic under control. but we also, the fed and

treasury got involved in trying to address problems with some individual critical institutions. in march of 2008 as i mentioned before, a fed loan facilitated the takeover of bear stearns by jpmorgan chase avoiding a failure of that firm. the reason we undertook that action is that first at the time the financial market were quite stressed and we were fear lul that the collapse of bear stearns would greatly add to that stress and perhaps set off a full fledge financial panic. moreover it was our judgment at least that bear stearns was solvent at least jpmorgan thought so. they were willing to buy the firm and to guarantee its obligations. so that by lending to bear stearns we were consistent with the proposition that we should be making loans that are likely to be paid