Over the past several years, the nation has experienced its most severe financial crisis since the Great Depression of the 1930s. In response, policymakers undertook a series of extraordinary actions to stabilize financial markets and institutions. The Federal Reserve System used its traditional policy tools to reduce short-term interest rates and increase the availability of funds to banks, and it created a variety of nontraditional credit programs to help restore liquidity and confidence to the financial sector. In doing so, it more than doubled the size of its asset portfolio to over $2 trillion and assumed more risk of losses than it normally takes on.
The financial system plays a vital role in the U.S. economy. It channels funds from savers to businesses, households, and governments that need money to finance
investments and other expenditures, and it provides
services that are essential for commercial and financial
transactions. When the financial system is functioning
smoothly, investors trade securities in liquid markets that
provide reliable signals about the values of assets, and
loans are readily available to creditworthy borrowers. As
the nation's central bank, the Federal Reserve System
plays an important role in maintaining the stability and
liquidity of the financial system through its conduct of
monetary policy and its authority as a supervisor and regulator of banking institutions.
Over the past several years, the nation has experienced its
most severe financial crisis since the Great Depression of
the 1930s. Unexpected losses on subprime mortgages
(loans made to borrowers with poorer-than-average
credit) as well as heightened uncertainty about how
exposed some financial institutions might be to additional losses led to a sharp decline in the liquidity of some
markets and the availability of credit. The contraction in
lending became more severe as the turmoil spread beyond
the subprime mortgage market, several large financial
institutions failed, and the economy weakened. Net lending by the private financial sector fell from more than
$3.0 trillion in 2007 to annual rates of about $1.4 trillion
in the fourth quarter of 2008 and -$1.8 trillion in the
first quarter of 2009.
In response to that contraction, the Federal Reserve
undertook a series of extraordinary actions to stabilize
financial markets and institutions. It continued to use its
traditional monetary policy tools, but in addition, it created a variety of targeted credit programs to help restore
liquidity and confidence to the financial sector. Its actions
included:
- Expanding lending to depository institutions-that is,
to financial institutions, such as commercial banks and savings and loan associations, whose liabilities largely consist of checking and savings accounts and other deposits;
- Creating new lending programs, or "facilities," for
nondepository financial institutions and other participants in the financial markets;
- Purchasing mortgage-related securities and medium and long-term securities of the U.S. Treasury in the open market to put downward pressure on medium and long-term interest rates in the mortgage and debt markets; and
- Extending support to financial institutions whose failures policymakers believed could lead to a systemic collapse of financial markets and institutions.
In effect, the Federal Reserve assumed some of the credit-
providing functions that participants in the financial markets were unable or unwilling to perform. In doing so, it also assumed significantly more risk of incurring
losses than it normally takes on in its operations.
The Federal Reserve's activities during the crisis have had
a striking impact on the amount and types of assets that it
holds (see Summary Figure 1). In July 2007, before the financial
crisis began, the Federal Reserve held about $900 billion
in assets; U.S. Treasury securities accounted for about
$790 billion of that amount. The central bank had
acquired those securities during its normal operations in
conducting monetary policy-the process of influencing
the level of short-term interest rates and consequently the
pace of U.S. economic activity. (Box 2 on page 6 outlines the basic mechanics of monetary policy.) By the end of
2008, the value of the Federal Reserve's assets had grown
to about $2,275 billion; of that amount, loans and other
support extended to financial institutions made up
$1,686 billion. At the end of 2009, when the turmoil in
the financial markets had subsided, the total value of the
central bank's assets remained essentially where it was at
the end of 2008. The amount of direct loans and other
support to financial institutions, though still quite high
by historical standards, had fallen markedly by the end of
2009, to about $280 billion, but holdings of mortgagerelated
securities had risen, to just over $1,000 billion.
The Federal Reserve's activities during the crisis have also led to a marked shift in the composition of the central
bank's liabilities (see Summary Figure 2). Before the crisis, the
major liability on the Federal Reserve's balance sheet was
the amount of currency (Federal Reserve notes) in circulation-
about $814 billion as of July 2007. At the end of
2009, the amount of reserves that banks held with the
Federal Reserve was the central bank's largest liability.
Such reserves have grown from about $6 billion at the
end of July 2007 to more than $1,022 billion at the end
of 2009; those reserves greatly exceed the amount that
banks are required to hold. In effect, the Federal Reserve
financed its activities during the crisis primarily by creating bank reserves rather than by issuing more currency or increasing its other liabilities.
The amount and composition of the central bank's assets and liabilities are major determinants of the Federal Reserve's impact on the federal budget. That impact is measured by the central bank's cash remittances to the Treasury, which are recorded as revenues in the budget. (The amount that is remitted is based on the Federal Reserve System's income from all of its various activities minus the costs of generating that income, dividend payments to banks that are members of the Federal Reserve System, and changes in the amount of the surplus that it holds on its books.) For fiscal years 2000 through 2008,annual remittances by the Federal Reserve ranged
between $19 billion and $34 billion.
The Congressional Budget Office (CBO) projects that the Federal Reserve's actions to stabilize the financial system will boost its remittances to the Treasury during the next several years. That increase reflects the Federal Reserve's larger portfolio of assets, most of which are likely to earn a great deal more than the amount the system must pay in interest on reserves and its other liabilities. CBO projects that remittances will grow from about $34 billion in fiscal year 2009 to more than $70 billion in fiscal years 2010 and 2011.
Projections of the Federal Reserve's remittances to the
Treasury over the next few years, however, are more
uncertain than projections made in the past. The system's
asset holdings are now riskier, exposing the central bank
to a considerably greater possibility of losses than its usual
holdings of Treasury securities do. Moreover, the risk of
losses from default associated with the amounts of the
remittances is asymmetric. The chances are great that the
Federal Reserve will remit slightly more than the amounts
CBO expects. But there is also a small chance that it will
remit much less-or even nothing-if serious problems
reemerge in the financial markets or the economy greatly
weakens again.
Measuring the impact of the Federal Reserve System's
actions by the magnitude of its cash remittances to the
Treasury fails to account for the cost of the risks to taxpayers from those actions. When the Federal Reserve
invests in a risky security, it increases its expected net
earnings because the return it anticipates on that security
exceeds the interest rate it pays on the debt used to fund
the purchase. If the Federal Reserve purchases the security
at a fair market price, equivalent to what private investors
would have paid, then the purchase creates no economic
gain or loss for taxpayers; the price compensates the central bank for the risk it has assumed. By contrast, if the
Federal Reserve purchases a risky security for more than
the amount that private investors would have paid, it
gives a subsidy to the seller of the security, creating an
economic loss, or cost, for taxpayers.
The economic cost of the Federal Reserve System's
actions to stabilize the financial markets-which incorporates the risks to taxpayers-can be estimated using "fair-value" subsidies. Fair value in many instances corresponds to market value; it is defined as the price that would be received by selling an asset in an orderly transaction between market participants on a designated measurement date. Subsidies estimated on a fair-value basis provide a more comprehensive measure of cost than do estimates made on a cash basis: They take into account the discounted value of all future cash flows associated with a credit obligation, and they include the cost of bearing risk. CBO and the Administration's Office of Management and Budget (OMB) use a conceptually similar subsidy measure, as specified by the Emergency Economic Stabilization Act of 2008, to estimate the budgetary cost of the Troubled Asset Relief Program, or TARP. (CBO calls such subsidies "fair value" in part to distinguish them from subsidies calculated through the method specified by the Federal Credit Reform Act of 1990 and used by CBO and OMB to estimate the budgetary cost of federal credit programs.)
In CBO's estimation, the fair-value subsidies conferred by
the Federal Reserve System's actions to stabilize the financial markets totaled about $21 billion (see Summary
Table 1 for details). The subsidies are estimated as of the
date of inception of the main programs that the central
bank put in place-when the major economic commitments
occurred-and they incorporate CBO's projections
of all future cash flows over the life of those facilities,
the uncertainty surrounding the flows, and the expected rate of return that investors would have required
for taking on the same obligations. The gains or losses
that will ultimately be realized from the Federal Reserve's
activities will almost certainly deviate from CBO's estimates
of the fair-value subsidies those actions provided.
Such forward-looking estimates are based on averages
over many possible future outcomes, whereas realized
gains or losses reflect a particular outcome.
In total, the fair-value subsidies that CBO has estimated
are modest when compared, for instance, with CBO's
estimate of the $189 billion subsidy provided by the
TARP at its inception-even though most of the central
bank's facilities were introduced near the height of the
crisis, when the price of risk was substantial and the probability of default was elevated. The subsidies' relatively
small magnitude reflects the fact that the Federal
Reserve's potential for losses was limited in most instances
by requirements for borrowers to provide collateral, by
guarantees from the Treasury under the TARP and from
the Federal Deposit Insurance Corporation, or by various
restrictions on the programs. Furthermore, some of the
assistance that the Federal Reserve provided involved no
subsidies because the transactions were conducted on a
fair-value basis or at prices determined in competitive
auctions-meaning that the central bank was fully compensated
for the risks it assumed.
CBO's estimates of the economic subsidies that the Federal
Reserve has provided are highly uncertain. The estimates
necessarily rely on judgments about the probability
that the crisis would have deepened or abated, about the
sums that might be borrowed and their associated interest
rates at such times, and about the severity of losses.
Uncertainty also surrounds the discount rates used in
CBO's calculations, but that effect is mitigated by the
short time over which most of the facilities were scheduled
to operate. Indeed, most programs have already been
ended.
It bears emphasizing that CBO's fair-value estimates
address the costs but not the benefits of the Federal
Reserve's actions. In CBO's judgment, if the Federal
Reserve had not strategically provided credit and
enhanced liquidity, the financial crisis probably would
have been deeper and more protracted and the damages
to the rest of the economy more severe. Measuring the
benefits of the Federal Reserve's interventions in avoiding
those worse outcomes is much more difficult than estimating
the subsidy costs of the interventions, and CBO
has not attempted to do so. It is likely, though, that the
benefits of the Federal Reserve’s actions to stabilize the
financial system exceeded the relatively small costs
reported here for fair-value subsidies.
