Federal Reserve and US Monetary Policy - Case Study Example

Federal Reserve and U.S. Monetary Policy al Affiliation Top of Form Bottom of Form Money can be referred as anything thatperforms the functions of money. One of the functions of money is that it acts as a medium of exchange that is used in the buying and selling of goods and services (Jiménez, Peydró & Saurina, 2014). Second is that it is a unit of account in that money is used as a yard stick to measure the relative worth of wide variety of goods and services and more so resources. Third important function of money is that it acts as store of value as this can be used to transfer purchasing power from the present to the future. Money plays a critical role in the monetary system of the economy. It worth noting that, when monetary system is working properly it provides the livelihood of circular flow of income and expenditure in the country which in turn helps the economy achieve both full employment and use of resources. However, a malfunctioning monetary system distorts allocation of resources creating severe fluctuation in the economy’s levels of output, employment and prices. Money is defined in terms of M1 and M2 in which the first is the narrowest U.S money supply which is usually in two components the currency i.e. paper and coins money in the hands of the public and all checkable deposits i.e. all deposits in the commercial banks and thrift while later is used to define broader definition of money that is inclusive of M1 and several near monies. Several near monies is a term used to describe a given liquid financial assets that do not function directly as a medium of exchange by is readily changeable into currency (Jiménez, Peydró & Saurina, 2014). It is also important to note that Federal Reserve controls the lending activities of nation’s banks hence money supply control. The reason behind this topic is the urge to know the role played by the Federal Reserve and more so other financial institutions to combat the financial depression/crisis of 2007-2008. Through this analysis I will be able to appreciate their contribution and more so have the knowhow on the techniques applied to end this crisis. According to Dawn Kopecki (2014), on the announcement of the fourth-quarter gains (January 14, 2014), as per the financial year, JPMorgan Chase (JPM), which was the most profitable U.S. bank as per the initial bank review, was overtaken by Wells Fargo (WFC) which recorded its personal best. WFC incurred profits of $5.6 billion whilst JPM had $5.3 billion. However, JPM made profits amounting to $17.9 billion at the end of the financial year 2013. Although JPM spent more on its legal settlements up to $23 billion, the gains for the year 2013 were deemed productive and worthwhile. Even though profits were realized in the two companies, they were not that solid. This followed after a further review of the latter. It was noticed that up to 31% of JPM’s profits of the financial year 2013 averaging $5.6 billion and 10% of WFC’s profits gained the same year amounting to $2.2 billion were not realistically earned. That money accrued came from the two bank’s loan-loss reserves. It was noted that despite bank earnings poor performance, investors notably still embraced them. This was concluded by a bank analyst by the name Paul Miller who works at FBR capital markets (FBRC). However, not all investors have the same thoughts on this. Considering the accounting standards set for American banks - the banks are urged to release the loan-loss reserves given the loan is performing well - what results is that no meaningful profits are realized. Widespread usage of loan-loss reserves is not advised in the banks. Jamie Dimon, Chief Executive Officer (CEO) of JPM, admitted all the occurrences above to be ‘okay.’ Notably, BOA dropped its profits accrued by 44.6% over a period of 12 months whereas JPMorgan, Citigroup and also Wells Fargo gained in their realized profits with their percentages being 25%, 27.5% and 31.3% respectively According to (Jiménez, Peydró & Saurina, 2014) in the year 2007 U.S and also the global financial market were faced by potential financial crisis and more so Federal Reserve found itself in a fixed situation. It was becoming clear that banks and other financial institutions would make big losses from the exposure to the mortgage market loans. Due to the fact that banks capital worth is closely tied to banks lending, the bank regulatory board requires that loans does not exceed certain multiple of capital. During the deep recession of 2007, Federal Reserve a danger of a sharp contraction in bank lending and credit. When this happens the central bank assures that financial institutions have the funds that they need to conduct their daily business i.e. the liquidity to make time to time payment and transfers. From the research it is evident that for example in United States alone literally trillions of dollars are transferred between banks each day to support the $50 trillion credit outstanding in the economy as a whole in accordance to (Thomas, & Robert, 2009). In this regard it is evident that banks and other financial institution need funds to instigate mortgages, auto loans, and credit cards debt they then sell into financial markets, while venture bank finance much of their activity with daily borrowing. In the early stages of the crisis, well capitalized banks were forced to make very large loans at ago based on the previous committed lines of credit. At such a situation the central banks ease access large amount of liquidity constraints by giving the banks a lot of funds as per their requirement in the short run. For example in the fall of 2007 the Federal Reserve gave short term funding liquidity by providing and allowing banks to swap over their holding of Treasury securities for cash. Through this the banks were able to meet their credit line outstanding (Woolley, 1984). In October, 2007 the traditional central banks tools of control of the monetary supply was limited use. The Federal Reserve therefore came up with new procedures of lending in form of Term Action facility and Primary Dealer Credit Facility through their innovation and more so changed their securities lending program coming up with the Term Securities Lending Facility. According to (Thomas, & Robert, 2009) in the financial perspective it is evident that all the actions conducted by all the monetary policy makers have an effect on the quantity of funds available in the financial system as it manipulates the assets and liabilities held by the central bank and therefore affecting the price of the funds through the interest rates. An example of a balance sheet, whose source is the article report of the Federal Reserve report of July, 2007 is shown below. This shows the balance sheet prior onset of the crisis. From table 1, it is evident that the liabilities side, the amount of currency in circulation is about $2,600 per U.S resident. This seems to be very high irrespective of underground economy and amounts of currency held by retailers. From this therefore currency plays no role in the episode at hand. In this regard it, this shows that commercial bank reserve banks are highly affected and that it had no reserves. It is worth to note that commercial banks do hold reserves in relation to the Federal Reserve for some given reason. In accordance to (Thomas, & Robert, 2009) first is that it is mandated to do so, second is that they need them do business co as to be able meet the customers’ demands in terms of payment and withdrawals and lastly is the fact it is prudent to do so due to reason that reserves acts as emergency funds to the bank which it can easily access in case of any disaster. From the table it is evident that reserves were $16.8 billion. This was very little in relation to level held by the European banks national central banks of the Euro-system. Often U.S banks do keep their reserves at very low due to fact that they do not receive any interest on the reserve they make while on the other hand the European banks are paid something close to overnight interbank transfers. On the assets sides, Federal Reserve hold securities both total and as part of repurchase agreement. The U.S Treasury bills, notes and bonds makes up the securities held by the Federal Reserve’s. From the article it is evident that before the crisis these holding comprised of about 90% of Feds assets (VIVIANA, March 01, 2006). However, in 2007 repos was $30.3 billion of the total Fed assets. To control all these Federal Reserve uses only two principles which are the policy maker size control by use of open market operations. Second is through control of its assets composition in its balance sheet depending on the number of assets it wishes to hold. After the Federal Reserve had taken a lot of action it was evident that there were changes in lending policy that had been put in place and therefore banks were unwilling to borrow from the Fed. However, interbank lending continued. In 2007 the LIBOR rose highly within three month. As a result the Fed had to find other alternatives mechanisms to inject funds into banking system. According to (VIVIANA, March 01, 2006) in March 16 in 2007there was an announcement on creation of Primary Dealer Credit Facility (PDCF); that led to approval of $30 billion loan to JPMorgan Chase for the reason of purchasing Bear Stearns, during this time there was a cut in primary lending rate from 50 to 25 basis points above the federal funds rate target and more so an increase in the term of discount lending from a maximum of 30 days to a maximum of 90 days. This was a very good and had a lot of impact to the investment and more so to the investors. It is through this time that Fed announced the approval of loan to Bear Sterns through JPMorgan Chase. In March 2008, The Bear Stearns Companies was among the major securities companies in the United State with an approximate of $400 billion consolidated assets. The company had diversified into a wide portfolio that included banking, securities and derivatives trading and clearing, brokerage services and provisions of mortgage loans (VIVIANA, March 01, 2006) However, despite its diversification the company went down in the mid-2008 which later made it notify the Fed of its situation and that it required some funding so as to be able to meet its financial obligations it would just have its borrowing from private sector sources. The situation of this company would affect the economy as it had a lot of diversifications in the economy markets. To address the immediate need of Bear Stearns a bridge loan had to be made to avoid the stressing of the economy credit market. On Friday, March 14, 2008, the Federal Reserve Board gave an order the Federal Reserve Bank of New York (FRBNY) to expand credit to Bear Stearns through JPMorgan Chase Bank (VIVIANA, March 01, 2006) The reason behind this bridge loan was to make sure that Bear Stearns would meet up its responsibility as they came due that day, permitting for time during the weekend for Bear Stearns to investigate options with other financial institutions that had capacity to enable it avoid bankruptcy and for policymakers to keep on to seek ways to contain the risk to financial markets in the incident that no private-sector solution proved possible. The loan that Bear Stearns needed was of $12.9 billion whose security was its assets that amounted to $13.8 billion. After the JPMC bank provided the loan it was repaid in full by FRBNY on the following Monday with an interest that amounted to around $4 million. In this regard the loan was given under the authority of Section 13(3) of the Federal Reserve Act that gave permission to the board to extend credits and loans individuals, partnership and corporation to grant loans to different companies at unusual and demanding situations. Despite being given support fund by the Federal Reserve through a bridge loan on March 14, 2008, market pressures on Bear Stearns worsened that day and during the weekend. Bear Stearns likely would have been unable to keep away from bankruptcy on Monday, March 17, without either very huge injections of liquidity from the Federal Reserve or an acquisition by a stronger firm. JPMorgan Chase and Co. (JPMC) came out as the only viable bidder for Bear Stearns, and on Sunday, March 16, Bear Stearns accepted an offer to merge with JPMC (Thomas, & Robert, 2009) However, JPMC was anxious about its ability to absorb a portion of Bear Stern’s mortgage trading portfolio, given the uncertainty about the scale of possible losses facing the financial system at the time and stressed credit markets. Therefore, to enable the JPMC to facilitate acquisition Maiden LLC, a limited company was formed. This enabled the company to acquire the assets of the Bears Stearns. During this time FRBNY extended credit to the LLC, which would intern manage the assets through all time to maximize the repayment of the credit that was given to Maiden LLC so as to be able to purchase the company’s assets of which it enabled purchase assets worth $30 billion from Bear Stearns with a lone that was about $29 billion (Thomas, & Robert, 2009). At the same time JPMC gave a loan worth $1 billion to Maiden lane so as to subordinate or boost the loan from the FRBNY. Unlike standard discount lending, where the Fed has alternative to go after the entire borrowing bank’s assets if the considered collateral is not enough to cover the loan, here there is no remedy. This means that if the value of the assets placed in this new company becomes less than $29 billion, the Federal Reserve would undergo a loss. But the credit risk associated with this unusual loan clearly belongs to the U.S. Treasury. According to (Thomas, & Robert, 2009) in March 17, 2008, letter from Secretary of the Treasury Henry Paulson to Geithner reads, in part, “that if any loss arises out of the special facility . . . the loss will be treated by the FRBNY as an expense that may reduce the net earnings transferred by the FRBNY to the Treasury general fund.” The standard practice is that Federal Reserve System revenue that contains interest on its securities assortment, net of operating expense could be turned over to the U.S. Treasury. Thus, any losses produced from the credit facility created to support the J.P. Morgan Chase purchase of Bear Stearns will decrease the amount of that transfer rather than the level of the Fed’s capital. The financial assistance implied in the loan to Bear Stearns is clearly a fiscal, not a monetary, operation. The Federal Reserve is effectively standing as the fiscal manager for the Treasury (Brezina, 2012). As an aside, note that proceedings in which the fiscal authority dictates how the central bank holds its assets can run the threat of compromising central bank independence if they become a regular occurrence. References Brezina, C. (2012). Understanding the Federal Reserve and monetary policy. New York: Rosen Pub. Dawn Kopecki (2014). Banks: The Accounting Wizardry behind Banks’ Strong Earnings. Retrieved April 1, 2014, from http://www.businessweek.com/articles/2014-01-14/jpmorgan-wells-fargo-earnings-boosted-by-accounting-maneuver Jiménez, G., Ongena, S., Peydró, J.-L., & Saurina, J. (March 01, 2014). Hazardous Times for Monetary Policy: What Do Twenty-Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk-Taking? Econometrica, 82, 2, 463-505. Thomas, F., & Robert, J. (June 06, 2009). Too Big to Bail: The " Paulson Put, " Presidential Politics, and the Global Financial Meltdown. International Journal of Political Economy, 38, 1, 3-34. VIVIANA, F. E. R. N. A. N. D. E. Z. (March 01, 2006). Emerging Derivatives Markets: The Case of Chile. Emerging Markets Finance and Trade, 42, 2, 63-92. Woolley, J. T. (1984). Monetary politics: The Federal Reserve and the politics of monetary policy. Cambridge [Cambridgeshire: Cambridge University Press. Read More