Question 1:
International Timeline clearly shows that banks around the world were failing throughout 2007 due to the mortgage-backed-securities they were holding. Nevertheless it is not until December of 2007 that our Federal Reserve Bank created the first special facility, the Term Auction Facility, to support bank liquidity (Appendix B - Facilities Created). Looking at Data Set-3, the first two tables showing Bank Reserves, a very clear picture emerges of bank distress in 2007 and 2008. Can you describe in a few sentences what is happening to liquidity preference in the banksby looking at the evolution of their reserve position? Consider these two points:
a. At what point do banks suddenly start borrowing money from the Fed? And what are they doing with the borrowed money? Is it sitting in their excess reserves, or are they using it to offset other assets that have devalued?
b. At what point do the non-borrowed excess reserves start to balloon?
You will probably need several sentences to state your observations but I am basically looking for the points in time when bank reserve data alert us to the impending crisis.
Question 2:
Facilities Created, you can see that Fed assistance to the banks gains momentum as time passes. At first the Fed accepts only prime mortgage backed securities in exchange for cash, but by the end of 2008 the Fed is accepting just about anything as collateral on bank borrowings from the Fed. We know that it was the toxic assets (the overvalued sub-prime mortgage assets) that were ruining the banks, and that the Fed wished to avoid creating a moral hazard by bailing out the banks for these poor choices, but do you think we could have avoided the plunge into a very deep recession if the Fed had been more realistic about the problem and absorbed the toxic assets first instead of last? In one or two sentences, state your opinion.
Question 3: On October 8, 2008 the Fed announced that it would begin paying interest on required and excess reserves. Are you able to explain in your own words why high excess reserves represent a significant opportunity cost for the bank when the economy is moving into a recession?
Question 4: As a matter of bank accounting, when the TARP fund was legislated in November 2008 it was intended to be an additional lending vehicle, but the Treasury Secretary restructured the fund so that it would be used to buy preferred stock in the banksinstead of loaning the money. (It was also used to buy preferred stocks in other companies such as General Motors).
How does this affect the balance sheet of the banks, when the money comes in as Equity instead of Borrowed Reserves?
Given that the crisis was caused by a crash in the value of assets, what is the practical difference between
(a) buying the toxic assets and replacing them with cash reserves
(b) loaning money to the banks and increasing their liabilities
(c) buying preferred stock in the banks and increasing their equities?