76

CHAPTER 4

Federal Reserve System

 

W H E R E W E H AV E B E E N . . . In Chapter 3 we discussed the types and roles of fi nancial institutions that have evolved in

the United States to meet the needs of individuals and businesses and help the fi nancial sys-

tem operate effi ciently. We also described the traditional diff erences between commercial

banking and investment banking, followed by coverage of the functions of banks (all depos-

itory institutions) and the banking system. By now you also should have an understanding of

the structure and chartering of commercial banks, the availability of branch banking, and the

use of bank holding companies. You also should now have a basic understanding of the bank

balance sheet and how the bank management process is carried out in terms of liquidity and

capital management. Selected information also was provided on international banking and

several foreign banking systems.

W H E R E W E A R E G O I N G . . . The last two chapters in Part 1 address the role of policy makers in the fi nancial system and

how international trade and fi nance infl uence the U.S. fi nancial system. In Chapter 5 you will

have the opportunity to review economic objectives that direct policy-making activities. We

Copyright © 2017 John Wiley & Sons, Inc.

4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession 77

then briefl y review fi scal policy and how it is administered through taxation and expenditure

plans. This is followed by a discussion of the policy instruments employed by the U.S.

Treasury and how the Treasury carries out its debt management activities. You will then see

how the money supply is changed by the banking system, as well as develop an understand-

ing of the factors that aff ect bank reserves. The monetary base and the money multiplier also

will be described and discussed. Chapter 6 focuses on how currency exchange rates are

determined and how international trade is fi nanced.

H O W T H I S C H A P T E R A P P L I E S TO M E . . .

Actions taken by the Fed impact your ability to borrow money and the cost of, or interest

rate on, that money. When the Fed is taking an easy monetary stance, money becomes

more easily available, which in turn leads to a lower cost. Such an action, in turn, will

likely result in lower interest rates on your credit card, your new automobile loan, and

possibly your interest rate on a new mortgage loan. Actions by the Fed also infl uence eco-

nomic activity and the type and kind of job opportunities that may be available to you. For

example, a tightening of monetary policy in an eff ort to control infl ation may lead to an

economic slowdown.

While many individuals know that the Federal Reserve System is the central bank of the

United States, what the Fed does and how it operates are less clear. Stephen H. Axilrod

comments,

There must be almost as many images of the Fed as an institution and of the wellsprings of its actions as there are viewers. Mine, born of a particular experience, is a generally benign one. It is of an unbiased, honest, straightforward institution that quite seriously and carefully carries out its congressionally given mandates. . . . It is of course through the window of monetary policy that the public chiefl y sees and judges the Fed.1

This chapter focuses on understanding the structure and functions of the Fed. Chapter 5 describes

how the Fed administers monetary policy in cooperation with fi scal policy and Treasury

operations to carry out the nation’s economic objectives.

4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession CRISIS As previously noted, the 2007–2008 fi nancial crisis and the 2008–2009 Great Reces-

sion combined to create a “perfect fi nancial storm.” Many government offi cials, politicians,

fi nancial institution executives, and business professionals felt during the midst of the

fi nancial storm that both the U.S. and world fi nancial systems were on the verge of collapse

in 2008. The Federal Reserve System (Fed), the central bank of the United States, is responsible for setting monetary policy and regulating the banking system. Direct actions

and involvement by the Fed were critical in government and related institutional eff orts to

avoid fi nancial collapse.

The federal government has historically played an active role in encouraging home own-

ership by supporting liquid markets for home mortgages. If banks and other lenders originate

home mortgages and then “hold” the mortgages, new mortgage funds are not readily available.

However, when banks and other lenders are able to sell their mortgages in a secondary mortgage

market to other investors, the proceeds from the sales can be used to make new mortgage loans. In

Federal Reserve System (Fed) U.S. central bank that sets monetary

policy and regulates banking

system

1Stephen H. Axilrod, Inside the Fed, (Cambridge: The MIT Press, 2009), p. 159.

Copyright © 2017 John Wiley & Sons, Inc.

78 CHAPTER 4 Federal Reserve System

1938, the president and Congress created the Federal National Mortgage Association (Fannie Mae) to support the fi nancial markets by purchasing home mortgages from banks and, thus, freeing-up funds that could be lent to other borrowers. Fannie Mae was converted to a government-

sponsored enterprise (GSE), or “privatized,” in 1968 by making it a public, investor-owned com-

pany. The Government National Mortgage Association (Ginnie Mae) was created in 1968 as a government-owned corporation. Ginnie Mae issues its own debt securities to obtain funds that

are invested in mortgages made to low to moderate income home purchasers. The Federal Home Loan Mortgage Corporation (Freddie Mac) was formed in 1970, also as a government-owned corporation to aid the mortgage markets by purchasing and holding mortgage loans. In 1989,

Freddie Mac also became a GSE when it became a public, investor-owned company.

Ginnie Mae and Fannie Mae issue mortgage-backed securities to fund their mortgage

purchases and holdings. Ginnie Mae purchases Federal Housing Administration (FHA)

and Department of Veterans Aff airs (VA) federally insured mortgages, packages them into

mortgage-backed securities that are sold to investors. Ginnie Mae guarantees the payment

of interest and principal on the mortgages held in the pool. Fannie Mae purchases individual

mortgages or mortgage pools from fi nancial institutions and packages or repackages them into

mortgage-backed securities as ways to aid development of the secondary mortgage markets.

Freddie Mac purchases and holds mortgage loans.

As housing prices continued to increase, these mortgage-support activities by Ginnie

Mae, Fannie Mae, and Freddie Mac aided the government’s goal of increased home own-

ership. However, after the housing price bubble burst in mid-2006 and housing-related jobs

declined sharply, mortgage borrowers found it more diffi cult to meet interest and principal

payments, causing the values of mortgage-backed securities to decline sharply. To make the

housing-related developments worse, Fannie Mae and Freddie Mac held large amounts of low

quality, subprime mortgages that had higher likelihoods of loan defaults. As default rates on

these mortgage loans increased, both Fannie and Freddie suff ered cash and liquidity crises.

To avoid a meltdown, the Federal Reserve provided rescue funds in July 2008, and the U.S.

government assumed control of both fi rms in September 2008.

The Federal Reserve, sometimes with the aid of the U.S. Treasury, helped a number of

fi nancial institutions on the verge of failing, due to the collapse in value of mortgage-backed

securities, to merge with other fi rms. Examples included the Fed’s eff orts in aiding the March

2008 acquisition of Bear Stearns by the JPMorgan Chase bank and the sale of Merrill Lynch

to Bank of America during the latter part of 2008. However, Lehman Brothers, a major invest-

ment bank, was allowed to fail in September 2008. Shortly after the Lehman bankruptcy and

the Merrill sale, American International Group (AIG), the largest insurance fi rm in the United

States, was “bailed out” by the Federal Reserve with the U.S. government receiving an own-

ership interest in the company. Like Merrill, Fannie, and Freddie, AIG was considered “too

large to fail,” due to the potential impact of this on the global fi nancial markets.

In addition to direct intervention, the Fed also engaged in quantitative easing actions to

help avoid a fi nancial system collapse in 2008, and to stimulate economic growth after the

2008–09 recession. We will discuss the Fed’s quantitative easing actions later in the chapter.

DISCUSSION QUESTION 1 Do you support the Fed’s decision to bail out selected fi nancial institutions that were suff ering fi nancial distress in 2008?

4.2 The U.S. Banking System Prior to the Fed In Chapter 1, when we discussed the characteristics of an eff ective fi nancial system, we

said that one basic requirement was a monetary system that effi ciently carried out the fi n-

ancial functions of creating and transferring money. While we have an effi cient monetary

system today, this was not always the case. To understand the importance of the Federal

Reserve System, it is useful to review briefl y the weaknesses of the banking system that gave

rise to the establishment of the Fed. The National Banking Acts passed in 1863 and 1864

provided for a national banking system. Banks could receive national charters, capital and

reserve requirements on deposits and banknotes were established, and banknotes could be

Federal National Mortgage Association (Fannie Mae) created to support the fi nancial markets by

purchasing home mortgages from