NEW YORK (MNI) – The following is the third of five sections of
the text of remarks of Simon Potter, executive vice president, New York
Federal Reserve Bank, prepared Monday for the Third Annual Connecticut
Bank and Trust Company Economic Outlook Breakfast:

Phase 3: Panic

The bankruptcy of Lehman Brothers on September 15, 2008,
precipitated a run on the global financial system of a previously
unimaginable scale. The Federal Reserve was immediately confronted with
a huge unanticipated call on its lender-of-last-resort power as a result
of a substantial liquidity problem at one of world’s largest insurance
companies, American International Group (AIG). The Federal Reserve’s
decision on September 16 to lend to AIG was a classic
lender-of-last-resort action of exactly the type envisaged by the
statutory power given in 13(3). However, given the speed of developments
that week, there has been considerable confusion and misperceptions over
the validity of the initial decision to lend to AIG.6

It was unknown on September 16 just how quickly the panic would
spread and how harmful it would be to the real economy. By the next
evening it was already obvious that the panic had spread to prime money
market mutual funds with devastating effects. These funds provided
short-term financing to numerous firms and institutions through the
commercial paper market. A myriad of other breakdowns were occurring as
trust vanished from the global financial system. Against this backdrop,
the request for the $700 billion Troubled Asset Relief Program (TARP)
appropriation was made the next day.

In the short time it took Congress to pass the TARP appropriation,
the panic continued to spread; on September 25, Washington Mutual, the
sixth largest depository institution, was resolved by the FDIC and just
days later Wachovia, the fourth largest bank holding company encountered
severe funding difficulties and was eventually taken over by Wells
Fargo. As with the need to place the two largest GSEs into
conservatorship, it became apparent that much of the supposed ample
capital in the U.S. financial system was not an effective bulwark
against insolvency or the perception of possible insolvency. The latter
possibility, whether true or not at its inception, can ultimately become
a self-fulfilling prophesy if it results in a run on the financial
system.

There are three broad forms of policy responses available to arrest
the self-fulfilling prophesy dynamic that can take hold during a run on
the financial system:

— Lender-of-last-resort actions to assist the economy in adjusting
to the severe funding strains produced by the run,

— Guarantees issued to reassure existing liability holders, and

— Capital injections to strengthen the actual, and therefore
perceived, solvency of financial institutions.

By early October 2008, it was apparent that a substantial
escalation on all three fronts was required to give the financial system
what was essentially a time-out in order to halt the self-fulfilling
prophesy dynamics. It is useful to consider the analogy of the time-outs
that parents give to their children when they are misbehaving. While the
analogy is not appropriate in terms of the punishment aspect of
time-outs for kids, there are a number of similar problems in
establishment of a robust time-out strategy.

First, how to define the boundaries associated with the time-out.
In the case of arresting a run on the financial system, who does and who
does not have access to the lender-of-last-resort, guarantees and
capital injections? Next, can the parent/government credibly announce
and then efficiently operate the time-out? Finally, as all parents are
acutely aware, how does one build an appropriate exit strategy from the
time-out?

In the second week of October there was no room for error on any of
these strategic dimensions but instead of one unruly child and a parent
playing out an enduring battle, a diverse set of policymakers were
confronting a wide range of financial institutions with no experience
with time-outs on either side.7 Further, full participation by
systemically important firms was crucial due to the inter-connectedness
of the financial system.

The solution for the efficient operation of the time-out was “on
the fly” to combine the power of the FDIC to provide guarantees to
liability holders of banks under the systemic risk exemption embedded in
FDIC Improvement Act with two other authorities. The first was the U.S.
Treasury’s new ability to provide capital from the new TARP funds, and
the second was the Federal Reserve’s authority in unusual and exigent
circumstances to flood the financial system with as much liquidity as it
needed. In the latter case the appropriate measure of the escalation is
not the actual amount of liquidity that was drawn from the Federal
Reserve but the commitment to supply whatever was needed.8

This commitment was captured succinctly in the minutes of the
October 2008 FOMC meeting:

“…the Committee agreed that it would take whatever steps were
necessary to support the recovery of the economy.”

Of course parents usually have the capacity to perform on a
time-out if the initial announcement directs the child in the
appropriate direction. In this case, the initial announcement had to
direct thousands of institutions in the appropriate direction on equal
terms, including a majority that had not been misbehaving in the run-up
to the crisis. In particular, stronger institutions might view their
agreement to use the guarantees and issue equity to the U.S. Treasury as
stigmatizing and make them more vulnerable to runs. The solution was to
obtain agreement from nine systemically important institutions to
participate at the start of the time-out on the same terms available to
thousands of other eligible financial institutions.

The time-out announced on October 14 was a critical success in
terms of stopping the run on the global financial system, but it could
not and did not address all the aspects of the crisis. The global
propagation of the financial shock had already triggered an economic
slowdown at least as abrupt as any during the Great Depression period.
The underlying question was now how strong the adverse feedback loop
would be between the rapidly deteriorating real economy and the
condition of the banking sector.

One clear lesson from this phase was the need for formal
coordination among the diverse authorities in the U.S. in establishing
and maintaining financial stability. Another lesson that emerged was
that some forms of regulatory and accounting capital were very weak
defenses against the fear of insolvency. Both lessons are informing the
ongoing work of regulatory reform and of enhancing the resiliency of the
financial system through stronger capital and liquidity requirements.

-more- (3 of 5)

** Market News International New York Newsroom: 212-660-6430 **

[TOPICS: M$$CR$.M$U$$$,MMUFE$,MGU$$$,MFU$$$,MK$$$$]