The Federal Reserve Bank of New York has released a Staff Report by Asani Sarkar and Jeffrey Shrader titled Financial Amplification Mechanisms and the Federal Reserve’s Supply of Liquidity during the Crisis:
The small decline in the value of mortgage-related assets relative to the large total losses associated with the financial crisis suggests the presence of financial amplification mechanisms, which allow relatively small shocks to propagate through the financial system. We review the literature on financial amplification mechanisms and discuss the Federal Reserve’s interventions during different stages of the crisis in light of this literature. We interpret the Fed’s early-stage liquidity programs as working to dampen balance sheet amplifications arising from the positive feedback between financial constraints and asset prices. By comparison, the Fed’s later-stage crisis programs take into account adverse-selection amplifications that operate via increases in credit risk and the externality imposed by risky borrowers on safe ones. Finally, we provide new empirical evidence that increases in the Federal Reserve’s liquidity supply reduce interest rates during periods of high liquidity risk. Our analysis has implications for the impact on market prices of a potential withdrawal of liquidity supply by the Fed.
Of interest is the first sentence in the introduction:
One of the primary questions related to the recent financial crisis is how losses on subprime mortgage assets of roughly $500 billion led to rapid and deep drops in both the value of a wide range of other financial assets and, increasingly, real economic output.
Footnote: Acharya and Richardson (2009), Adrian and Shin (2009), Brunnermeier (2009), Gorton (2008) and Blanchard (2009), among others, describe the genesis of the crisis and provide explanations for how it was propagated
It is unfortunate that the authors do not provide more specific support for the $500-billion figure – this has been a topic of interest since the first figure of Greenlaw of $400-billion and much lower ultimate losses projected by the BoE and others.
There’s some discussion of interest to players in illiquid markets:
Brunnermeier and Pedersen (2009) examine the relationship between margin conditions and market illiquidity. In their model, customers with offsetting demand shocks arrive sequentially to the market. Speculators smooth the temporal order imbalance and thereby provide liquidity. They borrow using collateral from financiers who set margins (defined as the difference between the security’s price and its collateral value) to control their value-at-risk (VaR). Financiers can reset margins every period and so speculators face funding liquidity risk from the risk of higher margins or losses on existing positions. A margin spiral occurs as follows. Suppose markets are initially highly illiquid and margins are increasing in market illiquidity. There is no default risk in balance sheet models as loans are fully collaterized. A funding shock to the speculator lowers market liquidity and results in higher margins which causes speculators to delever, further tightening their funding constraints. Therefore, market liquidity falls even further.
The authors review the Fed’s programmes for liquidity provision and declare:
To understand the intent behind these programs, we examine amplification mechanisms based on asymmetric information between borrowers and lenders. In contrast to the balance sheet amplifiers, the focus here is on the role of credit risk and the distribution of credit risk across borrowers. The papers surveyed below find a role for central bank intervention when adverse selection problems lead to market breakdowns. However, they also raise concerns that public liquidity provision might crowd out private liquidity.
The authors conclude, in part:
We find that an increase in supply of funds by the Fed is associated with a reduction in interest rate spreads early in the crisis. During more recent periods, the Fed has been gradually withdrawing funds from some of its programs. We find that these actions have had no significant impact on interest rate spreads in the most recent period. Our results suggest that changes in the Fed’s liquidity supply might be asymmetrically related to change in the LIBOR-OIS spread: increases in supply tend to be associated with decreases in the spread but decreases in supply have a more variable relationship. These results indicate that the potential withdrawal of liquidity by the Fed is unlikely to have an adverse impact on market prices.