In the second week of August, the short-term fixed-income sales team at JPMorgan Securities Inc. sat stunned as the trillion-dollar market for asset-backed commercial paper began to collapse.
In normal markets, JPMorgan sells $25 billion of short-term IOUs for clients daily. ``Within the span of six or seven business days, every single investor stopped buying asset-backed commercial paper tied to structured investment vehicles,'' said John Kodweis, a managing director at the New York bank.
How the Federal Reserve has responded to that credit debacle -- the worst since the savings and loan crisis of the early 1990s -- defines Chairman Ben S. Bernanke's reshaping of the world's most important central bank.
With its focus on building consensus around long-term goals and attempts to separate liquidity from broader monetary policy, Bernanke's approach evokes appreciation among some economists. He's also caused frustration among traders trying to discern his intentions.
``The chairman walked into a job that I can best describe as trial by fire,'' said Allen Sinai, president of New York- based Decision Economics Inc. Separating interest-rate policy from liquidity tools was ``absolutely brilliant,'' he said.
To critics, his failure to quickly recognize the economic impact of the market tumult exacerbated the slowdown and meant that when the Fed began cutting rates, reductions needed to be deeper and faster.
``It's hard to be democratic in a crisis when leadership and image are so key,'' said Karl Haeling, head of strategic debt distribution in New York at Landesbank Baden-Wuerttemberg, Germany's fourth-largest bank. ``The Fed seemed awfully smug until August that this subprime issue was not a big issue. Then, they had to come out with both barrels blasting.''
The 54-year-old Fed chairman is giving his semi-annual testimony to the House Financial Services Committee today. He pledged to act in a ``timely'' manner to help revive the economy. Inflation risks are greater than a month ago, he said.
In August, Bernanke defied traders' predictions of an immediate cut in the federal funds rate, which affects borrowing costs for consumers and businesses. Instead, as credit dried up, he responded with a $35 billion cash injection into banks Aug. 10. Seven days later, he lowered the cost for banks to borrow directly from the Fed.
Inflation Still Emphasized
Officials waited a month before lowering the federal funds rate. Even then, they said ``inflation risks remain,'' leading some on Wall Street to complain Bernanke was out of touch.
``They stepped on their message in the first five months,'' said Vincent Reinhart, former director of the Fed's Division of Monetary Affairs. ``They weren't willing to emphasize why, or how they arrived at that inflation risk.''
Meanwhile, the economy continued to weaken.
As mortgage delinquencies rose to a 20-year high in the third quarter, Fed officials cut the federal funds rate just a quarter-point in October and said they thought inflation risks ``roughly balance'' risks to growth. Coming after a half-point cut the previous month, the October action was seen by economists including Stephen Stanley as a signal that policy makers thought they had eased credit enough to sustain the economic expansion.
``It really kind of scares me that the Fed had no idea things were going to get worse,'' said Stanley, chief economist at RBS Greenwich Capital Markets Inc., and a former member of the Richmond Fed staff. ``They were totally blindsided by the deterioration in liquidity conditions after the October meeting.''
By December, investors were expecting some promise of year- end liquidity following the Federal Open Market Committee's meeting on Dec. 11. They didn't get one. Instead, policy makers again cut the benchmark rate a quarter point and maintained their view that ``some inflation risks remain.''
Investors showed their disappointment, driving the Dow Jones Industrial Average down 2.1 percent. Markets were setting up for a panic.
The Fed again surprised Wall Street the following morning, announcing that the central bank would loan as much as $40 billion for 28 days through a facility that would let banks borrow directly from the Fed.
The Fed also arranged swap lines with the European Central Bank and the Swiss National Bank, allowing them to channel dollars into their markets.
`Credit for Trying'
The Fed's response to the credit squeeze ``wasn't handled with the aplomb you would have liked,'' said E. Craig Coats Jr., co-head of fixed income at Keefe Bruyette & Woods Inc. in New York. Still, ``it was actually pretty creative, and I give them credit for trying.''
Only after Fed officials saw the potential for higher unemployment and indicators such as retail sales declining did they have confidence that inflation risks were subsiding. They then cut the benchmark rate 1.25 percentage points in nine days in January, the fastest reduction in two decades.
Bernanke's goal of keeping policy trained on a medium-term forecast while flooding the banking system with short-term cash shows how the chairman has adopted some of the discipline of inflation-targeting central banks in the United Kingdom and Sweden.
``Good central banking is not a matter of magic touch,'' said Doug Elmendorf, a senior fellow at the Brookings Institution in Washington, and a former Fed staff economist under both Bernanke and former chairman Alan Greenspan. ``It is a matter of doing something systematically right.''
The Bernanke system also includes changes in governance and communication. Bernanke persuaded fellow members of the Federal Open Market Committee to publish their projections four times a year instead of two, and stretch out to a third year. The exercise transformed the undefined preferences of Greenspan into numeric priorities of an institution.
Last to Vote
Bernanke votes last in policy meetings, unlike Greenspan who argued his policy choice first. Bernanke calls it ``depersonalization.''
``It is commendable that they are implementing these changes in the midst of the most challenging environment for central banks in decades,'' said Angel Ubide, director of global economics in Washington at Tudor Investment Corp., a hedge fund.
Bernanke's scholarly work on the Great Depression also came into play as he retooled the Fed's function as lender of last resort to grapple with what NYU economist Nouriel Roubini calls ``the first crisis of financial globalization and securitization.''
Instead of bank depositors fleeing banks, as in the Depression, it was commercial paper investors who wanted safety. These investors were running from off-balance-sheet structured investment vehicles, which have some features of banks with none of the backstops.
`Frightening at Times'
Kodweis recalled how the normal din of ringing phones fell quiet inside JPMorgan's mid-town Manhattan trading room as credit markets dried up in early August. ``It was frightening at times,'' he said. ``It took longer to sell commercial paper, it was later in the day when we were done, and maturities were increasingly shorter.''
The rush by money market funds to securities not tied to mortgages or consumers created new problems for the Fed.
On Aug. 20, the three-month Treasury bill yield declined 0.66 percentage point in one day to 3.09 percent, the biggest fall in two decades, in a stampede to safety.
On Aug. 21, Bernanke, who had been holding twice-daily conference calls with the New York Fed, reached for another tool. The New York bank halved the fee for dealers borrowing securities from the central bank's portfolio.
By November, Fed officials faced a new challenge. ``Banks wouldn't lend to each other,'' said Haeling. ``There was enough liquidity in the system. The trouble was it wasn't getting to the right places.''
The price of three-month interbank dollar loans in London rose to an average 60 basis points over the federal funds rate in November, from 10 basis points in January to July.
By mid-February, the Fed had auctioned $130 billion in term reserves. The Libor to federal funds rate spread fell back.
Now, Fed officials have said they are considering making the facility permanent.
``He did creative intelligent things about the banking problem. He recognized that a central bank has two concerns -- the financial problem and the macroeconomic problem,'' said Allan Meltzer, a Fed historian and Carnegie Mellon University economist. ``He acted appropriately.'' (c) bloomberg