Federal Reserve and Great Recession
Name:
Institutional Affiliation:
Subprime mortgages and derivatives:
Studies and research have revealed that the hedge funds, banking institutions resulted in the subprime mortgage during the great recession. Well, hedge funds and financial institutions formed mortgage-backed securities; the insurance firms offset them with credit default swaps. The rise in demand for the mortgages resulted in an asset bubble within the housing sector. When the Fed increased the federal funds’ percentage, it brought about adjustable mortgage interest rates increasing. The outcome was that the home prices plunged, the most borrower failed to clear their loans. In essence, the derivatives tend to spread the risk in nearly all aspects of the economy. This led to the famous 2007/08 financial crisis as well as the Great Recession. Hedge funds are often under intense pressure to relevant in the market. They established demand for mortgage-backed securities through conjoining them with the so-called credit default swaps. There is nothing wrong with such a move up to when the Fed began increasing interest percentages. The ones with an adjustable-rate mortgage were not better positioned to account for the higher interest rates. The public demand decreased, and so the prices of houses. For instance, the American International Group was nearly bankrupt for attempting to offset the insurance. The subprime mortgages crisis resulted in deregulation: in 1999, the financial institutions enabled to function like hedge funds. They heavily invested in depositors monies, which was outside the hedge funds framework. This is what led to the Saving and Loan challenges of 1989.
Corrective measures by the Federal Reserve to mitigate the crisis
Initially, the payments to the financial institution on the reserve holdings were relatively fair given that the FedFed followed a low-interest rate regulation and the reserve hold by the financial institution was generally fewer. Beginning late 2008, the FedFed established the floor to the federal funds rate at 0, and the appropriate funds rate remained only a lesser basis point above this floor up to 2015 when the Federal started to increase the percentages (Roe, 2020). As indicated in figure I below, showing the lower limit to the federal funds’ percentage formulated but the FedFed at their time, whereas the dashed line shows the appropriate fed funds just a little above the floor by the Fed.
As evident in figure I, the monthly mean of the effective fed funds rate did not rise above 26 basis points at the crisis. As the Fed created the Treasury and mortgages-backed securities, it paid off directly through crediting the various accounts of the businesses at the FedFed, which include the banking institutions. Such credits accounted for reserve assets for the banking institutions. Thus, the assets purchase initiative of the FedFed brought about huge reserve raises for the banks. It is no doubt that the Federal Reserve was heavily involved in the large-scale asset purchase through the purchase of huge amounts of Treasury and mortgage-backed securities. As examined by Tuckman (2016), in the ensuing period, a sum of Fed asses was raised to approximately $ 5 trillion as at 2015, as the FedFed was also involved in other functions which were not meant to offered the much required liquidity to the financial market, bit equally increase the credit facilities to the already affected economy.
References
Roe, M. J. (2020). Derivatives and repos in bankruptcy. In Research Handbook on Corporate Bankruptcy Law. Edward Elgar Publishing.
Tuckman, B. (2016). Derivatives: Understanding their usefulness and their role in the Financial Crisis. Journal of applied corporate finance, 28(1), 62-71.