Holt 7525-9 S15_IT

y the financial system, not by the homeowners. The bursting of the housing bubble sent a shock
through the entire financial system, increasing the perceived credit risk throughout the economy,
as indicated by the TED spread. The TED spread is the difference between the interest rate on
three-month U.S. treasury bills and the interest rate on three-month interbank loans as measured
by the London Interbank Offered Rate (LIBOR).
Example 16: The TED spread is considered a good indicator of the perceived credit risk in the
economy. Historically, the TED spread has ranged between .2% and .5%. In August of 2007, the
TED spread jumped above 1% and generally stayed between 1% and 2% until mid-September of
2008, when it began spiking upward, reaching a record level of over 4.5% on October 10, 2008.
The TED spread finally fell back below .5% in June of 2009.
The increased perceived credit risk throughout the economy meant that not only would home
buyers find it more difficult to obtain financing, but so would commercial real estate investors,
corporations seeking financing for investment, municipalities seeking to issue new bonds, etc.
Example 17: Real investment spending decreased by 32% from the third quarter of 2007 to the
third quarter of 2009. By contrast, real consumption spending decreased by only 2% over this
time period.
Government Intervention
The bursting of the housing bubble did not immediately create widespread credit problems. The
TED spread did not significantly increase until August of 2007. When the credit crisis arising from
the bursting of the housing bubble became apparent, the federal government began to intervene
in the economy in unprecedented ways.
In September of 2007, the Federal Reserve began to take steps to attempt to ease the credit
crisis. On September 18, 2007, the Fed lowered the target for the federal funds rate from 5.25%
to 4.75%. Over the succeeding 15 months, the Fed would lower the rate nine more times,
eventually to a range of 0.00%-0.25% on December 16, 2008. In December of 2007, the Fed
began to lend billions of dollars directly to financial institutions (through such programs as the
Term Auction Facility) to enhance the Fed’s ability to provide liquidity to the financial system.
In February of 2008, the federal government enacted the Economic Stimulus Act of 2008. This
was a $168 billion stimulus plan, consisting primarily of tax rebates to individual taxpayers. The
act also increased the dollar size of mortgages eligible for purchase by Fannie Mae and Freddie
Mac.
In March of 2008, the Fed provided a $29 billion loan to facilitate the purchase of Bear Stearns,
an investment bank on the brink of bankruptcy, by JPMorgan Chase. From August of 2008 to
December of 2008, the Fed increased the money supply (M1) by more than 14%. In late 2008,
the Fed began using quantitative easing, a variation on traditional open market operations. (See
the appendix at the end of the chapter.)
On September 7, 2008, the Federal Housing Finance Agency placed Fannie Mae and Freddie
Mac into conservatorship. With the conservatorship, the federal government committed to provide
up to $100 billion in additional capital to each of the GSEs.
On September 16, 2008, the Fed provided an $85 billion loan to AIG, the largest insurance
company in the world, to prevent its bankruptcy. The Fed received an 80% equity stake in the
company. The loans and lines of credit provided to AIG would eventually grow to over $180
billion.
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On October 3, 2008, the $700 billion Emergency Economic Stabilization Act of 2008 was
enacted. The initial plan was to buy up illiquid mortgage assets from banks. Instead, the bailout
money was used to make direct investments in financial institutions.
The Federal Reserve System 11 - 10