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Why the coming recession could force the Federal Reserve to swap greenbacks for digital dollars

In November , U. Treasury Secretary Henry Paulson realized the true situation. The banks had a credibility problem, not a liquidity problem.

He created a Superfund. They were even guaranteed by the Treasury. Panic had already gripped the financial markets. Two things could have prevented the crisis. The second would have been recognized early on that it was a credibility problem. The only solution was for the government to buy bad loans.

But the financial crisis was also caused by financial innovation that outstripped human intellect. The potential impact of new products, like MBS and derivatives, were not understood even by the quant jocks who created them. Regulation could have softened the downturn by reducing some of the leverage. It couldn't have prevented the creation of new financial products. To some extent, fear and greed will always create bubbles. Innovation will always have an impact that isn't apparent until well after the fact.

The Balance uses cookies to provide you with a great user experience. By using The Balance, you accept our. Subprime Crisis Financial Crisis Obamacare. Hot Topics Subprime Crisis. By Kimberly Amadeo.

Federal Reserve responses to the subprime crisis - Wikipedia

First, banks were not as worried about the credit-worthiness of borrowers. They resold the mortgages on the secondary market. Second, unregulated mortgage brokers made loans to people who weren't qualified. Third, many homeowners took out interest-only loans to get lower monthly payments.

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As mortgage rates reset at a higher level, these homeowners could not pay the mortgage. As a result, they defaulted. Fourth, banks repackaged mortgages into mortgage-backed securities. They hired sophisticated "quant jocks" to create the new securities. The "quants" wrote computer programs that further repackaged these MBS into high-risk and low-risk bundles.

The high-risk bundles paid higher interest rates, but were more likely to default.

The low-risk bundles paid less. The programs were so complicated that no one understood what was in each package. They had no idea how much of each bundle were subprime mortgages. When times were good, it didn't matter.

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Everyone bought the high-risk bundles because they gave a higher return. As the housing market declined, everyone knew that the products were losing value. Since no one understood them, the resale value of these derivatives was unclear. Last but not least, many of the purchasers of these MBS were not just other banks. They were individual investors , pension funds, and hedge funds. That spread the risk throughout the economy. Hedge funds used these derivatives as collateral to borrow money. That created higher returns in a bull market but magnified the impact of any downturn.

The central bank could lower the rate of interest it pays on excess reserves at its meeting Wednesday, a technical tweak that it has made several times to help to keep rates within its desired range. The Fed is expected to lower its benchmark interest rate at that meeting by a quarter-point. The Fed may now need to revisit its operating plan rather than relying on such minor adjustments. It could be that the supply of excess reserves is now small enough that short-term stresses — like the coming due of corporate taxes this week — will feed through into repurchase rates and the fed funds rate more regularly.

And if outright intervention is needed again, the Fed should be better-prepared, economists said. The glitch could hurt confidence, Mr. The market for repurchase agreements is an important, but often-overlooked part of the large markets for short-term debt, referred to as money markets.

Repo rates are often quite low and hover close to the short-term interest rates the Federal Reserve sets. But the spike in repo rates this week — the rate surged to more than 4 percent at times on Monday before falling back to more normal levels — showed that is not always the case. And it seemed to influence other important short-term money market rates, including the fed funds rate.

Fed officials, who are meeting this week in Washington, could also discuss, and maybe even announce, when they will begin to allow their balance sheet to increase in size again. Officials are currently holding it steady, but it typically would expand alongside the economy. She previously covered economics at Bloomberg News, where she also wrote feature stories for Businessweek magazine.