by Craig Swanson, Senior Asset Manager, Wealth Enhancement Group

In last month’s article we provided a high-level overview of the Federal Reserve System. This month we will take a look at the unprecedented actions the Federal Reserve has taken during the recent financial crisis and the extent to which it is winding down many of the financial intervention programs used during the crisis.

The causes of the financial crisis were numerous and varied, but pivotal factors in the depth of the chaos were the reluctance of financial institutions to lend to one another and the seizing up of some segments of the credit market. In its effort to support orderly economic activity, the Federal Reserve initiated measures to provide liquidity and measures to assist credit flow through monetary policy and asset purchases.

At the onset of the crisis, banks were extremely reluctant to lend to one another under normal market conditions because of various risks and uncertainties. The liquidity programs put in place by the Fed were intended to ensure money made its way through the financial system. Using its operating arms, the Reserve Banks, the Fed made funds readily available via its existing Discount Window program and the new Term Auction Facility (TAF). These programs provided short-term lending to financial institutions, enabling them to provide capital to their creditworthy customers in turn. Addressing the blockage of U.S. dollar lending to companies in foreign countries, the Fed developed the foreign currency swap program. The Fed also developed facilities intended to buoy the primary dealer network (large banks that trade directly with the Fed), money market mutual funds, the commercial paper market, and the asset-backed securities market.

Of these, the only program still operating is the Term Asset-Back Securities Loan Facility (TALF), supporting the market for loans backed by newly issued commercial mortgage-backed securities. The TALF is scheduled to close on June 30, 2010. In a somewhat optimistic sign that the worst may be behind us, total credit outstanding for all of these programs has declined to under $100 billion from a peak of $1,500 billion.

The largest component of the intervention measures has been the purchase of assets, including longer-term U.S. Treasuries in addition to mortgage-back securities (MBS) and debt from government agencies (Fannie-Mae, Freddie-Mac and Ginnie-Mae). The Federal Reserve authorized purchases of up to an additional $300 billion in Treasuries, $1.25 trillion of agency MBS, and $200 billion of agency debt. A final, and somewhat controversial, asset purchase program was the purchase of select assets of Bear Stearns and American International Group. Investment in this program was about $65 billion with additional credit extended—as part of the liquidity program—totaling $116 billion. While most of the newly purchased assets are still on the books, the Fed’s goal is to dispose of them in an orderly fashion and with minimal loss.

Although it will likely be debated for some time, these extraordinary measures were intended to stabilize the financial markets and provide a normal credit flow. As economic conditions slowly return to pre-crisis norms, these programs are being discontinued and wound down. Now comes the balancing act of scaling back liquidity at a pace that does not impede economic growth, yet does not provide for unreasonable levels of inflation.