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FRB: Speech Chairman Ben S. Bernanke At the Economic Club of New York, New York, New York Stabilizing the Financial Markets and the Economy

Chairman Ben S. Bernanke
At the Economic Club of New York, New York, New York
October 15, 2008

Stabilizing the Financial Markets and the Economy

Good afternoon. I am pleased once again to share a meal and some thoughts with the Economic Club of New York. I will focus today on the economic and financial challenges we face and why I believe we are well positioned to move forward. The problems now evident in the markets and in the economy are large and complex, but, in my judgment, our government now has the tools it needs to confront and solve them. Our strategy will continue to evolve and be refined as we adapt to new developments and the inevitable setbacks. But we will not stand down until we have achieved our goals of repairing and reforming our financial system and restoring prosperity.

The crisis we face in the financial markets has many novel aspects, largely arising from the complexity and sophistication of today's financial institutions and instruments and the remarkable degree of global financial integration that allows financial shocks to be transmitted around the world at the speed of light. However, as a long-time student of banking and financial crises, I can attest that the current situation also has much in common with past experiences. As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets. The crisis will end when comprehensive responses by political and financial leaders restore that trust, bringing investors back into the market and allowing the normal business of extending credit to households and firms to resume. In that regard, we are, in one respect at least, better off than those who dealt with earlier financial crises: Generally, during past crises, broad-based government engagement came late, usually at a point at which most financial institutions were insolvent or nearly so. Waiting too long to respond has usually led to much greater direct costs of the intervention itself and, more importantly, magnified the painful effects of financial turmoil on households and businesses. That is not the situation we face today. Fortunately, the Congress and the Administration have acted at a time when the great majority of financial institutions, though stressed by highly volatile and difficult market conditions, remain strong and capable of fulfilling their critical function of providing new credit for our economy. This prompt and decisive action by our political leaders will allow us to restore more normal market functioning much more quickly and at lower ultimate cost than would otherwise have been the case. Moreover, we are seeing not just a national response but a global response to the crisis, commensurate with its global nature.

This financial crisis has been with us for more than a year. It was sparked by the end of the U.S. housing boom, which revealed the weaknesses and excesses that had occurred in subprime mortgage lending. However, as subsequent events have demonstrated, the problem was much broader than subprime lending. Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress. The unwinding of these developments, including a sharp deleveraging and a headlong retreat from credit risk, led to highly strained conditions in financial markets and a tightening of credit that has hamstrung economic growth.

The Federal Reserve responded to these developments in two broad ways. First, following classic tenets of central banking, the Fed has provided large amounts of liquidity to the financial system to cushion the effects of tight conditions in short-term funding markets. Second, to reduce the downside risks to growth emanating from the tightening of credit, the Fed, in a series of moves that began last September, has significantly lowered its target for the federal funds rate. Indeed, last week, in an unprecedented joint action with five other major central banks and in response to the adverse implications of the deepening crisis for the economic outlook, the Federal Reserve again eased the stance of monetary policy. We will continue to use all the tools at our disposal to improve market functioning and liquidity, to reduce pressures in key credit and funding markets, and to complement the steps the Treasury and foreign governments will be taking to strengthen the financial system.

Notwithstanding our efforts and those of other policymakers, the financial crisis intensified over the summer as mortgage-related assets deteriorated further, economic growth slowed, and uncertainty about the financial and economic outlook increased. As investors and creditors lost confidence in the ability of certain firms to meet their obligations, their access to capital markets as well as to short-term funding markets became increasingly impaired, and their stock prices fell sharply. Prominent companies that experienced this dynamic most acutely included the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, the investment bank Lehman Brothers, and the insurance company American International Group (AIG).

The Federal Reserve believes that, whenever possible, the difficulties experienced by firms in financial distress should be addressed through private-sector arrangements--for example, by raising new equity capital, as many firms have done; by negotiations leading to a merger or acquisition; or by an orderly wind-down. Government assistance should be provided with the greatest reluctance and only when the stability of the financial system, and thus the health of the broader economy, is at risk. In those cases when financial stability is broadly threatened, however, intervention to protect the public interest is not only justified but must be undertaken forcefully and without hesitation.

Fannie Mae and Freddie Mac present cases in point. To avoid unacceptably large dislocations in the mortgage markets, the financial sector, and the economy as a whole, the Federal Housing Finance Agency put Fannie and Freddie into conservatorship, and the Treasury, drawing on authorities recently granted by the Congress, made financial support available. The government's actions appear to have stabilized the GSEs, although, like virtually all other firms, they are experiencing effects of the current crisis. We have already seen benefits of their stabilization in the form of lower mortgage rates, which will help the housing market.

The difficulties at Lehman and AIG raised different issues. Like the GSEs, both companies were large, complex, and deeply embedded in our financial system. In both cases, the Treasury and the Federal Reserve sought private-sector solutions, but none was forthcoming. A public-sector solution for Lehman proved infeasible, as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid, and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman's acquisition by another firm. Consequently, little could be done except to attempt to ameliorate the effects of Lehman's failure on the financial system. Importantly, the financial rescue legislation, which I will discuss later, will give us better choices. In the future, the Treasury will have greater resources available to prevent the failure of a financial institution when such a failure would pose unacceptable risks to the financial system as a whole. The Federal Reserve will work closely and actively with the Treasury and other authorities to minimize systemic risk.
In the case of AIG, the Federal Reserve and the Treasury judged that a disorderly failure would have severely threatened global financial stability and the performance of the U.S. economy. We also judged that emergency Federal Reserve credit to AIG would be adequately secured by AIG's assets. To protect U.S. taxpayers and to mitigate the possibility that lending to AIG would encourage inappropriate risk-taking by financial firms in the future, the Federal Reserve ensured that the terms of the credit extended to AIG imposed significant costs and constraints on the firm's owners, managers, and creditors.

AIG's difficulties and Lehman's failure, along with growing concerns about the U.S. economy and other economies, contributed to extraordinarily turbulent conditions in global financial markets in recent weeks. Equity prices fell sharply. Withdrawals from prime money market mutual funds led them to reduce their holdings of commercial paper--an important source of financing for the nation's nonfinancial businesses as well as for many financial firms. The cost of short-term credit, where such credit has been available, jumped for virtually all firms, and liquidity dried up in many markets. By restricting flows of credit to households, businesses, and state and local governments, the turmoil in financial markets and the funding pressures on financial firms pose a significant threat to economic growth.

The Treasury and the Fed have taken a range of actions to address financial problems. To address illiquidity and impaired functioning in commercial paper markets, the Treasury implemented a temporary guarantee program for balances held in money market mutual funds to help stem the outflows from these funds. The Federal Reserve put in place a temporary lending facility that provides financing for banks to purchase high-quality asset-backed commercial paper from money market funds, thus reducing their need to sell the commercial paper into already distressed markets. Moreover, we soon will implement a new, temporary Commercial Paper Funding Facility that will provide a backstop to commercial paper markets by purchasing highly rated commercial paper directly from issuers at a term of three months when those markets are illiquid.

To address ongoing problems in interbank funding markets, the Federal Reserve has significantly increased the quantity of term funds it auctions to banks and accommodated heightened demands for temporary funding from banks and primary dealers. Also, to try to mitigate dollar funding pressures worldwide, we have greatly expanded reciprocal currency arrangements (so-called swap agreements) with other central banks. Indeed, this week we agreed to extend unlimited dollar funding to the European Central Bank, the Bank of England, the Bank of Japan, and the Swiss National Bank. These agreements enable foreign central banks to provide dollars to financial institutions in their jurisdictions, which helps improve the functioning of dollar funding markets globally and relieve pressures on U.S. funding markets. It bears noting that these arrangements carry no risk to the U.S. taxpayer, as our loans are to the foreign central banks themselves, who take responsibility for the extension of dollar credit within their jurisdictions.

The expansion of Federal Reserve lending is helping financial firms cope with reduced access to their usual sources of funding and thus is supporting their lending to nonfinancial firms and households. Nonetheless, the intensification of the financial crisis over the past month or so made clear that a more powerful, comprehensive approach involving the fiscal authorities was needed to address these problems more effectively. On that basis, the Administration, with the support of the Federal Reserve, asked the Congress for a new program aimed at stabilizing our financial markets. The resulting legislation, the Emergency Economic Stabilization Act, provides important new tools for addressing the distress in financial markets and thus mitigating the risks to the economy. The act allows Treasury to buy troubled assets, to provide guarantees, and to inject capital to strengthen the balance sheets of financial institutions. The act also raises the limit on deposit insurance from $100,000 to $250,000 per account, effectively immediately.

The Troubled Asset Relief Program (TARP) authorized by the legislation will allow the Treasury, under the supervision of an oversight board that I will head, to undertake two highly complementary activities. First, the Treasury will use the TARP funds to help recapitalize our banking system by purchasing non-voting equity in financial institutions. Details of this program were announced yesterday. Initially, the Treasury will dedicate $250 billion toward purchases of preferred shares in banks and thrifts of all sizes. The program is voluntary and designed both to encourage participation by healthy institutions and to make it attractive for private capital to come in along with public capital. We look to strong institutions to participate in this capital program, because today even strong institutions are reluctant to expand their balance sheets to extend credit; with fresh capital, that constraint will be eased. The terms offered under the TARP include the acquisition by the Treasury of warrants to ensure that taxpayers receive a share of the upside as the financial system recovers. Moreover, as required by the legislation, institutions that receive capital will have to meet certain standards regarding executive compensation practices.

Second, the Treasury will use some of the resources provided under the bill to purchase troubled assets from banks and other financial institutions, in most cases using market-based mechanisms. Mortgage-related assets, including mortgage-backed securities and whole loans, will be the focus of the program, although the law permits flexibility in the types of assets purchased as needed to promote financial stability. Removing these assets from private balance sheets should increase liquidity and promote price discovery in the markets for these assets, thereby reducing investor uncertainty about the current value and prospects of financial institutions. Unclogging the markets for mortgage-related assets should put banks and other institutions in a better position to raise capital from the private sector and increase the willingness of counterparties to engage. With time, the provision of equity capital to the banking system and the purchase of troubled assets will help credit flow more freely, thus supporting economic growth.

These measures will lead to a much stronger financial system over time, but steps are also necessary to address the immediate problem of lack of trust and confidence. Accordingly, also announced yesterday was a plan by the Federal Deposit Insurance Corporation (FDIC) to provide a broad range of guarantees of the liabilities of FDIC-insured depository institutions, including their associated holding companies. The guarantee covers all newly issued senior unsecured debt, including commercial paper and interbank funding, and it will also cover all funds held in non-interest-bearing transactions accounts, such as payroll accounts. This broad guarantee will be effectively immediately, and fees for coverage will be waived for 30 days. After the 30-day grace period, banks may continue to participate in the guarantee program by paying reasonable fees.

I would like to stress once again that the taxpayers' interests were very much in our minds and those of the Congress when these programs were designed. The costs of the FDIC guarantee are expected to be covered by fees and assessments on the banking system, not by the taxpayer. In the case of the TARP program, the funds allocated are not simple expenditures, but rather acquisitions of assets or equity positions, which the Treasury will be able to sell or redeem down the road. Indeed, it is possible that taxpayers could turn a profit from the program, although, given the great uncertainties, no assurances can be provided. Moreover, the program is subject to extensive controls and to oversight by several bodies. The larger point, though, is that the economic benefit of these programs to taxpayers will not be determined primarily by the financial return to TARP funds, but rather by the impact of the program on the financial markets and the economy. If the TARP, together with the other measures that have been taken, is successful in promoting financial stability and, consequently, in supporting stronger economic growth and job creation, it will have proved itself a very good investment indeed, to everyone's benefit.

Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away. Economic activity had been decelerating even before the recent intensification of the crisis. The housing market continues to be a primary source of weakness in the real economy as well as in the financial markets, and we have seen marked slowdowns in consumer spending, business investment, and the labor market. Credit markets will take some time to unfreeze. And with the economies of our trading partners slowing, our export sales, which have been a source of strength, very probably will slow as well. These restraining influences on economic activity, however, will be offset somewhat by the favorable effects of lower prices for oil and other commodities on household purchasing power. Ultimately, the trajectory of economic activity beyond the next few quarters will depend greatly on the extent to which financial and credit markets return to more normal functioning.

Inflation has been elevated recently, reflecting the steep increases in the prices of oil, other commodities, and imports that occurred earlier this year, as well as some pass-through by firms of their higher costs of production. However, expected inflation, as measured by consumer surveys and inflation-indexed Treasury securities, has held steady or eased, and prices of imports now appear to be decelerating. These developments, together with the recent declines in prices of oil and other commodities as well as the likelihood that economic activity will fall short of potential for a time, should lead to rates of inflation more consistent with price stability.

This past weekend, the finance ministers and central bank governors of the Group of Seven industrialized countries met in Washington. We committed to work together to stabilize financial markets and restore the flow of credit to support global economic growth. We agreed to use all available tools to prevent failures that pose systemic risk. We affirmed we will ensure our deposit insurance programs instill confidence in the safety of savings. We agreed to ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources. We further agreed that we would take all necessary steps to unfreeze interbank and money markets, and that we will act to restart the secondary markets for mortgages and other securitized assets. Finally, we recognized that we should take these actions in ways that protect taxpayers and avoid potentially damaging effects on other countries. I believe that these are the right principles for action, and I see the steps announced by our government yesterday as fully consistent with them.

I have laid out for you today an extraordinary series of actions taken by policymakers throughout our government and around the globe. Americans can be confident that every resource is being brought to bear to address the current crisis: historical understanding, technical expertise, economic analysis, financial insight, and political leadership. I am not suggesting the way forward will be easy, but I strongly believe that we now have the tools we need to respond with the necessary force to these challenges. Although much work remains and more difficulties surely lie ahead, I remain confident that the American economy, with its great intrinsic vitality and aided by the measures now available, will emerge from this period with renewed vigor.

FRB: speech by Vice Chairman Donald L. Kohn At the Georgetown University Wall Street Alliance, New York, New York Economic Outlook

Vice Chairman Donald L. Kohn
At the Georgetown University Wall Street Alliance, New York, New York

October 15, 2008

Economic Outlook

We gather in difficult times for our financial markets and our economy. Recent weeks have seen a sharp intensification of the turmoil in financial markets: There has been a broad-based pullback in risk-taking and a virtual seizing up of term lending to many banks and other financial institutions; interest rates have risen for many borrowers, and credit availability has significantly diminished; and equity prices have fallen sharply, on net. The authorities have responded with a series of forceful and innovative measures that promise to rebuild confidence and free up lending. Tonight I will try to put these developments in the context of the recent course of our economy and its prospects for the future.1

Before commenting on the current situation and its economic implications, I thought it might be useful to begin by giving you my perspective on where the economy stood prior to the recent intensification of financial turmoil. Overall economic activity--as measured by the growth of real gross domestic product (GDP)--held up surprisingly well over the first half of 2008 given the ongoing stresses in broader financial markets and the further rise in oil prices. At the same time, however, a number of disquieting signs lay underneath the surface of the aggregate growth figures. Conditions in housing markets, as had been widely expected, were continuing to deteriorate, with further declines in home sales, new construction, and house prices in most markets. And, while consumer spending posted moderate gains during the spring, it seemed likely that much of that strength stemmed from the sizable tax rebate checks that began to go out to households at the end of April. Meanwhile, on the business side, employers had been reducing payrolls since the turn of the year, industrial production fell from February through May, and many corporations were seeing their profits squeezed by rising costs and weak demand.

During the summer, it became increasingly clear that a downshifting in the pace of economic activity was in train. In particular, the long list of negative factors weighing on domestic demand--including high prices for oil and other commodities, tight credit conditions, and the housing downturn--were beginning to take a significant toll on the economy.

The deterioration was led by a noticeable retrenchment in consumer spending. Although rebate checks continued to provide a boost to incomes in June and July, households were facing some stiff headwinds. Ongoing job losses and sharp increases in energy and food prices subtracted from household purchasing power, declining home prices and falling equity values led to a further drop in household wealth, and consumers remained extremely downbeat about prospects for jobs and income. At the same time, credit became more difficult to obtain as lenders became increasingly concerned about the prospects for loan performance in a softening economy. Many banks and other creditors tightened standards for credit cards and other consumer loans, and some lenders either reduced borrowing limits on or eliminated home equity lines of credit. As a result of all these influences, real consumer outlays fell from June through August, putting real consumer spending for the third quarter as a whole on track to decline for the first time since 1991.

Business investment also appears to have slowed over the summer. Orders and shipments for nondefense capital goods have weakened, on net, in recent months, pointing to a decline in real outlays for new business equipment. Similarly, outlays for nonresidential construction projects edged lower in July and August after rising at a robust pace over the first half of this year. Although the deteriorating sales outlook and increased uncertainty about the economy undoubtedly played a role, the softening in business outlays also appeared to reflect reduced credit availability from banks and other lenders.

In addition, conditions in housing markets have remained on a downward trajectory. Sales and construction of new homes continued to decline over the summer, and while existing home sales showed signs of stabilizing at low levels, many of the sales that did occur appear to have been stimulated by sharp price reductions for distressed properties. National indexes of house prices continued to post sizable declines.

Unfortunately, our trading partners have proven not to be immune from financial turmoil and economic weakness. Incoming data indicate that the pace of activity in many foreign economies slowed in recent quarters, reflecting many of the same forces of credit contraction, rising energy prices, and housing market decelerations that have affected the U.S. economy. This weakening in foreign activity suggests that the support to domestic production from net exports that was evident in the first half of this year is likely diminishing. We can see evidence of this in manufacturing production outside of motor vehicles, which had benefited from the earlier decline in the dollar and strong foreign growth; it fell for a third consecutive month in August, and indications for September suggest a further decline last month, even after excluding the effects of the recent hurricanes and the strike at Boeing.

Meanwhile, inflation remained uncomfortably high through much of the summer. The sharp increases in the prices of oil and many agricultural commodities showed through to consumer food and energy prices, and producers passed through some of their higher input costs into retail prices for "core" goods and services. More recently, however, the prices of oil and other commodities have posted substantial declines, non-oil import prices have edged down, and the prospect of greater slack in resource markets and weak demand seems likely to restrain labor cost pressures and pricing power. Reflecting these developments, inflation expectations appear to have eased a bit.

The weakening U.S. economy and ongoing declines in house prices, with their implications for credit performance, put further pressure on exposed financial institutions over the summer. Investors lost confidence in some of these institutions, which then saw their access to liquidity dry up, causing some to fail and others to require government assistance or to consolidate via their acquisition by healthier institutions.

The speed with which these developments occurred, along with worries about losses throughout the financial system, led banks and other lenders to pull back from extending credit except at the very shortest maturities. As a result, conditions in funding markets deteriorated substantially further in September and early October, with interbank lending rates moving up sharply from already-high levels and spreads over comparable-maturity overnight index swaps widening to unprecedented levels.

In addition, the commercial paper market became severely disrupted as money market mutual funds, the largest investors in that market, substantially reduced their demand in response to outflows and the difficulty of liquidating commercial paper in secondary markets. As a result, yields on commercial paper skyrocketed for most issuers, and funding became increasingly concentrated in paper with overnight maturities. Similarly, interest rates on longer-term corporate bonds rose sharply even for investment-grade firms, and bond markets were closed off to many issuers. These developments quickly led to sharp declines in equity prices more generally, as well as to widespread disruptions in other markets, including the markets for municipal bonds. Market distress fed on itself, as efforts by lenders to protect themselves triggered calls for increased margins, sales of assets that accentuated price declines, large increases in volatility in an uncertain and unfamiliar environment, and a sharp cutback in the willingness to extend credit. Financial stresses have intensified in major foreign economies as well, with many also experiencing a drying up of liquidity in financial markets, sharp increases in the cost of short-term credit, and steep declines in equity prices.

The net result of the erosion of confidence, declines in asset prices, and freezing up of many financial markets has been a marked deterioration in the outlook for economic growth both here and abroad. Already, the latest readings on the U.S. economy have become more downbeat. In the labor market, private payroll employment fell 170,000 in September, a faster pace of decline than had been evident in preceding months, and the Institute for Supply Management survey of conditions in the manufacturing sector turned down sharply. In addition, motor vehicle sales fell to a 12-1/2 million unit pace in September, and today's report on retail sales indicated that purchases of other goods also dropped sharply last month. Meanwhile, pressures in financial markets have undoubtedly further restricted the availability of credit to households and businesses. Indeed, many of our contacts for the Beige Book, which was published today, highlighted tight and tightening credit conditions, and, in increasing numbers, indicated that a lack of credit availability is negatively affecting their customers' ability to spend or impairing their own ability to maintain the normal working capital they need to manage their day-to-day operations.

To combat the increased stresses in financial markets and their effects on the economy, the U.S. authorities, as well as those of many foreign governments, have taken a number of forceful and innovative steps in recent weeks. Of greatest consequence was the passage of the Emergency Economic Stabilization Act (EESA) with its authority for the government to use up to $700 billion to support financial markets. Importantly, the U.S. Treasury has indicated that a significant share of this authority will be used to inject capital into financial institutions. As the turmoil has persisted and deepened, it has become increasingly clear that the fear and uncertainty gripping markets stems from questions about the exposure of many financial intermediaries to losses on mortgages and other loans. Banks and other lenders need greater capital cushions to reassure their counterparties that they will be able to meet their obligations, and they need it soon. The capital purchase plan announced by the Treasury yesterday is a start on building capital and confidence, and, by strengthening lenders, should make it easier for them to access the private capital they also require. In addition, the troubled asset purchase program should help by counteracting the effect of forced sales and impaired market liquidity on asset prices.

Although capital is the bedrock of confidence, it probably will take some time for enough to be raised to completely reassure those who extend funds to many intermediaries. In the meantime, the inability of lenders to fund themselves beyond the very near term creates vulnerability in the financial system and impedes their capacity to make loans to households and businesses to finance the purchases of cars, houses, and business capital. To bridge the gap to stronger capital, the Federal Deposit Insurance Corporation (FDIC) is offering banks and their holding companies an opportunity to issue guaranteed obligations for the next nine months. This guarantee covers the obligations most likely to be withdrawn when confidence erodes, but it is also structured to encourage banks to lengthen the maturity of their borrowing to provide stability, rebuild confidence, and stimulate lending. The FDIC program will operate alongside the earlier Treasury guarantee of money market fund balances designed to stabilize investments in those accounts and hence reduce the need for these funds to liquidate assets.

For its part, the Federal Reserve has greatly expanded its provision of liquidity to banks here and abroad and to other borrowers. We could do so in part because the EESA accelerated the authority for the Federal Reserve to pay interest on reserves. With that power, we can expand our lending and still maintain the federal funds rate target established by the Federal Open Market Committee (FOMC). Under normal circumstances, we face no tension between supplying liquidity and achieving our interest rate objective, because we supply a relatively small amount of funds to the private sector through our open market operations with primary dealers and discount window lending to banks. Over the past 15 months, however, as lenders have become increasingly reluctant to lend to each other, the Federal Reserve has had to take on a much greater role in the financial system to carry out its public policy responsibilities to provide a backstop source of liquidity. At first, we did this by expanding the amount and lengthening the maturity of our lending to banks at the discount window and through our traditional open market operations with dealers. Then, we found that we needed to supply credit against a greater variety of collateral to primary dealers so we opened the discount window to them and expanded our securities lending facilities. And just within the past few weeks we determined that, with normal intermediation increasingly disrupted, economic and financial stability required us to lend to firms that issued commercial paper. At the same time, we have greatly expanded our dollar swaps with foreign central banks to help them meet the dollar funding needs of their domestic banks--needs that have been adding to pressures on our markets here at home.

By opening and expanding these facilities, we are trying to assure banks, dealers, and commercial paper issuers that they can extend credit without worrying about whether they will be able to borrow to fund those loans. We are also trying to assure those who lend to these firms that the borrowers will have a source of funding to pay them back. Clearly, the willingness of the Federal Reserve to lend substantial amounts to more counterparties over longer periods has not, by itself, been sufficient to unlock private credit flows; but Federal Reserve credit has been a critical ingredient in the mix of policy tools.

As I noted earlier, the troubles in the financial markets have spilled over to the economy. Indeed, fear of economic weakness and the associated deterioration in credit quality contributed to the adverse dynamics in credit markets. To counter this dynamic and adjust its policy to the evolving economic outlook, the FOMC reduced the target federal funds rate 50 basis points last week. To be sure, the effects of the easier stance of policy on the cost and availability of credit were overwhelmed last week by the further erosion in confidence. But, over time, lower rates will help to support asset prices and reduce the cost of capital to encourage spending, economic expansion, and job creation.

Importantly, this easing action was taken alongside similar actions by many other central banks. Financial markets are connected around the world by the free flow of capital, and the freezing up of credit has occurred, to one degree or another, in many foreign economies as well as our own. In these circumstances, measures to address financial market problems within each country are likely to be more effective if other countries are also taking similar steps, as they are doing not only in monetary policy but also in their efforts to recapitalize banks, guarantee bank obligations, and shore up the confidence of lenders.

I am optimistic that this multipronged approach is laying the groundwork for a return to more normal functioning in financial markets and a restoration of vigorous economic growth. The initial reaction has been positive, but it will take some time before we know to what extent the current stresses in the financial sector are being resolved. Over time, financial firms will need to bolster profits to offset losses and attract capital, to delever by reducing debt relative to equity, and in many cases to consolidate through mergers and acquisitions. All of this points to a prolonged period of cautious lending and a high cost of capital relative to benchmark interest rates like the federal funds rate, even as market functioning improves.

Similarly, although the adjustment in housing markets is well under way, it likely still has further to go. House prices will probably continue to fall for a while, and inventories of unsold homes, while decreasing, will remain elevated. At some point, however, house prices will begin to stabilize, demand will be bolstered by the lower level of prices and low interest rates, and inventories will come into better alignment with sales. To be sure, any rebound in housing activity will likely be modest, but even a stabilization in housing markets will remove what has been a significant drag on the U.S. economy.

Given the likely drawn-out nature of the prospective adjustments in housing and financial markets, I see the most probable scenario as one in which the performance of the economy remains subpar well into next year and then gradually improves in late 2009 and 2010. As credit restraint abates, the low level of policy interest rates will begin to show through into more accommodative financial conditions. This improvement in financial conditions, together with the gradual stabilization of housing markets and the stimulative effects of lower oil and commodity prices, should lead to a pickup in jobs and income, contributing to a broad recovery in the U.S. economy.

At the same time, inflation seems likely to move onto a downward track. If sustained, the recent declines in commodity prices should soon lead to a sharp reduction in headline inflation. In addition, I expect core inflation to slow from current levels as lower commodity prices and greater economic slack moderate upward pressures on costs. Similar reductions in inflation abroad, as well as the recent appreciation of the dollar, should restrain increases in the prices of imported goods.

I would caution, however, that the uncertainty around my forecast is substantial. The path of the economy will depend critically on how quickly the current stresses in financial markets abate. But these events have few if any precedents, and thus we can have even less confidence than usual in our economic forecasts.

Here's what I do know: The authorities around the world have brought to bear on this situation an array of actions that are unprecedented in scope and force; these actions show every promise of being successful in restoring confidence in lending institutions and freeing the flow of credit to households and businesses; and governments in the United States and elsewhere have shown themselves able to work across political parties and across international boundaries to craft new approaches to problems. As Chairman Bernanke has often remarked, at the Federal Reserve we will utilize all the tools at our disposal to meet our responsibilities for fostering high employment and stable prices. I also know that the U.S. economy has proven itself over the years to be flexible and resilient as well as innovative and productive, qualities which enable it to rebound from serious economic shocks. I am confident that we will emerge from this episode with a stronger and more robust financial system and with a restoration of solid and sustainable economic growth.

Footnotes
1. The views expressed are my own and do not necessarily represent the views of other members of the Board or the Federal Open Market Committee. William Wascher, of the Board’s staff, contributed to these remarks

White House Press Release October 14, 2008

President Bush Discusses Economy Rose Garden


In Focus: Economy
8:02 A.M. EDT

THE PRESIDENT: Good morning. I just completed a meeting with my working group on financial markets. We discussed the unprecedented and aggressive steps the federal government is taking to address the financial crisis. Over the past few weeks, my administration has worked with both parties in Congress to pass a financial rescue plan. Federal agencies have moved decisively to shore up struggling institutions and stabilize our markets. And the United States has worked with partners around the world to coordinate our actions to get our economies back on track.

This weekend, I met with finance ministers from the G7 and the G20 -- organizations representing some of the world's largest and fastest-growing economies. We agreed on a coordinated plan for action to provide new liquidity, strengthen financial institutions, protect our citizens' savings, and ensure fairness and integrity in the markets. Yesterday, leaders in Europe moved forward with this plan. They announced significant steps to inject capital into their financial systems by purchasing equity in major banks. And they announced a new effort to jumpstart lending by providing temporary government guarantees for bank loans. These are wise and timely actions, and they have the full support of the United States.

Today, I am announcing new measures America is taking to implement the G7 action plan and strengthen banks across our country.

First, the federal government will use a portion of the $700 billion financial rescue plan to inject capital into banks by purchasing equity shares. This new capital will help healthy banks continue making loans to businesses and consumers. And this new capital will help struggling banks fill the hole created by losses during the financial crisis, so they can resume lending and help spur job creation and economic growth. This is an essential short-term measure to ensure the viability of America's banking system. And the program is carefully designed to encourage banks to buy these shares back from the government when the markets stabilize and they can raise capital from private investors.

Second, and effective immediately, the FDIC will temporarily guarantee most new debt issued by insured banks. This will address one of the central problems plaguing our financial system -- banks have been unable to borrow money, and that has restricted their ability to lend to consumers and businesses. When money flows more freely between banks, it will make it easier for Americans to borrow for cars, and homes, and for small businesses to expand.

Third, the FDIC will immediately and temporarily expand government insurance to cover all non-interest bearing transaction accounts. These accounts are used primarily by small businesses to cover day-to-day operations. By insuring every dollar in these accounts, we will give small business owners peace of mind and bring stability to the -- and bring greater stability to the banking system.

Fourth, the Federal Reserve will soon finalize work on a new program to serve as a buyer of last resort for commercial paper. This is a key source of short-term financing for American businesses and financial institutions. And by unfreezing the market for commercial paper, the Federal Reserve will help American businesses meet payroll, and purchase inventory, and invest to create jobs.

In a few moments, Secretary Paulson and other members of my Working Group on Financial Markets will explain these steps in greater detail. They will make clear that each of these new programs contains safeguards to protect the taxpayers. They will make clear that the government's role will be limited and temporary. And they will make clear that these measures are not intended to take over the free market, but to preserve it.

The measures I have announced today are the latest steps in this systematic approach to address the crisis. I know Americans are deeply concerned about the stress in our financial markets, and the impact it is having on their retirement accounts, and 401(k)s, and college savings, and other investments. I recognize that the action leaders are taking here in Washington and in European capitals can seem distant from those concerns. But these efforts are designed to directly benefit the American people by stabilizing our overall financial system and helping our economy recover.

It will take time for our efforts to have their full impact, but the American people can have confidence about our long-term economic future. We have a strategy that is broad, that is flexible, and that is aimed at the root cause of our problem. Nations around the world are working together to overcome this challenge. And with confidence and determination, we will return our economies to the path of growth and prosperity.

Thank you.

White House Press Releases

Speeches & News Releases
October 14, 2008
Text of a Letter from the President to the Speaker of the House of Representatives and the President of the Senate

President Bush Discusses Economy

October 13, 2008
Fact Sheet: Protecting American Innovation

October 11, 2008
President's Radio Address

President Bush Meets with G7 Finance Ministers to Discuss World Economy

Joint Statement of Henry M. Paulson, Jr.,Secretary of the Treasury, and Jim Nussle, Director of the Office of Management and Budget,on Budget Results

October 14, 2008

HP-1213

Joint Statement ofHenry M. Paulson, Jr.,Secretary of the Treasury, andJim Nussle, Director of the Office of Management and Budget, onBudget Results for Fiscal Year 2008

SUMMARY

The Administration today released the September 2008 Monthly Treasury Statement of Receipts and Outlays of the United States Government[1][1]. The statement shows the actual budget totals for the fiscal year that ended September 30, 2008, as follows:

• A deficit of $455 billion, or 3.2 percent of Gross Domestic Product (GDP)
• total receipts of $2,524 billion, or 17.8 percent of GDP; and
• total outlays of $2,979 billion, or 21.0 percent of GDP.

"This year's budget results reflect theongoing housing correction, and the manifestations of that instrained capital markets and slower growth. We are taking aggressiveactions to stabilize our financial markets and strengthen ourfinancial institutions so they can finance economic growth. While it will take time towork through this period, we will overcome the current challengesfacing our nation.

"The budget results reinforce the need to notonly address short term challenges, but pursue policies that promoteeconomic growth and fiscal responsibility, and address entitlementreform."-Treasury SecretaryHenryPaulson

"The bipartisan stimulus bill and the sloweconomy are the primary reasons for the increase in deficit asreflected in this year's budget results. This increase reinforcesthe need to adopt and maintain policies that promote economic growthand fiscal responsibility, including entitlement reform andpro-growth tax policies. I am confident the economy can return tostronger growth with a declining deficit - after working throughcurrent challenges - if Congress limits wasteful and excessivespending."-OMBDirectorJimNussle

Table 1. TOTAL RECEIPTS, OUTLAYS AND SURPLUS/DEFICIT (-)

Receipts Outlays Surplus/Deficit (-)
FY 2007 Actual. 2,568 2,729 -162
FY 2008 Estimates:
FY 2009 Budget. 2,521 2,931 -410
FY 2009 Mid-Session Review 2,553 2,942 -389
Actual. 2,524 2,979 -455








The FY 2008 unified deficit was $455 billion, or an estimated 3.2 percent of GDP. The deficit was $65 billion higher than projected in the July Mid-Session Review (MSR), because outlays were $36 billion higher than expected and receipts were $29 billion lower than expected. The deficit was also $45 billion higher than projected last February in the FY 2009 Budget, with receipts coming in $3 billion higher and outlays $47 billion higher than projected.

Overall, receipts in FY 2008 were $44 billion, or 1.7 percent, lower than in FY 2007. Receipts were reduced relative to the previous year by the tax rebates and other provisions of the Economic Stimulus Act enacted in February 2008, and by the effects of the current economic slowdown on incomes and corporate profits. Receipts fell from 18.8 percent of GDP in FY 2007 to 17.8 percent of GDP in FY 2008, after rising for the previous four years. This level of receipts is below the 40-year historical average of 18.3 percent of GDP.

Outlays for FY 2008 grew by $249 billion, or 9.1 percent, from FY 2007. The increase was driven by growth in defense outlays, payments of the portion of stimulus tax rebates that was recorded as outlays, and payments by the Federal Deposit Insurance Corporation to resolve recent bank failures. Outlays were also boosted by increases in unemployment, Food Stamp, and Medicaid benefits due to slower economic growth. In addition, the growth rate was influenced by proceeds for spectrum auctions recorded in FY 2007, which held down FY 2007 outlays relative to FY 2008. Overall, outlays increased as a percent of GDP from 20.0 percent in FY 2007 to 21.0 percent in FY 2008. This spending level is above the 40-year historical average of 20.6 percent.

At $455 billion, the deficit for FY 2008 was $293 billion higher than the deficit for FY 2007. The deficit increased to 3.2 percent of GDP, up from 1.2 percent of GDP for FY 2007. As a percentage of GDP, the FY 2008 deficit was the largest since the deficit of 3.6 percent of GDP in FY 2004, but below the peak postwar deficit in FY 1983 (6.0 percent).

Borrowing from the public increased by $768 billion during FY 2008, to $5,801 billion or 40.8 percent of GDP. In addition to the $455 billion needed to finance the deficit, the increase included $300 billion in debt issued through Treasury's new Supplementary Financing Program (SFP). Under the SFP, Treasury issues short-term debt and deposits the cash proceeds with the Federal Reserve for use by the Federal Reserve in its actions to stabilize the financial markets. Although debt held by the public as a percentage of GDP increased from 36.9 percent at the end of FY 2007, it remains below the levels of the 1990s, when debt held by the public averaged 46.1 percent of GDP.

RECEIPTS

Total receipts for FY 2008 were $2,524 billion, $29 billion lower than the MSR estimate of $2,553 billion. Lower-than-expected collections of individual income taxes and corporation income taxes accounted for most of the net decrease in receipts relative to the MSR. Table 2 displays actual receipts and estimates from the MSR by source.

Individual income taxes were $1,146 billion, $23 billion lower than the MSR estimate. Lower-than-estimated withheld tax payments accounted for $16 billion of the shortfall in individual income tax receipts relative to the MSR. Lower-than-anticipated growth in total wages and salaries and a different distribution of that growth among taxpayers, relative to what was assumed in the MSR, contributed to most of the shortfall in withheld tax payments. An accounting adjustment based on more recent data, which reallocated $1 billion less than had been expected in withheld tax payments from the Social Security and Medicare Trust Funds to individual income taxes, also contributed to the shortfall in withheld tax payments. Lower-than-estimated non-withheld payments reduced individual income taxes an additional $7 billion below the MSR estimate. Lower-than-anticipated growth in non-wage sources of income such as capital gains and dividends contributed to this shortfall in non-withheld payments.

Corporation income taxes were $304 billion, $5 billion lower than the MSR estimate. Lower-than-estimated corporate tax payments of $4 billion and higher-than-estimated refunds of $1 billion were responsible for the shortfall in collections relative to the MSR. The ability of corporations affected by Hurricanes Gustav and Ike to delay estimated tax payments otherwise due on September 15th until January 2009 accounted for $2 billion of the shortfall in corporate tax payments. Lower-than-expected corporate profits accounted for the remaining $2 billion shortfall in corporate tax payments.

Social insurance and retirement receipts were $900 billion, $1 billion lower than the MSR estimate. A $2 billion shortfall in State deposits to the unemployment insurance trust fund was partially offset by a $1 billion increase in Social Security and Medicare receipts, relative to the MSR. The increase in Social Security and Medicare receipts was attributable to the lower-than-expected reallocation of withheld tax payments from the Social Security and Medicare Trust Funds to individual income taxes, as described above. Lower-than-expected State tax rates and taxable wages, relative to what was assumed in the MSR, contributed to the shortfall in State deposits to the unemployment insurance trust fund.

Excise taxes were $67 billion, $1 billion lower than the MSR estimate. This decline was in large part attributable to lower-than-expected demand for taxed goods, especially transportation
Other sources of receipts (customs duties, estate and gift taxes, and miscellaneous receipts) were $106 billion, $1 billion higher than the MSR estimate. This was the net effect of lower-than-expected customs duties and deposits of earnings by the Federal Reserve System, which was more than offset by higher-than-expected estate and gift taxes and other miscellaneous receipts (gifts, contributions, fines and penalties).

OUTLAYS

Total outlays were $2,979 billion for FY 2008, which was $36 billion above the MSR estimate. Outlays for many agencies were below MSR estimates, including differences of $2 billion or more in the Departments of Agriculture, Health and Human Services, Labor, and Transportation as well as Other Defense Civil Programs. These lower-than-expected outlays were more than offset by significantly higher-than-expected outlays in the Departments of Defense and the Treasury (interest on inflation-adjusted securities), along with the Federal Deposit Insurance Corporation. Table 3 displays actual outlays by agency and major program as well as estimates from the Budget and the MSR. The largest changes in outlays from the MSR were in the following areas:

Department of Agriculture – FY 2008 outlays for the Department of Agriculture (USDA) were $91 billion, $2.6 billion below the MSR estimate. USDA's actual outlays for its commodity and disaster payments were $1.4 billion lower than projected in the MSR. Programs funded through the Commodity Credit Corporation were $0.6 billion lower due to higher commodity prices and fewer requests from producers for advanced Direct Payments for the 2008 crop year. Outlays for advanced Direct Payments were lower than anticipated potentially due to several factors, including late enactment of the farm bill and producers' choices to defer payments until FY 2009. Finally, delays in making crop disaster quality loss payments reduced FY 2008 outlays by an additional $0.5 billion. These outlays are expected to occur in FY 2009 rather than FY 2008.
Department of Defense – Outlays for the Department of Defense (DOD) were $595 billion, exceeding the MSR estimate by $12.5 billion. The increase over the MSR was primarily due to outlays for operations and maintenance, which were $20.5 billion above the MSR estimate. In the MSR, bridge funding provided by Congress for war-related operations and maintenance was assumed to have a "normal" outlay rate for supplemental appropriations, which turned out ultimately to be too low. The fact that the bridge funding for the war was available early in the fiscal year (mid-November 2007) meant that DOD did not have to use appropriations for its base activities to support the war and could spend base funding for its non-war operational needs, thus increasing total outlays. Partially offsetting the increased outlays for operations and maintenance, outlays for DOD procurement were $11.7 billion lower than the MSR estimated, primarily because of lower-than-anticipated outlays for the Mine Resistant Ambush Protected Vehicles Program.

Department of Education – Outlays for the Department of Education were $66 billion in FY 2008, $1.7 billion below the MSR estimate. These differences were due to three factors. First, while the MSR assumed higher outlays compared to FY 2007 in the Student Financial Assistance account, due to projections of a significant increase in the number of Pell Grant recipients, the actual increase in Pell recipients and costs was lower than anticipated. Second, the MSR estimates failed to reflect an increase in Direct Student Loan volume in the 2008-2009 academic year, resulting in a reduction in net outlays since this program has a negative subsidy. Finally, the value of the on-budget Federal Student Loan Reserve Fund increased more than anticipated. While in prior years the Department of Education did not update the reserve fund valuation estimates, the Department instituted this practice in FY 2008 and will continue it in future years.

Department of Health and Human Services – The Department of Health and Human Services (HHS) had FY 2008 outlays of $701 billion, $5.9 billion less than the MSR estimate. Medicare gross outlays in FY 2008 were $461 billion, about $1.3 billion (0.3 percent) less than MSR estimates. Part A expenditures finished FY 2008 about $1.0 billion above MSR estimates due to slightly higher than projected spending for skilled nursing facility and hospice services. Part D spending finished FY 2008 about $2.5 billion lower than projected in the MSR. Medicaid outlays were $201 billion, $3.5 billion or 1.7 percent below the MSR estimate, due to an unanticipated slowdown in State Medicaid spending over the second half of FY 2008. The HHS actuaries will have a better understanding of the factors contributing to this difference when the final year-end expenditure data are available in about six months.

Department of Homeland Security – Outlays for the Department of Homeland Security were $41 billion in FY 2008, $1.2 billion more than the MSR estimate. The difference was attributable primarily to faster-than-expected outlays in the aviation security account in the Transportation Security Administration, which spent $1.0 billion more than projected in the MSR.

Department of Housing and Urban Development – Outlays for the Department of Housing and Urban Development were $49 billion in FY 2008, $1.4 billion below the MSR estimate. Slower-than-expected outlays of Community Development Block Grant disaster supplemental funds accounted for $1.0 billion of the $1.4 billion difference. These disaster funds were obligated to the Gulf Coast States after the 2005 hurricanes, but the States did not expend the funds as quickly as projected. The remaining difference in outlays was mainly due to slower spending in the Tenant-Based Rental Assistance and Housing Certificate Fund accounts.

Department of the Interior – Outlays for the Department of Interior were $9.9 billion, or $1.0 billion less than the MSR estimate. The main driver was outlays for the Bureau of Reclamation, which were $0.6 billion less than estimated due to slower-than-expected spending of prior year appropriations. Fish and Wildlife Service outlays were $0.3 billion below estimates for several reasons, including slower obligations for operations (due to project delays as a result of hurricanes and flooding), and grant programs. In addition, land acquisition programs had difficulty finding willing sellers. The net reduction in outlays also reflected an increase in proprietary offsetting receipts of $0.2 billion (3.6 percent) over the MSR estimates, primarily due to greater onshore oil and gas receipts.

Department of Labor – FY 2008 outlays for the Department of Labor were $59 billion, $2.2 billion below the MSR estimate. The major contributors to this difference were the Unemployment Trust Fund and the Pension Benefit Guaranty Corporation. Actual outlays for the Unemployment Trust Fund were $0.9 billion (2 percent) below the MSR, largely because of lower-than-projected outlays for the Emergency Unemployment Compensation program that was enacted in late June. Actual outlays for the Pension Benefit Guaranty Corporation were $0.7 billion (34 percent) below the MSR, largely because of a change in accounting guidance that requires PBGC and other agencies to no longer mark holdings of zero coupon bonds to market each month.

Department of State – Outlays for the Department of State were $18 billion in FY 2008, $1.6 billion below the MSR estimate. Outlays for Administration of Foreign Affairs were $1.0 billion below the MSR estimate, primarily due to slower-than-expected spending on capital construction projects and higher-than-expected receipts in the Department's Working Capital Fund. In addition, outlays for International Organizations and Conferences were $0.6 billion lower than the MSR estimate because bills from the United Nations for international peacekeeping missions were still in process at the end of the fiscal year.

Department of Transportation – Outlays for the Department of Transportation were $65 billion in FY 2008, $2.7 billion below the MSR estimate. The decrease was due to slower-than-anticipated obligation and spending of funds for transit formula grants, surface transportation safety bureaus, and Federal Aviation Administration capital investments.

Department of the Treasury – Actual outlays for the Department of the Treasury were $549 billion, $12.2 billion higher than the MSR estimate. Interest on the public debt, which includes interest paid to government accounts as well as interest paid to the public, was $451 billion, $10.1 billion higher than the MSR estimate. Of this $10.1 billion difference, $9.7 billion was due to the increase in interest paid to the public on inflation-indexed Treasury securities resulting from faster-than-expected inflation in the Consumer Price Index, and $0.5 billion related to higher interest paid to trust funds and other government accounts, such as Federal retirement funds. Higher-than-projected interest paid to credit financing accounts ($0.7 million) and lower-than-anticipated offsetting receipts of interest from credit financing accounts ($1.8 billion) added to the higher-than-estimated Treasury outlays. Finally, the portion of Treasury's outlays for the Economic Stimulus Act of 2008 that was attributed to child tax credits ($2.3 billion) was lower than anticipated, but recovery rebates were higher than projected ($1.3 billion), resulting in a net decrease of $1.0 billion in projected outlays.

Department of Veterans Affairs – Outlays for the Department of Veterans Affairs were $85 billion, $1.0 billion lower than estimated in the MSR. This difference results primarily from lower-than-anticipated outlays for veterans' benefits and for departmental administration. Within veterans' benefits, compensation and pension payments were $0.2 billion less than anticipated. In addition, spending on readjustment benefits was $0.2 billion less than anticipated. Within departmental administration, spending on major construction lagged $0.2 billion behind the MSR estimate.

Army Corps of Engineers – Actual outlays for the Army Corps of Engineers were $5.1 billion, $1.5 billion lower than the MSR estimate. A number of factors contributed to this discrepancy, including: overly optimistic assumptions about the spending of supplemental funds; an extensive storm season that slowed down a number of project operations; and higher-than-expected reimbursements, also due to storm-related reimbursable activity. The two accounts with the greatest difference between the estimates and year-end actuals were the Construction and the Operation and Maintenance accounts. Actual outlays for the Construction account were $0.7 billion below the MSR estimate and actual outlays for the Operation and Maintenance account were $0.4 billion below the MSR estimate, both due to higher-than-expected reimbursements. Outlays for the Flood Control and Coastal Emergencies account were $0.2 billion lower than the MSR estimate.

Other Defense Civil Programs – Actual outlays for Other Defense Civil programs were $46 billion, $3.2 billion below the MSR estimate. This was almost entirely the result of $3.1 billion in higher-than-anticipated interest earnings for the DOD Medicare-eligible retiree health care fund.

International Assistance Programs – Outlays for International Assistance Programs were $11 billion in FY 2008, $1.0 billion below the MSR estimate. Within this amount, outlays for the Foreign Military Sales program were $1.4 billion lower than the MSR estimate due to lower-than-expected disbursements from the Foreign Military Sales Trust Fund for the purchase of military equipment and services. These lower outlays were offset by a net increase of $0.4 billion above the MSR resulting from higher-than-estimated outlays in a number of other foreign assistance accounts.

Federal Deposit Insurance Corporation – The Federal Deposit Insurance Corporation (FDIC) had actual outlays of $18 billion, $15.2 billion higher than the MSR estimate. Subsequent to the preparation of the MSR estimates, the FDIC made deposit insurance claim payments related to the failures of IndyMac Bank and other smaller depository institutions. Almost $11 billion of the increase was attributable to insurance losses and $4 billion was attributable to higher-than-expected working capital needed to resolve the bank failures.

National Credit Union Administration – The National Credit Union Administration (NCUA) had actual outlays of $1.0 billion, $1.3 billion higher than the MSR estimate. The additional outlays resulted primarily from the unexpected use of the NCUA Central Liquidity Facility (CLF) by Natural Person Credit Unions (NPCU), which are non-corporate member credit unions. Loan disbursements from the CLF are recorded on a cash basis due to the program's statutory exemption from the Federal Credit Reform Act. The MSR did not estimate that the CLF would be used. During September, however, NPCUs applied for loans from the facility and as of September 30, 2008, the CLF had $1.1 billion in short-term loans outstanding. These loans are expected to be repaid in FY 2009. The NCUA also experienced about $0.2 billion in insurance losses and related resolution expenses in FY 2008 in addition to what was forecast in the MSR.
Railroad Retirement Board – FY 2008 outlays for the Railroad Retirement Board (RRB) of $9 billion were $2.9 billion higher than estimated in the MSR. This was the result of market losses on non-Federal securities held by RRB. The Railroad Retirement and Survivors Improvement Act of 2001 permitted assets of Tier II of the Railroad Retirement program to be invested in private equities. Net returns for FY 2008 on non-Federal securities, including unrealized gains and losses, were $2.9 billion lower than estimated in the MSR.

Undistributed Offsetting Receipts – Undistributed offsetting receipts were $278 billion in FY 2008, $16.8 billion below the MSR estimate. Offsetting receipts are deducted from gross outlays in calculating net outlays; therefore, reductions in these receipts increase outlays and the deficit. Proceeds from spectrum auctions related to the digital television transition were $15.1 billion less than estimated in the MSR. While total auction bids exceeded expectations, these bids are not recorded as receipts until license applications are approved and licenses are issued. The MSR assumed that licenses accounting for the bulk of the auction revenue would be issued in FY 2008, but only $1.8 billion of licenses were actually issued by the end of the fiscal year. The remaining licenses will be issued in FY 2009, at which point these offsetting receipts will be recognized, lowering net outlays and the deficit. Interest received by on- and off-budget trust funds was $2.9 billion lower than the MSR estimate, due primarily to lower-than-estimated interest earnings for the Civil Service Retirement and Disability Fund. Partially offsetting these lower receipts, employee contributions to the military retirement fund account were $1.6 billion above the MSR estimate. The actual collections exceeded the MSR estimate because the MSR underestimated contributions due to mobilized reservists.

-30-

[1][1] The September 2008 Monthly Treasury Statement of Receipts and Outlays of the United States Government containing these results can be found on the Financial Management Service website at www.fms.treas.gov/mts.

REPORTS
Table II
Table III

Statement by Secretary Henry M. Paulson, Jr. on Actions to Protect the U.S. Economy

October 14, 2008

HP-1205

Statement by Secretary Henry M. Paulson, Jr. on Actions to Protect the U.S. Economy

Washington, DC-- Treasury today issued the following statement by Secretary Henry M. Paulson, Jr. on actions to protect the economy and restore confidence and stability to our financial markets:

America is a strong nation. We are a confident and optimistic people. Our confidence is born out of our long history of meeting every challenge we face. Time and time again our nation has faced adversity and time and time again we have overcome it and risen to new heights. This time will be no different.

Today, there is a lack of confidence in our financial system – a lack of confidence that must be conquered because it poses an enormous threat to our economy. Investors are unwilling to lend to banks, and healthy banks are unwilling to lend to each other and to consumers and businesses.

In recent weeks, the American people have felt the effects of a frozen financial system. They have seen reduced values in their retirement and investment accounts. They have worried about meeting payrolls and they have worried about losing their jobs. Families all across our Nation have gone through long days and long nights of concern about their financial situations today, and their financial situations tomorrow. Without confidence that their most basic financial needs will be met, Americans lose confidence in our economy, and this is unacceptable.

President Bush has directed me to consider all necessary steps to restore confidence and stability to our financial markets and get credit flowing again. Ten days ago Congress gave important new tools to the Treasury, the Federal Reserve and the FDIC to meet the challenges posed to our economy. My colleagues and I are working creatively and collaboratively to deploy these tools and direct our powers at this disruption to our economy.

Today we are taking decisive actions to protect the US economy. We regret having to take these actions. Today's actions are not what we ever wanted to do – but today's actions are what we must do to restore confidence to our financial system.

Today I am announcing that the Treasury will purchase equity stakes in a wide array of banks and thrifts. Government owning a stake in any private U.S. company is objectionable to most Americans – me included. Yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable. When financing isn't available, consumers and businesses shrink their spending, which leads to businesses cutting jobs and even closing up shop.

To avoid that outcome, we must restore confidence in our financial system. The first step in that effort is a plan to make capital available on attractive terms to a broad array of banks and thrifts, so they can provide credit to our economy. From the $700 billion financial rescue package, Treasury will make $250 billion in capital available to U.S. financial institutions in the form of preferred stock. Institutions that sell shares to the government will accept restrictions on executive compensation, including a clawback provision and a ban on golden parachutes during the period that Treasury holds equity issued through this program. In addition, taxpayers will not only own shares that should be paid back with a reasonable return, but also will receive warrants for common shares in participating institutions. We expect all participating banks to continue and to strengthen their efforts to help struggling homeowners who can afford their homes avoid foreclosure. Foreclosures not only hurt the families who lose their homes, they hurt neighborhoods, communities and our economy as a whole.

While many banks have suffered significant losses during this period of market turmoil, many others have plenty of capital to get through this period, but are not positioned to lend as widely as is necessary to support our economy. Our goal is to see a wide array of healthy institutions sell preferred shares to the Treasury, and raise additional private capital, so that they can make more loans to businesses and consumers across the nation. At a time when events naturally make even the most daring investors more risk-averse, the needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it.

Nine large financial institutions have already agreed to participate in this program. They have agreed to sell preferred shares to the US government, on the same terms that will be available to a broad array of small and medium-sized banks and thrifts across the nation. These are healthy institutions, and they have taken this step for the good of the U.S. economy. As these healthy institutions increase their capital base, they will be able to increase their funding to U.S. consumers and businesses.

I am joined here this morning by Chairman Bernanke and Chairman Bair, who have also taken extraordinary actions to support investor confidence in our financial system, so that funds will again flow through our banks to the U.S. economy. Each of them will describe their actions.
Combined, our actions are extensive, powerful and transformative. They demonstrate that the government will do what is necessary to restore the flow of funds on which our economy depends and will act to avoid, where possible, the failure of any systemically important institution.

These three steps significantly strengthen financial institutions and improve their access to funding, enabling them to increase financing of the consumption and business investment that drive U.S. economic growth. Market participants here and around the world can take confidence from the powerful actions taken today and our broad commitment to the health of the global financial system.

We are acting with unprecedented speed taking unprecedented measures that we never thought would be necessary. But they are necessary to get our economy back on an even keel, and secure the confidence and future of our markets, our economy and the economic well-being of all Americans.

FRB Press Release: Chairman Ben S. Bernanke Remarks At the President’s Working Group Market Stability Initiative Announcement

Chairman Ben S. Bernanke
Remarks
At the President’s Working Group Market Stability Initiative Announcement
October 14, 2008

Good morning. Before I begin, I want to express my appreciation of my colleagues, Secretary Paulson and Chairman Bair, for their efforts in what has been an extraordinary collaboration. As Americans well know, the challenges evident in the financial markets and in the economy are large and complex, but I believe that the steps taken today will help us to overcome them. Our strategy will continue to evolve and be refined as we adapt to new developments and the inevitable setbacks. But we will not stand down until we have achieved our goals of repairing and reforming our financial system and thereby restoring prosperity to our economy.

Over the past year, the Federal Reserve has actively used all its powers and authorities to try to help our economy through this difficult time. And central banks around the world have consulted closely and cooperated in unprecedented ways to reduce strains in financial markets and to bolster our economies. We will continue to do so. However, clearly the time had come for a more comprehensive and broad-based solution.

History teaches us that government engagement in times of severe financial crisis often arrives very late, usually at a point at which most financial institutions are insolvent or nearly so. Waiting too long to act has usually led to much greater direct costs of the intervention itself and, more importantly, magnified the painful effects of financial turmoil on households and businesses. That is not the situation we face today. Fortunately, the Congress and the Administration have acted at a time when the great majority of financial institutions, though stressed by highly volatile and difficult market conditions, remain capable of fulfilling their critical function of providing new credit for our economy. The Congress's prompt and decisive action in passing the financial rescue legislation made possible the critical steps that have been announced this morning. I also find it heartening that we are seeing not just a national, but a global response to the crisis, commensurate with its global nature. Indeed, this past weekend, the finance ministers and central bankers of the Group of Seven industrialized countries announced a set of principles embodying a comprehensive approach to dealing with the crisis. The steps we are taking today are fully consistent with those principles.

As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets, which has had cascading and unwelcome effects on the availability of credit and the value of savings. The actions today are aimed at restoring confidence in our institutions and markets and repairing their capacity to meet the credit needs of American households and businesses. The voluntary equity purchase program will strengthen financial institutions' capacity and willingness to lend. The guarantee of the senior debt of all FDIC-insured depository institutions and their holding companies will restore the confidence of these institutions' creditors and reinvigorate the crucial inter-bank lending markets. Additionally, the Federal Reserve is pressing forward with its facility to provide a broad backstop for the commercial paper market, so vital to the functioning of our businesses.

Policymakers here and around the globe have taken a series of extraordinary steps. Americans can be confident that every resource is being brought to bear: historical understanding, technical expertise, economic analysis, and political leadership. I am not suggesting the way forward will be easy. But I strongly believe that the application of these tools, together with the underlying vitality and resilience of the American economy, will help to restore confidence to our financial system and place our economy back on a path to vigorous, healthy growth.

FRB Press Release:Commercial Paper Funding Facility

Press Release

Release Date: October 14, 2008
For release at 8:30 a.m. EDT

The Federal Reserve Board on Tuesday announced additional details regarding the Commercial Paper Funding Facility (CPFF), including that it would begin funding purchases of commercial paper on October 27, 2008.

The Board authorized the CPFF on October 7, 2008 under Section 13(3) of the Federal Reserve Act to provide a liquidity backstop to U.S. issuers of commercial paper. The CPFF is intended to improve liquidity in short-term funding markets and thereby increase the availability of credit for businesses and households.

Under the CPFF, the Federal Reserve Bank of New York will finance the purchase of unsecured and asset-backed commercial paper from eligible issuers through its primary dealers. The CPFF will finance only highly rated, U.S. dollar-denominated, three-month commercial paper.
The attached terms-and-conditions and questions-and-answers documents describe the terms and operational details of the facility, which were determined after consultation with commercial paper issuers and dealers.

Commercial Paper Funding Facility
Terms and conditionsFAQs
2008 Monetary Policy Releases

Treasury Announces TARP Capital Purchase Program Description

October 14, 2008
HP-1207

Treasury Announces TARP Capital Purchase Program Description

Washington- Treasury today announced a voluntary Capital Purchase Program to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy.

Under the program, Treasury will purchase up to $250 billion of senior preferred shares on standardized terms as described in the program's term sheet. The program will be available to qualifying U.S. controlled banks, savings associations, and certain bank and savings and loan holding companies engaged only in financial activities that elect to participate before 5:00 pm (EDT) on November 14, 2008. Treasury will determine eligibility and allocations for interested parties after consultation with the appropriate federal banking agency.

The minimum subscription amount available to a participating institution is 1 percent of risk-weighted assets. The maximum subscription amount is the lesser of $25 billion or 3 percent of risk-weighted assets. Treasury will fund the senior preferred shares purchased under the program by year-end 2008. Institutions interested in participating in the program should contact their primary federal regulator for specific enrollment details.

The senior preferred shares will qualify as Tier 1 capital and will rank senior to common stock and pari passu, which is at an equal level in the capital structure, with existing preferred shares, other than preferred shares which by their terms rank junior to any other existing preferred shares. The senior preferred shares will pay a cumulative dividend rate of 5 percent per annum for the first five years and will reset to a rate of 9 percent per annum after year five. The senior preferred shares will be non-voting, other than class voting rights on matters that could adversely affect the shares. The senior preferred shares will be callable at par after three years. Prior to the end of three years, the senior preferred may be redeemed with the proceeds from a qualifying equity offering of any Tier 1 perpetual preferred or common stock. Treasury may also transfer the senior preferred shares to a third party at any time. In conjunction with the purchase of senior preferred shares, Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15 percent of the senior preferred investment. The exercise price on the warrants will be the market price of the participating institution's common stock at the time of issuance, calculated on a 20-trading day trailing average.

Companies participating in the program must adopt the Treasury Department's standards for executive compensation and corporate governance, for the period during which Treasury holds equity issued under this program. These standards generally apply to the chief executive officer, chief financial officer, plus the next three most highly compensated executive officers.

The financial institution must meet certain standards, including: (1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. Treasury has issued interim final rules for these executive compensation standards.

Nine large financial institutions already have agreed to participate in this program, moving quickly and collectively to signal the importance of the program for the system. These healthy institutions have voluntarily agreed to participate on the same terms that will be available to small and medium-sized banks and thrifts across the nation.

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REPORTS
Public Term Sheet

Federal Reserve Board of Governors Speeches & Press Releases

Recent Speeches

October 14, 2008
Chairman Ben S. Bernanke
Remarks
At the President’s Working Group Market Stability Initiative Announcement
October 7, 2008
Chairman Ben S. Bernanke
Current Economic and Financial Conditions
At the National Association for Business Economics 50th Annual Meeting, Washington, D.C.

Monetary Policy Press Releases

October 14, 2008
FOMC authorizes an increase in the size of its temporary reciprocal currency arrangement with the Bank of Japan
October 14, 2008
Minutes of Board discount rate meetings, August 18 through September 15, 2008
October 14, 2008
Board announces additional details regarding the Commercial Paper Funding Facility (CPFF)
October 14, 2008
Joint statement by Federal Reserve, U.S. Department of the Treasury, and Federal Deposit Insurance Corporation (FDIC)
October 13, 2008
Federal Reserve and other central banks announce further measures to provide broad access to liquidity and funding to financial institutions

Treasury Press Releases October 10-14, 2008

10/14/2008 Treasury Requests Public Input on Guaranty Program for Troubled Assets
10/14/2008 Joint Statement on FY 2008 Budget Results
10/14/2008 Treasury Hires Custodian Under Emergency Economic Stabilization Act
10/14/2008 Dep Sec Kimmitt Remarks at the Palestinian Business and Investment Forum
10/14/2008 U.S. Government Actions to Strengthen Market Stability
10/14/2008 Treasury Announces Executive Compensation Rules Under the EESA
10/14/2008 Treasury Announces TARP Capital Purchase Program Description
10/14/2008 Joint Statement by Treasury, Federal Reserve and FDIC
10/14/2008 Paulson Statement on Actions to Protect the U.S. Economy
10/13/2008 PWG Announcement on Market Stability Initiative
10/13/2008 Treasury and Infrastructure Consortium for Africa Host Africa Power Symposium
10/13/2008 Dep Sec Kimmitt Remarks on Policy Principles for SWFs and Recipient Countries to the USCIB
10/13/2008 Treasury Hires Investment Adviser Under the EESA
10/13/2008 Plenary Remarks by Asst Sec Lowery at Annual IMF and World Bank Meetings
10/13/2008 Interim Asst Sec Kashkari Remarks on Implementation of Economic Stabilization Act
10/12/2008 Paulson Statement at Development Committee Meeting
10/11/2008 Kimmitt Statement on IWG Agreement on Generally Accepted Principles and Practices for SWFs
10/11/2008 Secretary Paulson Statement at the IMFC Meeting
10/10/2008 Paulson Statement Following G7 Meeting
10/10/2008 G7 Plan of Action
10/10/2008 Joint Statement by Treasury Secretary Paulson and Education Secretary Spellings
10/10/2008 PWG Issues 4th Quarter Policy Statement Update
10/10/2008 Treasury Department Public Engagements Schedule
10/09/2008 Interim Asst. Sec. Kashkari to Deliver Remarks

US Senate Banking, Housing, and Urban Affairs Committee

US Senate Banking, Housing, and Urban Affairs Committee

http://banking.senate.gov/public/index.cfm?FuseAction=Articles.Home

October 2008
3rd - DODD STATEMENT ON HOUSE PASSAGE AND PRESIDENT'S SIGNATURE OF THE EMERGENCY ECONOMIC STABILIZATION ACT
1st - STATEMENT OF SENATOR DODD ON SENATE PASSAGE OF THE EMERGENCY ECONOMIC STABILIZATION ACT
1st - DODD ANNOUNCES LAUNCH OF HOPE FOR HOMEOWNERS PROGRAM
1st - EMERGENCY ECONOMIC STABILIZATION ACT OF 2008

CBO Director's Blog

http://cboblog.cbo.gov/?p=177
Source: CBO Director's Blog

Monthly budget review: FY 2008 deficit of $438 billion
October 7th, 2008
CBO released its Monthly Budget Review today. Based on data from the Daily Treasury Statements, CBO estimates that the federal budget deficit was about $438 billion in fiscal year 2008, $276 billion more than the shortfall recorded in 2007. (The Treasury Department will report the actual deficit for fiscal year 2008 later this month.)

Relative to the size of the economy, that deficit was equal to 3.1 percent of gross domestic product, up from 1.2 percent in 2007. (The average deficit over the preceding five years, 2002-2006, was 2.6 percent of GDP.) The $438 billion figure is about $31 billion more than the $407 billion deficit CBO projected this summer, primarily because revenues are lower than we anticipated and spending for defense and deposit insurance is turning out to be higher.

CBO estimates that receipts in 2008 were about $44 billion (or 1.7 percent) below receipts in 2007, falling from 18.8 percent of GDP in 2007 to about 17.7 percent of GDP in 2008. Corporate income taxes declined the most, falling by about $65 billion (18 percent), due largely to weakness in corporate earnings throughout the fiscal year. Individual income tax receipts declined by about $19 billion (or 1.6 percent) relative to receipts in fiscal year 2007, reflecting $62 billion in tax rebates (from the economic stimulus legislation) that were recorded as offsets to revenues. In contrast, receipts of social insurance (payroll) taxes rose by about $31 billion (or 3.5 percent), and other receipts increased by about $9 billion (or 5.4 percent).

Spending rose by about 8 percent. Contributing significantly to the growth in spending were outlays for tax rebates (those rebates that were recorded on the spending side of the budget because they exceeded the recipients’ income tax liability), for deposit insurance, and for national defense.

Speech: Repercussions from the Financial Shock

http://www.minneapolisfed.org/news_events/pres/stern10-09-08.cfm

Repercussions from the Financial Shock

Gary H. SternPresidentFederal Reserve Bank of Minneapolis
National Investor Relations InstituteMinneapolis, Minnesota October 9, 2008 [PDF]

Introduction

Over the past 14 months, many financial markets and large financial institutions have been buffeted by a severe financial shock, a shock unprecedented in my tenure as a Reserve Bank president. The disruptions intensified over the summer and persist to this day, despite considerable injections of liquidity on our part and other actions intended to ameliorate the situation. Indeed, the Federal Reserve has undertaken a wide range of extraordinary actions to respond to conditions in the financial markets over the last year or so. Given the tools available to the Federal Reserve and our mission, we have largely focused our efforts on increasing the availability of liquidity to financial institutions. Without trying to be comprehensive, I would note the following:

We have added liquidity by easing the terms of our discount window lending to traditional users including reducing prices and lengthening maturities for example. We have also rolled out new ways to provide this credit including auctioning it off. More dramatically we have allowed certain securities firms, the so-called primary dealers, to access our credit facilities. Finally, in two cases, we used our lending powers to facilitate the orderly resolution of financial firms whose failure otherwise posed systemic risks. I could point to other actions, such as increasing our coordinated lending of dollars with other central banks and prospective entry into the commercial paper market, but suffice it to say the Federal Reserve has responded to unprecedented times with equally unprecedented actions. And, of course, we have reduced the Federal funds rate target from 5 1/4 percent in September 2007 to 1 1/2 percent today.

Making progress against the turmoil at hand is certainly the top priority at this stage. But soon enough policymakers will want to identify fundamental reforms that reduce the likelihood that we will face another period of financial instability. In this spirit, in my comments this afternoon I want to consider the repercussions of this turmoil from two distinct perspectives: first, I want to discuss its implications for regulatory, supervisory, and financial stability policies going forward; and, second, I want to consider its implications for the current and prospective economic environment.

To preview my major themes, I will suggest that the too-big-to-fail (TBTF) problem, with which I have long been concerned, has been exacerbated by actions taken over the past year to bolster financial stability. These actions were fully appropriate against the background of the risks at hand, and it is essential that they succeed, but going forward they will require policies to address spillovers and to reduce the likelihood of full protection of uninsured creditors of large, complex financial institutions. I will elaborate specific proposals in a few minutes, but let me underscore one point: it is critical that we address TBTF because, if left unchecked, it could well be a major source of future instability.

As to economic prospects, I have been convinced for some time that financial conditions in the wake of the shock are reminiscent of, although certainly not identical to, those prevailing during the “headwinds” episode of the early 1990s. At the least, that experience provides a useful framework for analysis of the current state of the credit markets, the economy, and intermediate-term prospects. And before proceeding further, let me also remind you of the usual caveat: I am speaking only for myself and not for others in the Federal Reserve System.

The Expanded Safety Net and Too-Big-To-Fail

In our Bank's 2007 annual report, I expressed concern about the expansion of the safety net for large financial firms and, particularly, its potential to dull the market forces that would otherwise serve to constrain excessive risk taking. Although the annual report essay was released just a few months ago, the financial safety net has expanded appreciably since then. The dimensions of the too-big-to-fail problem have increased once again.

At the same time, however, there has been progress in beginning to develop a policy framework to address TBTF and to enhance market discipline. Policymakers have begun to focus more explicitly on minimizing the fallout, or “spillovers,” from a financial firm's impairment as they consider how to improve financial stability and to reduce the moral hazard incentives for excessive risk taking inherent in TBTF.

Naturally, I view these latter developments positively. In 2004 I co-authored, with Ron Feldman, a book entitled Too Big to Fail, the Hazards of Bank Bailouts. In that work, we emphasized that “policymakers should give highest priority to reforms limiting the chance that one bank's failure will threaten the solvency of other banks.” We came to that conclusion using the following logic:

Policymakers provide financial support to weak but systemically important financial firms to contain spillovers;

Reducing the fallout from financial firm failures undermines the principal rationale for extraordinary government support;

Creditor expectations of receiving government support will diminish (and market discipline will increase) as policymakers have less reason to provide such support.

This reasoning can contribute to agreement on a general policy framework to address TBTF, but such a framework is not a sufficient base for reform. Government agencies charged with addressing instability and related TBTF concerns, and private sector groups and firms critical to that effort, require specific recommendations. We have long had a list of specific reforms to address TBTF, but heretofore we have not prioritized those proposals. So of the many recommendations we made, where would we have policymakers start? We would begin the effort to manage TBTF with an approach we call systemic focused supervision (SFS).

Systemic Focused Supervision

In general, SFS attempts to focus supervision and regulation efforts on spillover reduction, and it consists of three pillars: early identification, enhanced prompt corrective action (PCA), and stability-related communication. In particular, SFS uses the information-gathering and analytical skills of supervisors to better understand how one firm's impairment might spread to other firms or markets; it relies on the enforcement capabilities of regulation (combined with market information) to close firms before they incur losses that could bring down their peers; and it extends central bank communication techniques to financial-stability-related efforts.
This program builds on the strength and current direction of supervision and regulation to focus across firms and on the interconnections in the banking and financial system as a whole, rather than concentrating on supervisory assessment of single firms. Combined, these efforts constitute important actions in a long-term effort to limit the spillovers from the failure or impairment of a systemically important financial institution. Let me now describe what I see as the basics of the three components.

Early Identification. This is a process to identify and to respond, where appropriate, to the material exposures between large financial institutions and between these institutions and capital markets. By material, we mean a sufficient exposure such that problems at one of these financial institutions could significantly impair other depository institutions and/or normal market functions.

Early identification could take many forms. Supervisors might begin by examining the performance of a number of large financial institutions subject to a series of shocks. The shocks could include large losses to a given type of loan or security on the firms' balance sheet, or a significant drop in the availability of funding. The results of this examination would provide policymakers with a sense of which stresses lead to significant problems at the firms. A second step is to determine how the material difficulties of one of these large institutions would affect the others. At a minimum, this would involve determining how much the failing institution owes the others at the end of the business day, what form the exposure takes, how much the exposure varies over time, and so on.

The goals of the exercise I just described (1) to give policymakers a sense of the type of events that are not likely to cause severe impairment, thus permitting them to avoid support and (2) to identify those exposures that might bring down the firm, and thus are deserving of closer policy scrutiny and response. As an essential part of this effort, supervisors should consider how they will make assessments of spillover potential at the time a financial institution experiences serious difficulty. Supervisors must determine what type of information they will need in short order from financial institutions during a period of turmoil, what information they can actually get, and develop a plan to address gaps that are identified. Closing these gaps means that policymakers can make informed judgments at the time of failure and, where possible, identify and resolve those issues that would otherwise lead to provision of extraordinary support.

Enhanced Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991 implemented PCA. Like many so-called “structured early intervention and resolution (SEIR)” regimes, PCA works by requiring supervisors to take prespecified actions against a bank as its capital falls below certain levels. A bank whose capital declines below a given level, for example, would have its ability to pay dividends constrained. In the extreme, chartering authorities will close banks whose capital levels fall below the lowest established trigger and who cannot raise additional capital.

Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way. If a bank's failure does not impose large losses, by definition it cannot directly threaten the viability of other institutions that have exposure to it. Thus, PCA is an important tool to manage systemic risk.

However, many observers, including some of the most zealous advocates of using a SEIR regime in the United States, view PCA as inadequate because it relies, in great part, on the so-called book value of capital. This capital measure, particularly for bank loans, often reflects a “rearview mirror” or historical assessment of the bank's assets. Such assessments may, at times, prove excessively generous. Using PCA triggers based on more forward-looking measures of bank solvency could help to address this shortcoming.

Data from financial markets offer one source of forward looking measures of a bank's condition; market participants do not always get their forecast right but they do appear to incorporate assessments of the future prospects of firms in their pricing decisions. This suggests that an enhanced PCA regime relying on both book value capital and market measures of risk—such as subordinated debt spreads, prices of credit default swaps, and/or equity values, among others—would enhance the current regime. In fact, the original proposals for SEIR in the U.S. used market measures of bank net worth to provoke supervisory action. In practice this could mean that some combination of market signals and accounting measures of insolvency could lead to the timely closure of a bank.

Incorporating market signals into PCA certainly has potential downsides. Like other reforms that increase market discipline, enhanced PCA may force firms into resolution, and potentially into the sale of troubled assets, precisely when the financial system seems most vulnerable. This observation suggests the need to average market measures over time to smooth out short-run volatility, or to rely on peer comparisons, for example, so as to avoid overreaction. I would also note that enhanced PCA assumes a bank-like resolution regime, something that does not yet exist outside of the banking venue.

Communication. The first two pillars of SFS seek to focus supervision and to increase market discipline. But creditors will not know about efforts to limit spillovers, and will not change their expectations of support, absent explicit communication by policymakers about these activities.

What form might that communication take?

In general, we have suggested that this communication possess several attributes. First, it should be released routinely, like the semi-annual Humphrey-Hawkins testimony, so that interested parties can rely on it. Second, it should disclose information on stability related activity at an early stage, even if it is work in progress. Such a strategy would provide creditors with a richer sense of the changes underway. Finally, we think the communication should explicitly link the activity underway to the goal of reducing spillovers, thus raising the feasibility and prudence of putting creditors at greater risk of loss.If we take a step back and reflect on these proposals, at the end of the day SFS is all about preparation—preparation from two distinct, but closely-related, perspectives. The underlying idea is, before severe problems arise, to identify potential vulnerabilities and spillovers, and to select market signals to enhance PCA. And, secondly, specific, regular communication is necessary to prepare creditors for the change in regime and to encourage changes in their expectations and behavior.

The general cross-institution focus of SFS has similarities to what is often called macro prudential supervision. But just as I view SFS as building on current trends in safety and soundness supervision, effective SFS must have a strong foundation in the supervision of an individual financial institution, what some call “micro prudential supervision.” Implementation of SFS requires supervisory staff to maintain a strong grasp of the operational activities and the inherent risk profile of the financial institutions they supervise as well as the risk management systems these firms employ. Put another way, I think SFS has the best chance of meeting objectives if it becomes part and parcel of core supervisory operations; I have some concern about the value of SFS if it becomes an appendage to “routine” supervision carried out by macro prudential specialists.

Carrying out early identification, for example, requires a detailed understanding of how large financial institutions conduct their business, strong grasp on the financial reporting/MIS of the financial institutions under review, clear and routine communication with their management, and sufficient supervisory experience to evaluate the data/information provided by the financial institution. Enhanced PCA will maintain a supervisory capital measure. This requires supervisory evaluation of a financial institution's capital position which necessitates reviews of asset quality and the allowance for loan losses, among other items. Even robust communication will benefit from integration with institution specific supervision.

Headwinds and the Economy

Let me now move onto the second topic, namely the implications of the past year of financial turmoil for the economy. I suggested at the onset that a useful framework for thinking about this issue was the headwinds episode of the early 1990s. In that period, credit became expensive and, in some cases, unavailable, even for relatively high quality borrowers. These credit conditions restrained consumer spending and business investment, and as a consequence, the recovery from the recession of 1990-91 was initially quite subdued. Eventually, of course, the economy performed very well over much of the 1990s, despite a rather rocky start.

I think that today's circumstances align, although not perfectly, with the experience of the early 1990s. There is no doubt that a variety of potential borrowers are finding funding more difficult and expensive to obtain. Moreover, while there was a significant contraction in residential construction activity in the late 1980s and early 1990s, the recent correction in this sector has been more severe, especially with the decline in housing values, and is continuing.

It is important to bear in mind, however, that many “initial conditions” prevailing prior to this financial shock were perceptibly better than in the early 1990s. Unemployment, interest rates, and inflation were all lower at the outset of the latest period of turmoil than in the previous headwinds episode. Equally important, the financial condition of both most banking and nonfinancial businesses was relatively healthier at the onset of recent problems.

In my judgment, the 1990s headwinds episode continues to provide a valuable reference point for thinking about economic prospects. For the near-term, I think that this framework suggests further declines in employment and likely softness in consumer spending, with a diminution of inflation, absent a resurgence in energy and other commodity prices.

It is worth recalling that the recession of 1990-91 was brief but not especially mild. Depending on how one reads the data, headwinds restrained the pace of the ensuing expansion of the early 1990s from 12 to 36 months. Something similar is certainly conceivable today. However, in considering these prospects, we should note that, despite early challenges, the 1990s turned out to be an excellent decade for the U.S. economy by almost all metrics. The underlying flexibility and resilience of the economy are intact, and these characteristics should ultimately prevail.

Conclusion

Let me quickly wrap this up, before turning to your comments and questions. I have commented on two significant repercussions of the major financial shock which first struck the economy about 14 months ago. First, in view of what we have seen at some large financial institutions and in some funding markets, the need to address TBTF through a framework which reduces spillovers is critical, and we propose systemic focused supervision as a constructive first step in this process. Second, given the headwinds associated with the financial shock, the economy appears likely to be restrained until these conditions improve, and that will take some time.