On Thursday, the New York Fed announced that, after nearly four years, it had sold off all the securities in the Maiden Lane III portfolio , which had been set up to rescue AIG. And they did so at a profit of "approximately $6.6 billion." At Econbrowser , James Hamilton has taken this occasion to "review the various measures that the Fed implemented over the last 5 years." Hamilton: I was surprised to see that the Fed ended up making a profit on AIG-- my understanding had been that the Fed's strategy had been to mark these down at a loss over time. I was unable to discover the details of how this ended up favorably for the Fed. Thursday's statement indicates that more information will be provided on November 23. But the fact that the Fed ended up making a profit from these transactions is an important detail. The key uncertainty for policy makers at the time (just as it is the key dilemma for the ECB at the moment) was determining whether the crisis is one of illiquidity or insolvency. If the problem is just that assets are temporarily undervalued as a result of the financial panic (i.e., the assets are temporarily illiquid), the central bank can solve the problem by stepping in as a lender of last resort. If instead the problem is that the assets are correctly valued (i.e., the borrowers are fundamentally insolvent), all the central bank can do is transfer these losses from existing creditors to the taxpayer (possibly in the form of an inflation tax). A key indication that the central bank did exactly the right thing is if, as a result of their stepping in, the long-run value of the asset is restored, in which case the Fed would end up making a profit out of the transaction. Some have criticized the Fed's emergency lending on the grounds that the Fed took all these extraordinary actions and yet the economy still performed very badly in 2008:Q4 - 2009:Q2. I think this misses the point. I don't believe that it was ever within the Fed's (or anyone else's power) to bring the economy quickly back to full employment. Instead, the purpose of the Fed's emergency lending was to prevent a very bad situation from becoming even worse than it needed to be. The evidence we now have suggests that the Fed indeed accomplished exactly this. See for example the recent post-mortems by Adrian and Schaumburg on the CPFF and the PDCF. But let me now return to the first graph (below) to briefly discuss what I see as a very different strategy that the Fed has been following since winding down these emergency lending programs. The Fed replaced the emergency lending with significant growth in its holdings of U.S. Treasury securities, debt issued by Fannie Mae and Freddie Mac, and mortgage-backed securities guaranteed by Fannie and Freddie. These are fundamentally very different from the aggressive lending in the fall of 2008 in that they involved no new transfer of private risk to the taxpayers. The reason is that, before the Fed bought any agency debt or MBS, the U.S. Treasury had already assumed financial responsibility for these agency obligations. Rather than trying to serve as lender of last resort, these more recent measures (sometimes referred to as "QE1" and "QE2") were instead just intended to help keep long-term borrowing costs low and to make sure that the U.S. did not experience a Japanese-style deflation. Read U.S. monetary policy since the financial crisis here .
Filed under: Federal Reserve, monetary policy, bailouts, aig, James Hamilton, Econbrowser, financial crisis, financial crises, New York Fed, William Dudley, 2008, Maiden Lane III