The Fed did, in fact, dramatically increase the size of the monetary base in late 2008. It had taken 165 months (almost 14 years) for the monetary base to double...By January 1, 2009, the monetary based had doubled again in only five months.

This should have worked. The application of this amount of monetary "gas" should have nipped the recession in the bud and even produced an inflationary boom. The reason that it did not was that, on October 6, 2008, the Fed hit the monetary brakes by announcing that it would start paying interest on reserves (IOR) for the first time in its 95-year history.

The available data indicates that it was the Fed's IOR program, not the collapse of Lehman Brothers on September 15, 2008, that crashed the real economy and sent unemployment skyrocketing. Because the two events were only three weeks apart, many people believe that it was the Lehman bankruptcy that precipitated the worst economic downturn since the Great Depression. However, the market data from that period suggests strongly that the real cause was IOR.

...the day that the Fed announced IOR [Oct 6 - B], the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.
...

Now, because the market players have the alternative of buying or selling Treasury securities, the financial markets also arbitrage all other investment opportunities against the Treasury yield curve on the basis of maturity, liquidity, and credit risk. If market players (e.g., banks) saw corporate bonds or small business loans as being more attractive investments, on the margin, than Treasuries, they would sell Treasuries and buy the other investments until interest rates adjusted so that this was no longer the case. Accordingly, we can be sure that banks currently view making an incremental loan as no more (or less) attractive than buying a 90-day T-bill paying 0.12% interest.
...

In the absence of IOR, there is an incentive for anyone who receives a dollar to immediately pass it on by doing another transaction. There is also an incentive for banks to lend out their excess reserves. This lending produces a "money multiplier" effect that amplifies the impact of the creation of new dollars. If enough new dollars are created and enough new transaction chains are initiated, some of the transactions will involve items that show up in GDP. This is the basic mechanism by which an increase in the supply of money creates demand.

The payment of IOR at an "above market" interest rate (which has been the case for the past two years) short-circuits the processes described above. IOR creates a "roach motel" for money - the dollars go in and they don't come out
...

Now, here is the problem. Under IOR, the Fed is currently paying 0.25% on what amounts to a one-day T-bill. This is far above the current Treasury yield curve. ...

Accordingly, there is no more attractive investment available to the market than bank reserve deposits at the Fed. [and QE2 will only magnify this - B]...

Therefore, as soon as a new dollar is created via QE, it goes into bank reserves and then it just sits there. No endless chain of transactions is initiated, no loans get made, no "money multiplier effect" occurs, and no new demand is created.

Now comes a new study from the National Bureau of Economic Research that says, quite bluntly. that the CRA played a major role.

In the academic world, mealy-mouthed delivery of even powerful conclusions is the norm, so it's refreshing to see authors Sumit Agarwal, Efraim Benmelech, Nittai Bergman, Amit Seru answer the title's question, "Did the Community Reinvestment Act (CRA) Lead to Risky Lending?," with the clear, "Yes, it did. ... We find that adherence to the act led to riskier lending by banks." The full abstract reads:

Yes, it did. We use exogenous variation in banks’ incentives to conform to the standards of the Community Reinvestment Act (CRA) around regulatory exam dates to trace out the effect of the CRA on lending activity. Our empirical strategy compares lending behavior of banks undergoing CRA exams within a given census tract in a given month to the behavior of banks operating in the same census tract-month that do not face these exams. We find that adherence to the act led to riskier lending by banks: in the six quarters surrounding the CRA exams lending is elevated on average by about 5 percent every quarter and loans in these quarters default by about 15 percent more often. These patterns are accentuated in CRA-eligible census tracts and are concentrated among large banks. The effects are strongest during the time period when the market for private securitization was booming.

According to a IBD summary:

"We want your CRA loans because they help us meet our housing goals," Fannie Vice Chair Jamie Gorelick beseeched lenders gathered at a banking conference in 2000, just after HUD hiked the mortgage giant's affordable housing quotas to 50% and pressed it to buy more CRA-eligible loans to help meet those new targets. "We will buy them from your portfolios or package them into securities."
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Note that the authors of the study caution that their work here may actually understate the impact of the CRA. How? Because the study assumes that the major impact of CRA took place when banks were undergoing examination regarding their compliance with CRA goals. If banks found it difficult to shift gears in preparation for such exams, they may have altered their overall behavior to satisfy politicians and regulators. Or, as the authors put it in their conclusion, "If adjustment costs in lending behavior are large and banks can’t easily tilt their loan portfolio toward greater CRA compliance, the full impact of the CRA is potentially much greater than that estimated by the change in lending behavior around CRA exams."

The housing meltdown and the Great Recession. Something else for which you can thank the feds.

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