The signature event of this financial crisis was the “run,”
“panic,” “flight to quality,” or whatever you choose to call it,
that started in late September of 2008 and receded over the
winter. Short-term credit dried up, including the normally
straightforward repurchase agreement, inter-bank lending,
and commercial paper markets. If that panic had not occurred,
it is likely that any economic contraction following the housing
bust would have been no worse than the mild 2001 recession
that followed the dot-com bust….
Why was there a financial panic? There were two obvious precipitating
events: the failure of Lehman Brothers investment
bank in the context of the Bear Stearns, Fannie Mae, Freddie
Mac and AIG bailouts; and the chaotic days in Washington surrounding
the passage of legislation establishing the Troubled
Asset Relief Program (TARP).
Why would Lehman’s failure cause a panic? Why, after
seeing Lehman go to bankruptcy court, would people stop
lending to, say, Citigroup, and demand much higher prices for
its credit default swaps (insurance against Citi failure)?
Nothing technical in the Lehman bankruptcy caused a panic.
The usual “systemic” bankruptcy stories did not happen: We
did not see a secondary wave of creditors forced into bankruptcy
by Lehman losses. Most of Lehman’s operations were
up and running in days under new owners. Lehman credit
default swaps (CDSs) paid off. Sure, there was some mess–
repos in the United Kingdom got stuck in bankruptcy court,
some money market funds “broke the buck” and had to borrow
from the Fed– but those issues are easy to fix and they
do not explain why Lehman’s failure would cause a widespread
panic. What is more, Lehman’s failure did not carry any news
about asset values; it was obvious already that those assets were
not worth much and illiquid anyway.
We are left with only one plausible explanation for why
Lehman’s failure could have had such wide-ranging effect:
After the Bear Stearns bailout earlier in the year, markets
came to the conclusion that investment banks and bank
holding companies were “too big to fail” and would be bailed
out. But when the government did not bail out Lehman, and
in fact said it lacked the legal authority to do so, everyone
reassessed that expectation. “Maybe the government will not,
or cannot, bail out Citigroup?” Suddenly, it made perfect
sense to run like mad….
Let us go back one step further.
Why did Lehman fail–
along with Fannie Mae,
Freddie Mac, AIG, Wamu,
and very nearly Citigroup
and Bank of America? Here
is where I part company on
the usual worries about bubbles,
imbalances, silly mortgages,
and so on.
The underlying decline in
wealth from the housing
bust was not that large….
Most estimates put subprime losses around
$400 billion. The stock market absorbs losses like that in days.
But it turned out that housing risks are spread very differently
from stock market risks.
The difference is that mortgages were held in very fragile
financial structures. An extreme example: many mortgages
were pooled into securities, and the securities were held in
special purpose vehicles (SPVs), funded by rolling over short term
commercial paper with an off-the-books credit guarantee
from a large bank. Less extreme: when Bear Stearns
failed, it was holding a large portfolio of mortgage-backed
securities (MBSs) funded at 30-to-1 leverage by overnight
debt. In both cases, when the mortgages lose value, the debt-holders
refuse to renew their loans and the whole thing
blows up. In contrast, when your (and my) pension account
loses value, we cannot run for the exits and try to make
someone else hold the losses.
John raises a number of interesting points. But I must say that I put more weight than he does on “the usual worries about bubbles,
imbalances, silly mortgages,
and so on.” The problem is not just the fragility of the system in 2008, but the huge flows of capital into these devices in the years leading up to the crisis. U.S. home mortgage debt grew much more quickly than income, with almost $8 trillion in gross new U.S. household mortgage debt issued between 2004 and 2006 alone.
A graph of real home prices is remarkable not just for the dramatic descent since 2006 (which began two years before John picks up the story) but moreover for the meteoric rise between 2000 and 2005.
My view is that there were very serious problems with the U.S. financial system prior to 2008. But I think John has correctly described part of the reason why the failure of Lehman was such an important event.