Deciphering the Liquidity and Credit Crunch 2007–2008

Claims Supported by This Source

1. Mortgage losses, while large in absolute terms at several hundred billion dollars, were small compared to the $8 trillion in U.S. stock market value lost between the peak in October 2007 and October 2008. This paper explains why these losses were amplified.
2. Premise: A low-interest-rate environment (capital inflows from Asia and Fed interest rate policy) and the shift from "originate-to-hold" to "originate-to-distribute" banking. Securitization (pooling and tranching), CDS (notional principal in 2007 estimated to be between $45–62 trillion).
3. Shortening of maturities: SIVs and conduits raised funds with ABCP averaging 90 days and medium-term notes of just over one year, relying on liquidity backstops from sponsor banks. The ratio of overnight repos to total assets for investment banks roughly doubled from 2000 to 2007.
4. Record of events: February 2007, increase in subprime delinquencies; May 4, UBS closes Dillon Read; mid-June, Bear injects $3.2 billion into two funds; July, ABCP market dries up and IKB bailout (€3.5 billion); July 31, American Home Mortgage; August 9, BNP Paribas freezes three funds, ECB supplies €95 billion, Fed supplies $24 billion; ABCP rate 5.39% → 6.14% (August 8–10).
5. August 17, 2007, discount rate 5.75%; September 18, FF rate 4.75%; December 11, 25bp cut; December 12, TAF established. January 19, 2008, Ambac downgrade; January 22, emergency 75bp cut to 3.5%; January 30, another 50bp.
6. Bear Stearns: March 11, TSLF announced for $200 billion; March 11–12, a misunderstanding about a delay in Goldman's novation of contracts leaks, making it unable to obtain funds in the overnight repo market. Over the weekend, JPMorgan acquires it for $2/share (later $10), the NY Fed provides a $30 billion loan, the discount rate is cut from 3.5 to 3.25%, and the discount window is opened to investment banks for the first time with the PDCF.
7. July 11, 2008, IndyMac fails; September 7, Fannie Mae and Freddie Mac placed under conservatorship (a credit event for CDS). Over the weekend of September 12–14, potential buyers demand a government guarantee, which the Treasury and Fed do not provide, and Lehman files for bankruptcy early Monday morning. Merrill sells itself to Bank of America for $50 billion on Sunday. September 16, AIG receives $85 billion and an 80% stake (an additional $37 billion in October and $40 billion in November).
8. Contagion from Lehman's failure: MMF losses ("breaking the buck") and the Treasury's MMF guarantee, soaring CDS prices, a sharp drop in financial CP, and the creation of the CPFF. On September 19, the Treasury Secretary proposes a $700 billion plan. The Fed's balance sheet grows from about $1.2 trillion in November 2007 to about $2.3 trillion in December 2008; on December 16, the target rate is set to 0–0.25%.
9. Amplification mechanism (1) Borrower balance sheets: Loss spiral (e.g., with 10x leverage, a 5% drop in assets forces a halving of holdings) and margin/haircut spiral. Reasons for rising margins after price drops: increased volatility, adverse selection, and volatility measured with historical data.
10. (2) Lending channel: Moral hazard in monitoring and precautionary hoarding of funds (the 2007–08 interbank market is a textbook example). (3) Runs: Refusal to roll over ABCP, Bear (hedge fund withdrawals), AIG (a "margin run" from CDS collateral calls). (4) Network effects: Positions that could be netted out are not due to counterparty risk; investment banks bought each other's CDS from September 15–19 after Lehman's failure.
11. Conclusion: The trigger was an increase in delinquencies due to a nationwide fall in house prices. This crisis was close to a "classic banking crisis"; what was new was the opaque web of interconnected obligations created by the spread of securitization. The externalities of fire sales and network effects create incentives for institutions to take on too much leverage, too much maturity mismatch, and become too interconnected.
12. "In early 2007, many observers were concerned about the dangers of a liquidity bubble/credit bubble, but were reluctant to bet against it." Cites the Citigroup CEO's remark on July 10, 2007 (as long as the music is playing, you've got to get up and dance).

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