“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing” Chuck Prince, former CEO of Citigroup

Panic (see Brunnermeier 2009):

The music stops:

Banks had moved from “originate and hold” to “originate and distribute”. Due to securitisation, moral hazard problems arose of careless loans being made to everyone and anyone (even those with no income) through risk shifting and because house prices were considered to keep rising. As mortgage defaults rose, write downs increased. Mortgage related securities became very difficult to price and the market for asset backed commercial paper (ABCP) fell away. SIVs dried up and liquidity backstops took them out of the shadows and on to banks' balance sheets.

Interbank fear:

The TED spread ("risk indicator") shot up on the 9^th August 2007 (BNP Paribas moment), until the 20^th, then calmed down before soaring after the collapse of Lehman’s to a staggering 463 basis points on 10^th October 2008 (during the boom years it was around 20-30bp). The uncertainty of counterparty risk meant interbank rates increased and eventually the banks preferred to hoard liquidity. A loss spiral arose where funding problems forced banks to reduce their assets, leading to fire sales and therefore higher margins. Margin spirals caused banks to deleverage, worsening the problems further.

                                          Picture courtesy of Dreamstime

Government intervention:

Government bailouts were targeted as those institutions too interconnected to be allowed to fail (e.g. Fannie Mae, Freddie Mac and AIG), where a default would have led to huge write offs by other institutions further hurting the system.

Aftermath:

Chaos; the butterfly effect:

Due to the interconnectedness of the money markets, defaults in Ohio turned up on balance sheets across the Atlantic (through subsidiaries and securitisation). America and Europe had moved in tandem over the decade, with low interest rates fuelling growth. The subsequent interest rate hikes to curb inflation facilitated domestic property bubbles bursting (e.g. Ireland). The asset side of banks’ balance sheet was hit with defaults and the liability side was hit with problems in the interbank market. Economies slowed, governments bailed out banks (e.g. RBS in UK) and soon countries experienced huge sovereign debt problems. Austerity became the new focus and economies have been aching ever since (UK unemployment rate is currently the highest for 16 years). The interconnectedness of European banks holding each other’s sovereign debt means a default such as that of Greece could cause severe contagion. Until Greece is sorted the markets remain cautious. China is artificially keeping growth high, but new buildings are lying empty and trade with Europe and America has weakened. Next week’s post looks at the causes of the Chinese housing bubble.