Ten years after the Panic of 2007-8, there’s still major disagreement about what caused the financial crisis and the Great Recession.
That’s the sobering revelation in a flurry of commentary written for the 10th anniversary of the Lehman bankruptcy. Lehman filed on Sept. 15, 2008, and that’s generally considered to be the day the crisis erupted, although a panic had been building since early 2007.
From Yale professor Gary Gorton:
Ten years after the crisis began in the first quarter of 2007, there is no consensus on the cause of the crisis. Explanations abound. It is unfortunate that there is a lack of data on the shadow banking system, which makes it difficult to understand what happened.
This confusion matters. It matters a lot. Because we can’t fix, and we can’t prevent, what we don’t understand.
According to top experts including Gorton, the Panic of 2007-8 was a run on shadow banks. Lenders, whose short-term loans to those banks had helped finance the housing boom, panicked when housing collapsed and demanded that the shadow banks immediately return their money.
When these lenders “ran,” credit dried up and that caused the Great Recession. It was similar to the runs by depositors on commercial banks in the era of the stock market crash of 1929, which led to the Great Depression.
But many Americans don’t know this, and some prominent economists and financiers dispute it.
The debate comes down to this: Was the painful Great Recession caused by the collapse of bloated housing prices or by the collapse of the risky lending to shadow banks that financed the bloated housing prices?
What follows is a look at this important national conversation, in this order:
- One view: The Panic of 2007-8 was about runs on shadow banks
- Another view: The Panic of 2007-8 was about housing
- The view from the press
- The RepoWatch view
(RepoWatch editor’s note: To jump around, search for those exact words.)
One view: The Panic of 2007-8 was about runs on shadow banks
As RepoWatch readers know well, the panic was explained as a run on the repurchase market by Yale economist Gorton at Federal Reserve conferences in 2008 and 2009. In speeches in 2008 Federal Reserve Chairman Ben Bernanke and then-New York Fed President Timothy Geithner, who both had front-row seats to the crisis, also described the panic as shadow bank runs, especially on the tri-party repurchase market. Said Geithner:
The scale of long-term risky and relatively illiquid assets financed by very short-term liabilities made many of the vehicles and institutions in this parallel financial system vulnerable to a classic type of run, but without the protections such as deposit insurance that the banking system has in place to reduce such risks.
Many students of the financial panic have accepted this understanding (including your RepoWatch editor) and believe the bank bailouts that followed the Lehman bankruptcy were necessary to stop the runs and prevent a Great Depression.
In 2013 Yale University created its Program on Financial Stability to train regulators to respond to financial panics. Bernanke, Geithner and former U.S. Treasury Secretary Henry Paulson Jr. are on the advisory board. A pivotal class, taught by Geithner and program founder Andrew Metrick, is available free online, to spread understanding.
But some politicians, regulators, journalists and – therefore – Americans think of the crisis the way they first heard it described and personally experienced it, as an explosion in risky subprime lending, a housing bubble that burst, a madhouse of derivatives, corrupted credit rating agencies, households drowning in debt, trillions of dollars of losses in mortgage-backed securities, six to eight million foreclosures, duplicitous Wall Street traders and too-big-to-fail banks.
(All of that is true, of course, but “run-ners” would say it stops short of the next critical step, which was when the housing problems triggered runs on shadow banks and that ignited the panic.)
Many Americans are still furious that Congress and regulators bailed out banks instead of homeowners. That public anger led Congress to restrict future bailouts, a scenario so frightening to Bernanke and others who understand the dynamics of a financial panic that this year they launched a 10th-anniversary campaign to explain why the emergency powers they used in 2008 to stop runs were critical to preventing another Great Depression.
Their message: Our crisis tools must be reinstated. (RepoWatch editor’s note: See also Connectedness and Contagion by Hal S. Scott, published by The MIT Press, 2016.)
On September 5 the Yale program published Ten Years after the Financial Crisis: A Conversation with Timothy Geithner. Metrick asked and Geithner answered 28 questions like these:
–Why did the Fed help prevent the failure of Bear Stearns?
–Lehman got into trouble and you were not able to prevent its failure as you had Bear’s. Why?
–How important was Lehman as a cause of the crisis?
–Was the fallout from Lehman worse than you had expected?
–After Lehman failed you saved AIG. Why AIG and not Lehman?
Geithner ended the interview with his concern about the loss of panic-fighting tools:
Congress took away a range of important powers that will be essential in any future crisis, limiting the Fed’s lending facilities in an emergency and the FDIC’s and the Treasury’s abilities to provide broader guarantees.
On balance, the stronger regulations on risk taking combined with the new resolution authority should create a stronger financial system …. But they … cannot protect against the most severe systemic financial crisis. That would require a broader range of emergency firefighting authority like we used in late 2008 and 2009 ….
On September 7 Bernanke, Geithner and Paulson had an opinion piece in the New York Times entitled “What we need to fight the next financial crisis: Congress has taken away some of the tools that were crucial to us during the 2008 panic. It’s time to bring them back.“
Even if a financial crisis is now less likely, one will occur eventually. To contain the damage, the Treasury and financial regulators need adequate firefighting tools. After the crisis, Congress gave regulators some promising new authorities to help them manage the failure of an individual financial institution …. But in its post-crisis reforms, Congress also took away some of the most powerful tools used by the FDIC, the Fed and the Treasury.
Among these changes, the FDIC can no longer issue blanket guarantees of bank debt as it did in the crisis, the Fed’s emergency lending powers have been constrained, and the Treasury would not be able to repeat its guarantee of the money market funds. These powers were critical in stopping the 2008 panic….
We need to make sure that future generations of financial firefighters have the emergency powers they need to prevent the next fire from becoming a conflagration.
On September 10 the Yale program released its 86-page definitive report on the crisis, Charting The Financial Crisis, showing that between 2007 and 2010 the Federal Reserve, the Federal Deposit Insurance Corporation and the U.S. Treasury poured more than $6 trillion in commitments and guarantees into the worldwide financial markets to stop runs and keep credit flowing. As a result, by the middle of 2009 the economy had begun a slow recovery and, by the way, the programs made a profit. Officially, the Great Recession lasted 18 months. That was different from the Crash of ’29, when federal officials declined to intervene and the Great Depression lasted 12 years.
On September 11-12 the Brookings Institution and the Program on Financial Stability at Yale hosted a two-day conference, Responding to the Global Financial Crisis: What we did and why we did it. An initiative led by Bernanke, Geithner and Paulson had commissioned papers by people who designed the rescue of the financial markets in 2007-2008. The authors were asked to answer: Why and how did they do it?
The conference featured presentation of some of those papers and a 1½-hour interview of Bernanke, Geithner and Paulson by New York Times reporter Andrew Ross Sorkin. In the interview the trio discussed their concern about the cutback in emergency powers. Watch the video here.
On September 13 Bernanke, now a Distinguished Fellow at the Brookings Institution in Washington, D.C., published “The Real Effects of the Financial Crisis.”
Like the classic financial panics of the nineteenth and early twentieth centuries, the recent panic– in wholesale funding markets, rather than in retail bank deposits — resulted in a scramble for liquidity and a devastating credit crunch. In this narrative, the dominant problems were on the supply side of the credit market; and the implied policy imperative was to end the panic and stabilize the financial system as quickly as possible, to restore more-normal credit
On December 10 VICE publishing and HBO presented “Panic: The Untold Story of the 2008 Financial Crisis,” a film they described as providing “the definitive look inside the most successful—and most loathed—taxpayer-funded bailout in history.”
On December 11 the Brookings Institute hosted a panel to discuss the film. The movie is not about homeowners, it’s about bankers and their regulators. It’s the Bernanke, Geithner, Paulson story, built around scenes that clearly are a bank panic. Director John Maggio said he wants Americans to understand why Bernanke, Geithner and Paulson bailed out the banks.
While Bernanke, Geithner and Paulson were waging this campaign, other “run-ners” also spoke up during the 10th-anniversary period. Here are two, Gorton and Laurence Ball.
Yale professor Gorton has published a blizzard of papers and books since the crisis, to explain and justify the theory of panics and runs.
In July he, Toomas Laarits and Andrew Metrick published “The Run on Repo and The Fed’s Response,” a paper that describes pre-crisis repo as “a lightly regulated multi-trillion dollar market which funded nearly half of the asset holdings by the major investment banks” but was not well understood.
The Financial Crisis began and accelerated in short-term money markets. One such market is the multi-trillion dollar sale-and-repurchase (“repo”) market, where prices show strong reactions during the crisis. The academic literature and policy community remain unsettled about the role of repo runs, because detailed data on repo quantities is not available. We provide quantity evidence of the run on repo through an examination of the collateral brought to emergency liquidity facilities of the Federal Reserve.
In June Laurence M. Ball, economics professor at Johns Hopkins University, released his book The Fed and Lehman Brothers, which argues that regulators could have, and should have, saved Lehman. Ball stresses the importance of a central bank’s role as lender of last resort.
The traditional version of a run is one in which people rush to a bank to withdraw their money and the bank runs out of cash. An example, fictional but realistic, is the run on Jimmy Stewart’s bank in the 1946 classic It’s a Wonderful Life. The 2008 crises on Wall Street were twenty-first century versions of bank runs.
Ball argues that the Fed’s decision not to save Lehman was a failure to fulfill its duty as lender of last resort.
We can hope that the Fed does not make a similar mistake in the next financial crisis, but there is reason for pessimism: bank regulation since the 2008 crisis has taken a wrong turn. In response to widespread condemnation of “bailouts,” Congress included stringent new restrictions on Fed lending in the Dodd-Frank Wall Street Reform Act of 2010. … It is vital to the future safety of the financial system that Congress correct its 2010 mistake.
On December 16 economic journalist David Warsh described the public perception of the “bailouts” this way:
Because what happened after Lehman Brothers failed in September 2008 wasn’t framed as a traditional systemic banking panic, the traditional policy response was then widely misunderstood. Instead of being seen as performing their traditional role as “lenders of last resort” (backed by national treasuries), central banks’ emergency loans designed to stem the fear were routinely described as “bailouts,” despite the fact that in most cases loans were fully repaid.
But not everyone agrees that the financial crisis was caused by an old-fashioned run on banks that justified doing “whatever it takes” to save Wall Street and keep credit flowing.
Another view: The Panic of 2007-8 was about housing
At the 10th anniversary, economists Paul Krugman, Dean Baker and Bernanke had a debate over the damage done by the runs. Krugman and Baker don’t dispute the runs, but they believe the housing collapse caused the Great Recession.
On September 14 Krugman wrote:
On one side you have Dean Baker, who has long argued that the burst housing bubble was the main factor in both the slump and the slow recovery, with financial disruption a minor and transitory factor — a view I mostly agree with. On the other side we have none other than Ben Bernanke, who argues in a new paper that credit market disruption was indeed the big story. …
Specifically, I have trouble seeing the “transmission mechanism” — the way in which the financial shock is supposed to have affected actual spending to the extent necessary to justify a finance-first account of the slump.
On September 21 Bernanke blogged a reply.
Why was the Great Recession so deep? Certainly, the collapse of the housing bubble was the key precipitating event; falling house prices depressed consumer wealth and spending while leading to sharp reductions in residential construction. However, as I argue in a new paper and blog post, the most damaging aspect of the unwinding bubble was that it ultimately touched off a broad-based financial panic, including runs on wholesale funding and indiscriminate fire sales of even non-mortgage credit. The panic in turn choked off credit supply, pushing the economy into a much more severe decline than otherwise would have occurred.
He follows with more observations on transmission mechanisms.
On September 21 and 22 Baker and Krugman immediately replied. Let’s give Krugman the last word:
Now, does this mean that rescuing the financial system was pointless? Here Dean Baker and I disagree, I think. Dean says yes, because finance didn’t cause the slump. I think that the slump we had didn’t have much to do with finance — but the slump we would have had if the financial system had been allowed to implode might have been much worse. On precautionary grounds, bailouts were in my view the right thing to do, although the terms were too sweet for the bankers.
On the other hand, the fact that we suffered such a deep, prolonged slump despite rescuing banks shows the limits of a finance-centered view.
At the University of Missouri, two professors also say the focus on the runs is wrong.
On September 17 economist Michael Hudson wrote:
At the neoliberal/neocon Brookings Institution, Treasury secretaries Hank Paulson and Tim Geithner joined with the Federal Reserve’s Ben Bernanke to explain that the public simply didn’t understand how successful they all were in saving not only the banks, but non-bank financial institutions. … Bernanke wrote a Financial Times piece producing junk statistics purporting to show that there was no underlying debt or financial problem at all, merely a “panic.”
Hudson sees the runs but says the money that went to stopping them — to save the banks, the financial markets and the 1 percent — should instead have gone to paying down debt for regular Americans, the 99 percent. That’s because as long as regular Americans are burdened with debt, which keeps growing as people are unable to make payments and interest piles up, the economy will limp along.
The key financial principle is that this self-expansion of interest-bearing debt grows to absorb more and more of the economic surplus. The solution therefore must involve wiping out the excess debt – and savings that have been badly lent. That is what crashes are supposed to do. It was not done in 2008.
He believes the FDIC should have seized the insolvent Citigroup, protecting depositors but not shareholders, and regulators should have written down mortgages to 25 percent of household income, forcing banks to take the hit. After all, it’s lenders’ responsibility to make prudent loans. (RepoWatch editor’s note: See Adults in the Room by Yanis Varoufakis, published by Farrar, Straus and Giroux, 2017, for a complementary European view.)
From the economy’s vantage point, instead of asking how the banks are to be saved “next time,” the question should be, how should we best let them go under – along with their stockholders, bondholders and uninsured depositors whose hubris imagined that their loans (other peoples’ debts) could go on rising without impoverishing society.
On August 3 and September 20 William K. Black, professor of economics and law and a top savings and loan regulator during the savings and loan crisis, discussed the financial crisis with The Real News Network. He sees the runs but says they should have been prevented.
The crisis began, as I said, when markets started to shut down. And in particular they shut down for short-term borrowing. And Lehman and many other places had a strategy that was absolutely dependent on the ability to borrow incredibly short term. As soon as those short-term markets closed down, Bear Stearns first, which died in March, it was absolutely certain it was going to fail, and then it was certain that Lehman Brothers was going to fail. As soon as Lehman Brothers failed, AIG, the massive insurer that had the CDS, was sure to fail. As soon as Lehman failed, the largest- one of the largest money market funds in the world – failed within six hours, actually within four hours of the opening. It failed in one of the largest runs in world history. …
And then markets ceased to function. And if I can’t borrow money short term, then I’m forced into defaults, because these places had set themselves up in that way. And that means that asset prices are going to fall further, which are going to cause more of a liquidity crisis. And it all becomes the opposite of a virtuous cycle, and drags the economy down into the Great Recession.
An expert on bank fraud, Black points out that (1) since 1994 the Fed has had the power to prevent liar loans, by prosecuting lenders for fraud when they make home loans without checking tax returns to make sure the borrowers are telling the truth about their income, and (2) the Prompt Corrective Action section of federal law passed in 1991 requires that troubled FDIC-insured banks be placed in receivership, well before they become insolvent, using no taxpayer funds and paying no bonuses or raises to senior executives.
With these two powers, created after the savings and loan crisis, Black’s view is that fraud should have been prosecuted early and FDIC-insured banks should not have been bailed out, they should have been closed down. Going forward, the strategy should be to prosecute fraud early and close banks early, and not rely on a lender of last resort to parachute in at the last minute to save the day.
The estimated loss of GDP over the course of not just the Great Recession, but the very, very long recovery- this is economists- is $41 trillion. Now, a trillion is a thousand billion. So $41,000 billions. Right? That is the kind of assault, as an overall economy, we took. In other words, we cannot afford these kinds of crises. We can avoid them. We need to avoid them. When we don’t put in an effective response, that’s just so unbelievably insane, economically, that words fail.
Two interesting side notes:
Hudson does not agree with economists Baker and Krugman that housing caused the pain.
This misses the point that 2009 was the real beginning for most of the nine million homeowners being foreclosed on and evicted from their homes.
And Black does not agree with economist Ball that Lehman could have been saved.
This is a remarkable thing that assumes that Lehman is a solvent, profitable entity with just a really temporary liquidity problem because the markets are overreacting
Instead, Black told Congress, Lehman was hopelessly insolvent because of its large volume of liar loans.
In addition to these and other economists, the financial markets themselves weighed in on this conversation.
On September 4 J.P. Morgan issued its report “10 Years After The Financial Crisis.”
Ten years ago, the financial system was fully exposed. Governments around the world invested taxpayers’ money to save banks from failure, central banks were forced to use unconventional monetary policy to prop up markets and regulators stepped in to try and ensure that a liquidity crisis of that scale could not take place again.
Note that the J.P. Morgan report refers to the financial crisis as a “liquidity crisis” (jargon alert: “liquidity” means market participants can get the securities or cash they need to do the trading they want to do). But the public version of the report — there’s a proprietary version for clients — never mentions the causes of that liquidity crisis, that is, runs and short-term debt like repos, and it complains that post-crisis regulation is too onerous.
Poorly conceived and uncoordinated regulations have damaged our economy, inhibiting growth and jobs. It is appropriate to open up the rulebook in the light of day and rework the rules and regulations that don’t work well. — Jamie Dimon, Chairman and CEO
That’s an interesting position for the bank that, acting as a tri-party repo clearing bank, drove the devastating runs on Bear Stearns and Lehman Brothers.
On December 17 the Global Financial Markets Association and the International Capital Market Association published The GFMA and ICMA Repo Market Study: Post-Crisis Reforms and the Evolution of the Repo and Broader SFT Markets, a robust, full-throated defense of the repurchase market and other securities financing transactions (SFT) markets, which means mainly securities lending.
This report argues that the repurchase market was not at the heart of the Panic of 2007-8. Instead, while there were isolated problems, the bulk of the repo market performed valiantly throughout the crisis, and now post-crisis regulation is dangerously impeding its ability to provide critical funding for the financial markets.
The repurchase, or repo market is a cornerstone of the financial markets and is a fundamental contributor to the overall resiliency, risk mitigation activities and efficiency of financial markets. Both private market participants and central banks and regulators rely on the safety, liquidity and efficiency of this market to underpin market activities and implement official sector goals.
The GFMA/ICMA report does acknowledge some problems during the crisis:
In terms of banks and broker dealers, based on incomplete Fed Flow of Funds data, net repo financing provided to them fell by more than 50%, or nearly $900 billion, from the second quarter of 2007 to the first quarter of 2009 according to the New York Fed.
Hmmm. $900 billion. That’s not peanuts. Here’s more:
Prior to the financial crisis, many market participants were overdependent on short-term wholesale funding. The inability to refinance their portfolios led to the demise of certain dealers (e.g. Lehman Brothers, Bear Stearns), banks (Northern Rock) and shadow banks such as securitisation vehicles…..
… “runs on repo” can force market parties facing funding challenges to resort to asset fire-sales … If the funding challenges are acute, the firm could fail. ….
The Federal Reserve Bank of New York identified weaknesses in the policies, procedures, and systems supporting the US tri-party repo market during the crisis …
The European Securities and Markets Authority has highlighted that SFTs may be used by market participants to build leverage and that from a system-wide perspective, the contribution of SFTs to the build-up of (gross) leverage is widely recognised and documented.
Regulators estimated that the amount of reuse was significant during the crisis. …
This reference to “reuse” refers to trading that some analysts have said creates too much leverage. For example, a repo lender can reuse the collateral it receives, putting it up as collateral to get a repo loan of its own. The GFMA/ICMA report continues:
In the banking system for example, the Financial Stability Board (2017) finds that among the 13 largest global banks, collateral reuse 2006–2014 was about 30% of the total assets of these banks …
To justify its repo defense, the GFMA/ICMA study cites “Sizing Up Repo,” a 2014 paper by economists Arvind Krishnamurthy, Stefan Nagel and Dmitry Orlov that looked at the tri-party repurchase market. “Sizing Up Repo” concluded that repo funded only a small portion of the mortgage-backed securities market. Instead, tri-party repo lenders primarily accepted Treasuries as collateral, which these writers found were stable throughout the crisis.
These authors concluded that repo was devastating to some broker dealers, but they placed blame for the financial crisis more on asset-backed commercial paper, another form of housing finance that collapsed in late 2007. They emphasized, though, that data from the larger bilateral repurchase market was needed in order to fully assess the role of repo in the crisis.
Essentially, the GFMA/ICMA study pits Krishnamurthy vs. Gorton, two economists who cooperate in their efforts to understand the Panic of 2007-8 even when they disagree. See Gorton’s answer to “Sizing Up Repo” here.
The GFMA/ICMA report says that regulators should avoid over-regulating repos and instead should encourage good quality collateral, mainly government bonds, and good quality counterparties.
The post-crisis reforms have led to a financial system that depends on high-quality collateral that has low volatility and a high degree of liquidity ….Therefore, it is imperative that the system has adequate capacity to move high-quality collateral – mainly through SFTs – across the system to where and when it is needed by market participants.
The key aim of the GFMA/ICMA study is to get regulators to rethink three regulations that the study claims could add costs and dangerously hamper repo operations:
- Liquidity Coverage Ratio: Requires firms to hold enough high-quality liquid assets, such as cash or cash-like instruments, to meet financial demands during a severe 30-day crisis.
- Net Stable Funding Ratio: Requires firms to have a year’s worth of stable financing that matches the maturities and other characteristics of its assets and its off-balance-sheet exposures, so fewer long-term commitments are financed with short-term debt.
- Minimum haircuts: Requires firms to bear minimum costs for securities financing transactions, especially securities lending, in an effort to limit build-up of excessive leverage.
Writers like your RepoWatch editor have marveled that the Dodd-Frank act did little to regulate repos, but the GFMA/ICMA report makes it clear that U.S. and European regulators are implementing rules that do have impact.
On December 20 editor Josh Galper at Securities Finance Monitor, who tracks these markets and sympathizes with the cries of over-regulation, said about the GFMA/ICMA report:
These recommendations are rehashes in one way or another of earlier reports and calls to action; all ask regulators intent on damaging market liquidity in the name of a perfect gold standard of risk management to change their thinking. There must be a dented wall at ICMA from all the frustrated head banging that has gone on over the years. …
But will regulators take action based on this report? Probably not if they aren’t already heading in this direction ….
The view from the press
From the mainstream press
The mainstream press, the press with the best chance to inform regular Americans — represented here by the New York Times, the Washington Post and the Los Angeles Times — did not focus on bank runs in their 10-year packages. Instead, they dwelt on the pain suffered by regular Americans, today’s housing markets, troubling household debt, too-big-to-fail banks that are now even bigger, growing concentrations of wealth, few went to jail and we’re safer now but be careful out there.
That said, from New York Times reporters Peter Eavis and Keith Collins, one fine paragraph:
Capital wasn’t the only weak point in 2008. The big banks were also dangerously dependent on short-term borrowing like commercial paper and repo loans to finance their lending and trading. That type of borrowing dried up when Lehman Brothers went bankrupt and investors got spooked, crippling the broader financial system. Large banks have cut back on their use of this borrowing, according to figures from the Federal Reserve.
From the financial press:
Given the thousands of inches published for the 10th anniversary, it was surprisingly hard to find discussions of bank runs. Here are some:
On September 11 “Decade After Repos Hastened Lehman’s Fall, the Coast Isn’t Clear” by Liz Capo McCormick and Alexandra Harris. This story, led by repo veteran McCormick, covers repo runs and the Panic of 2007-8.
While most people are aware that the financial crisis stemmed from unbridled subprime-mortgage lending and the packaging of those loans into securities, fewer may recall the role played by secured funding — meaning repos. When lenders perceived that Lehman might not repay repo loans or be able to post adequate collateral, they required more and higher-quality assets from the firm, crimping its ability to fund itself.
McCormick and Harris report that regulations have made repo safer but risk remains. They conclude:
John Ryding, co-founder of RDQ Economics and the top U.S. economist at Bear Stearns when it was absorbed by JPMorgan, adds a new concern: the fact that Congressional measures have crimped the Fed’s ability to support individual firms in a future crisis….
“The financial system is a lot safer: There is more capital and it has a more forward-looking assessment of situations that could go on,” Ryding said. “But is the situation ideal now? No. And can we guarantee we won’t have another situation like that again? I don’t think we can.”
The Wall Street Journal:
On March 13 “Ten years after the Bear Stearns Bailout” by Justin Baer and Ryan Tracy. This story describes the Bear crisis as a run, and it delves in some detail into the ways that the Dodd-Frank act and public anger have made it harder for future bailouts.
On March 27 “10 Years After The Crisis” by Cezary Podkul. No mention of panics or runs.
On May 11 “Yale Professor Who Had Controversial Role in the Crisis Now Teaches About It” by Alexander Osipovich. This is one story in a yearlong series of updates on key crisis figures. Presumably discouraged by years of crisis reporting that didn’t mention runs and tired of taking criticism over his role as an advisor to AIG, Gorton emailed Osipovich, “Just reprint the old crap,” she reported. Gorton later told the Journal the article wouldn’t be “accurate except within your understanding of the crisis. Basically you don’t understand the crisis,” Osipovich wrote. She continued:
Many economists consider Mr. Gorton a top expert on financial crises. His fans include former Federal Reserve Chairman Ben Bernanke, who praised the professor’s insights in 2010.
Mr. Gorton has likened the 2008 crisis to an old-fashioned bank run. But instead of anxious depositors emptying their bank accounts, Mr. Gorton has said the bank run of a decade ago played out in the so-called repo market….
Some critics say Mr. Gorton’s work plays down other explanations for the crisis, such as the U.S. housing bubble—or wrongdoing on Wall Street. …
On August 27 – September 23 “Financial crisis: Are we safer now?” a month-long series. In spite of being the financial publication that has best understood the financial crisis from the beginning, and in spite of publishing at least 15 articles in this series, the Financial Times didn’t spend much time on runs. Joe Rennison, who has done fine work on runs in the past, instead wrote in this series about securitization.
That said, here are three bright moments:
On September 5 “Lehman insider: why the bank could and should have been saved” by Scott Freidheim, Lehman’s former chief administrative officer.
We should also take another look at the US rules around rescuing banks so that the Fed can do what needs to be done to protect the economy from another crisis. That means rethinking the additional requirements that were put in place after the crash that now make it harder to support a teetering lender.
Lastly, we should consider creating an industry-financed fund to supplement the Federal Deposit Insurance Corporation. Backed by the Fed, it would require institutions to contribute based on their level of systemic risk. That way, we can save failing banks and stabilise the financial system without worrying about a political backlash because the bailout will have been funded in advance by the banks, not afterwards, by the people. (RepoWatch editor’s note: On this topic, also see The Money Problem by Morgan Ricks, published by The University of Chicago Press, 2016.)
On September 7 “A reporter’s memories from the front lines” by John Authers.
September 18, 2008: This was the scariest day of the entire crisis, when the modern, highly sophisticated money market suffered what was in effect a catastrophic old-fashioned bank run.
On September 10 “After the crisis, the banks are safer but debt is a danger” by Adair Turner.
The financial crisis began because of dangerous features within the financial system itself. Massively leveraged investment banks engaged in socially useless trading of huge volumes of complex credit securities and derivatives. New forms of secured funding left the system vulnerable to self-reinforcing runs if confidence ever cracked. Banks operated with absurdly low equity ratios, so that when the market crash came, counterparties doubted their solvency. Within two weeks of Lehman’s collapse the global interbank money market had frozen, creating real danger of economic collapse.
National Public Radio, Morning Edition
On September 14 “What’s Changed In The Decade Since The Financial Crisis” with host Steve Inskeep and David Wessel, former economics editor of the Wall Street Journal, now a senior fellow at Brookings Institution. From Wessel:
The housing crisis alone didn’t do this. It triggered a financial panic, a run on the entire financial system – not this time on the banks with depositors lining up but on the short-term borrowing that all sorts of big financial institutions relied on. And, you know, when that happens, the financial system moves credit around the economy the way blood moves through the circulatory system. The financial system froze up. And with that, the economy collapsed.
Inskeep asked if the economy is any safer today than it was a decade ago. Wessel replied with a familiar concern.
Safer but not safe enough …. we did some things to restrain the banks from making the same mistakes again. … But we’ve taken away some of the tools that the authorities used the last time so that if we have another crisis, they won’t be able to do all the same things again. That may make people happy today. They may regret it in the future.
The RepoWatch view
Your RepoWatch editor believes our priority must be to prevent future runs on the repurchase market. I am influenced by comparisons to the era of the Crash of 1929 and by the way that FDIC insurance, started in 1933, has protected bank depositors for 75 years.
That’s why I support FDIC-type insurance for the repurchase market, paid for by repo participants, as mentioned by Scott Freidheim above, by Vanderbilt law professor Morgan Ricks in The Money Problem and others.
Hopefully that insurance will give repo lenders confidence and prevent runs. If not, then the next time we have to bail repo borrowers out, it’ll be on their dime. In the financial crisis, when 500 commercial banks failed, the FDIC did not have to use one penny of taxpayer money.
I also support restoring panic fighting tools prohibited by the Dodd-Frank act.
And I support the positions taken by Hudson and Black, but I’m afraid to rely on them.
I’ve been a reporter through four real estate downturns: the early 1980s when mortgage interest rates were 18 percent; the early 1990s after the savings and loan excesses; the early 2000s after the dot.com bust; and the long fallout from the housing bubble that burst in my county in August 2005. All were painful.
But on Monday, September 22, 2008, when Treasury Secretary Paulson went to Congress for $700 billion — $700 billion – to fight a financial panic, I knew something beyond real estate had to be involved.
By that time my county had already been in a severe real estate recession for three years. But something entirely different happened when Lehman failed.
That has haunted me for 10 years.
Great article, thanks!
Thank you for reading!
Thank you for this fascinating piece. I’ll have to read it 3 or 4 more times when I can devote the time to reading the underlying sources that are referenced. While I totally subscribe to the belief that 2008 was a liquidity crisis, most analysts fail to understand that the crisis began not in 2008 but in 2007 when financial institutions worldwide began to suffer from a shortage of liquidity. As a result of overlooking the early impact of the financing environment, most researchers erroneously take the position that the banks and quasi-banks purposely chose to finance illiquid assets with short term repo and other short term funding and got the punishment they deserved. Nothing could be further from the truth: long term funding was disappearing long before the Street got into trouble and the reliance on short term repo was the result of the liquidity crisis, not the cause of it.
Starting in 2007, it became more and more difficult to borrow long term, either secured or unsecured. As a result, the liability side of bank and quasi-bank balance sheets got shorter every day. At the same time, much of the traditional buyers of complex securities on a leveraged basis–hedge funds, mortgage REITS, etc–found themselves unable to source financing for new purchases and, as a result, they backed away from buying assets. The net result for dealers was a consistently decreasing ability to sell complex assets and an increasing difficulty in issuing new term debt. The result should have been easily predicted: by the time 2008 arrived, dealers had no choice but to finance more and more of their illiquid (primarily mortgage) assets with ever increasingly short term repos. We all know how that turned out.
Thank you for this thoughtful reply. You raise a very interesting point – that borrowers turned to short-term debt because they couldn’t get long-term loans. I haven’t heard that before.
But wasn’t much of the lending to companies making home loans done in the form of short-term warehouse lines, which were repurchase agreements? For example, the failure of New Century Mortgage on April 2, 2007, was largely a run on repo. See page 63 and other pages here: http://pdfserver.amlaw.com/ca/newcentury01_0327.pdf
It’s great to hear from you and to know there are people like you who care about these things.
Excellent article. All of the perspectives have a particle of truth to them, but the underlying problem is the fact that the current paradigm for the sole form and vehicle for monetary distribution is Debt Only. Integrate the new monetary, economic and financial paradigm of Direct and Reciprocal Monetary Gifting intelligently and strategically into the economy and it will make regulation a lot more effective and undoubtedly less complicated. Why? Because genuine paradigm changes are such transformative and obviously progressive events that everything adapts to the new paradigm, not the other way around.
You have an important insight. Debt has become a problem. The saying used to be, “You can’t get a loan unless you don’t need one.” In those days, bankers made sure you could pay back what you borrowed. Securitization and the widespread use of short-term debt has changed all that.
I’ve not heard of Direct and Reciprocal Monetary Gifting. I will research it.
I’ve begun developing a talk that would explain to people how the new debt machine works, and I’m working with educators to get personal finance education in the public schools (I’m in California, where it’s not required), all in hopes that knowledge will help consumers make better choices. What do you think?
I was thinking about the failures and near-failures of the street firms but I agree with you regarding what happened to their customers, including mortgage originators and hedge funds. The customers had a perverse view that it was their right to do relatively short term repo—including warehouse loans—while believing the dealers would always roll the loans over at maturity. Which they did—until they didn’t. For hedge funds, the view was “You sold me that bond with an agreement to finance it—what do you mean I can’t count on the financing forever?” In the case of warehouse loans, the belief in perpetual repo was accompanied by a view that the Street also had a moral obligation to buy the loan pipeline, even when the securitization machines ground to a halt. The fact that most dealers tried to accommodate the mortgage originators even when they were having difficulty selling securitized mortgages only exacerbated the asset/liability mismatch already occurring on the Street.
Well! What a concise description of how the market was working. And that’s a cool insight into hedge fund thinking.
What’s your view of where we stand today?
Both sides of the street (and their regulators) understand liquidity much better than they did, firms are generally better capitalized than they were before the last crisis and they generally have a liquidity plan in place and manage their business accordingly.
But 11 years is a long time and memories of how bad things can get grow dim, especially as people with grey hair who lived through the last crisis move on. Moreover, we are always fighting the last war. Will the guardrails that have been put in place help prevent the next crisis when the only thing we know about it is that it will be different than the last crisis? Beats me.
I really liked what Paul said. Mary, you asked the $64 question. That is what I keep asking myself. “Where do we stand today?” We all know what happened. My question is, “what are the odds of another melt down?” The one that happened in 2008 gave me a very short haircut. One more of those and I will have to buy a lawn tractor and start mowing grass in my spare time.
I must admit, that the current financial landscape has my complete attention. Mary, thanks for your excellent reporting. You are really tenacious. I read everything that you say, a concerned investor.
Did the 2020 Cares legislation restore any of the tools that Congress took way in 2010?
I don’t think so. The Fed was able to take “emergency” action based on Section 13(3) of the Federal Reserve Act because it had the approval of Congress and the U.S. Treasury and because the Fed didn’t try to rescue a particular firm but rather broad markets like repos, commercial paper and money market funds. Read about the Fed actions here, it’s pretty amazing: https://www.federalreserve.gov/newsevents/funding-credit-liquidity-and-loan-facilities.htm.
Thanks for writing!