Short-term: The Sequence of Events
Even though the credit crisis attained dangerous proportions only in mid-September, it had already announced itself in the early part of the year with the collapse of Bear Stearns, one of the five famed investment banks that defined Wall Street; today none of those five investment banks – Bear Stearns, Goldman Sachs, Lehmann Brothers, Merril Lynch and Morgan Stanley – exist, an indication of the depth of the crisis. Faced with a fierce run on it’s dwindling reserves and it’s stock plummeting, Bears Stearns was forced to sell itself off to J P Morgan Chase (one of the largest commercial banks in the US) on March 16, 2008. The next three months could be best described in terms that the police often use in India: tense but under control. On July 01, the next piece of bad news emerged and shattered the uneasy calm: Country Wide Financials, the largest mortgage seller in the US, collapsed and was acquired by Bank of America (one of the largest commercial banks in the US). Following closely on the heels of this event, IndyMac bank failed – the second largest bank failure in US history – and was taken over by the Federal Deposit Insurance Corporation (FDIC), one of the institutions responsible for monitoring the health of the banking system in the US. IndyMac was, unsurprisingly perhaps, part of the Country Wide financial family.
Things started speeding up in September. On September 08, Freddie Mac and Fannie Mae, the two government supported enterprises (GSE) operating in the mortgage market was nationalized, with assets of the two entities totalling to more than $ 5 trillion. On September 15 another of the five famed investment banks, Lehmann Brothers, filed for bankruptcy; Lehmann’s assets were a little over $ 600 billion and this made it’s bankruptcy filing the largest in US history. Next day, the Fed stepped in with a $ 85 billion loan to prevent American International Group (AIG), the largest insurance firm in the US from going under. These two events, Lehmann’s bankruptcy filing and AIG’s rescue, sent shock waves through the world financial system. The result was a rapid erosion of faith in the financial system leading to a veritable credit freeze: financial institutions stopped lending, to other financial institutions, to businesses and to consumers.
The next thirty six hours, from the morning of September 17 to the evening of September 18, accelerated the credit crisis to extremely dangerous proportions and convinced the US Treasury and the Federal Reserve that government intervention of unheard magnitudes (at least since the Great Depression) would be necessary to prevent total financial collapse. Ben Bernanke, the chairman of the Federal Reserve (the US Central Bank), was famously reported as saying, at one point during this 36 hours, that if the government did not save the (financial) markets now there might not be any financial markets in the future. So, what happened during those crucial 36 hours?
The crucial 36 hours
The first indication of a severe stress in the financial system was a shooting up of credit default swap (CDS) rates, especially on Morgan Stanley and Goldman Sachs (two of the famed five Wall Street investment banks) debt, during the early hours of September 17. Credit default swaps are insurance contracts that can protect bondholders against the possibility of default. For example if an investor has bought bonds worth $ 1 million issued by firm A, then the investor can also buy CDS – typically issued by financial institutions like large commercial banks, investment banks or insurance companies – to protect herself against a possible loss resulting from firm A defaulting on it’s bonds; the premium that the investor pays for the CDS is called the “rate” or “spread” and it is typically around 2% of the amount insured (the “notional value”). So, in the case of this example, the investor would pay $ 20,000 to buy CDS and if firm A were to go under, then the “counterparty” to the CDS contract (i.e., the financial institution that issued the CDS to the investor) would step in to pay the investor $ 1 million and the interest on that amount.
CDS rates (i.e., the premiums that are paid on the insurance contracts) are, thus, an indication of the market’s belief about the possibility of default of some institutions; CDS rates on bonds issued by firms are typically low when the market thinks the probability of default of those firms are low and high when the market thinks the probability of default are high. Thus, on the morning of September 17, when CDS rates went through the roof, this provided evidence of severe loss of faith in the financial system.
When investors lose faith in the financial instruments issued by private parties, they turn back to those issued by the government and that is what happened when CDS rates multiplied by close to a factor of five. Investors let go of private financial instruments like hot bricks and rushed into US government securities, a phenomenon often described as “flight to safety”. The US government, i.e., the US Treasury department, issues three primary kinds of securities: T-bills, T-notes and T-bonds (where the “T” stands for Treasury), where bills mature in less than a year, notes mature between one and ten years and bonds are of longer maturities than a decade. When investors lost faith in the private financial system, they rushed in to US T-bills, the short-run heavily-traded ultra-safe US government securities. This huge rush into T-bills pushed up the price of T-bills and drove the yield (i.e., interest rate) on T-bills down. At one point in time, during this 36 hour period, the yield on T-bills was pushed down all the way to zero (the lowest it can ever go to) implying that investors were willing to hold T-bills even though the nominal return was zero and real returns were negative (because the inflation rate was positive).
As private investors were madly rushing into the safety of US T-bills, another important event was unfolding in the mutual funds market. Money market mutual funds (MMMF) are financial institutions that have become popular over the last three decades, especially in the US. They typically work as follows: investors put their money in MMMF’s by purchasing shares in the MMMF’s stock; thus the MMMF becomes a mechanism for pooling huge amounts of money and then using those large sums for investing in a very diversified portfolio of financial assets, thereby making the investments extremely safe. Thus MMMF’s were, till September 17, thought to be as safe as a deposit account in a commercial bank, and the added advantage was that the money invested in MMMF shares would give a positive rate of return as opposed to a deposit account which is usually non-interest bearing. On September 17, one of the oldest and largest MMMF’s, Reserve Primary Fund, “broke the buck”, i.e., it made losses on it’s investments such that it could not guarantee a positive return to it’s shareholders. Every dollar invested in Reserve Primary was now, by it’s own admission, worth less than a dollar. This was an unheard of event and as news of Reserve Primary Fund’s losses spread, investors started pulling money out of MMMFs.
This had a very negative consequence for the real economy because of the serious involvement of MMMFs in the commercial paper (CP) market. Businesses typically need to constantly borrow short-term funds to keep their operations going; these borrowed funds go towards funding payroll, paying suppliers, maintaining inventory, etc. Firms, at least the big ones, usually borrow short-term funds in the US by issuing commercial paper (which is essentially a bond with a short maturity of about a week or a month). Who buys commercial papers? The most active institutional investors in the CP market are the MMMFs; some of the largest chunks of commercial papers are bought by the MMMFs. So when the MMMFs faced an increasing spate of withdrawal, in the wake of Reserve Primary Fund’s breaking the buck, they stopped buying commercial paper. This, essentially, meant that the CP market ground to a halt. Thus businesses were no longer able to borrow the short-term funds that they need to keep operating. The economy, by all means, shut down.
Adding to and going hand-in-hand with these processes were the growing problems in the interbank (lending) market. Commercial banks typically lend and borrow banking system reserves (roughly the sum of currency in the banks’ vaults and the amount they hold in their account with the Central Bank) among themselves for very short periods, usually overnight periods. The interbank lending market that is most closely watched is the London interbank market and the rate at which loans are made in this market is the London Inter Bank Offered Rate (LIBOR). The most important characteristic of loans in the interbank market is that they are unsecured, i.e., they are not backed by collateral. Thus, a bank can get a loan in the interbank market only if other banks consider it financially sound; thus when the LIBOR jumps up suddenly it provides evidence that the largest and the best banks in the world have lost faith on each other. On September 17, the LIBOR shot up giving indication of increasing strain in the interbank market.
It was these sets of events – CDS rates shooting up, closing down of the CP market, increasing strain in the interbank market – that spooked the US administration and convinced them of the necessity of the most extensive government intervention in the financial markets since the Great Depression. These crucial sets of events were precipitated by the string of big financial failures that the US economy had witnessed over the first two weeks of September: the failure of Fannie and Freddie, the bankruptcy of Lehmann and the near-collapse of AIG. It was these failures that led to a rapid loss of faith in the financial system and heralded a full-blown credit crisis. And why did Fannie and Freddie and Lehmann and AIG fail? All these financial institutions failed because at crucial points in time they could no longer raise money from the market to finance their assets, i.e., they could not borrow money or roll over their short-term debt; financing, for these institutions, had dried up. And why did financing dry up for these big and reputed financial institutions? Because each of these, in their own ways, were exposed to the subprime mortgage market and took huge losses when the subprime mortgage market started unravelling. As news of these failures spread, investors, fearing losses, became increasingly unwilling to lend money to these institutions.
(To be continued.)