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SPREAD OF THE CRISIS TO THE FINANCIAL SYSTEM

As subprime borrowers defaulted, hedge funds trading the bundled subprime securities stopped trading. Mortgage originators could not sell their loans, and therefore banks, mortgage brokers, and in turn, the six largest financial institutions that comprise 60 percent of gross domestic product (GDP) in the US (Johnson 2009a), began to face the specter of serious losses. The shocking losses announced by investment bank Bear Stearns in July 2007, the collapse of Germand Sachsen Landesbank in August 2007, and the run on Northern Rock in September 2007, revealed that the subprime trouble was beginning to spread. At year end 2007, the US Federal Reserve coordinated an action by five leading central banks around the world to offer billions of dollars in loans to banks (Guillen 2009).

Following that, 2008 was a year of excruciating financial drama. To start the year off, a group of US Treasury officials traveled to Europe to analyze the state of the European banking system, concluding that European banking was in a weak state (Paulson 2010). Global stock markets plunged in January, foreclosure rates increased, and US financial institutions suffered over the course of the year: Bear Stearns was bought out, Fannie Mae and Freddie Mac were taken over by the government, Lehman Brothers went bankrupt, and AIG received a government bailout. Indy Mac Bank became the largest thrift bank ever to fail in the US (Guillen 2009).

Fannie Mae and Freddie Mac were created in 1938 and 1970, respectively, and were both private institutions as of the 1970s that purchased and securitized mortgages (Dodd 2007). They were critical to providing financial backing for consumers to borrow home loans and obtain consumer finance. Due to fears over increasing losses from home foreclosures, these corporations were placed into government conservatorship in September 2008, bringing in new management and receiving injections of liquidity from the Treasury and Federal Reserve under close monitoring of these institutions.

Bear Stearns, exposed to the subprime securities crisis, was bought out by JP Morgan Chase in a Federal Reserve and Treasury-engineered purchase in March 2008. This angered some Congresspeople and frightened European leaders (Paulson 2010). In continuing government intervention, and just after the government takeover of Fannie Mae and Freddie Mac, the imperiled investment bank Lehman Brothers sought a buyer. However, when Lehman Brothers could not find a buyer, the Federal Reserve and Treasury were unable to bail out the firm, and on September 15, 2008, Lehman Brothers declared bankruptcy. Lehman Brothers’ bankruptcy represented the largest bankruptcy in US history, at more than $600 billion dollars in debt (Mamudi 2008).

Ferguson and Johnson (2009) and others question the government’s actions to bail out Bear Stearns and then refuse to bail out Lehman Brothers, which opened a floodgate of panic in the market. In light of US Treasury Secretary Henry Paulson’s (2010) book on the subject, it is clear that the Federal Reserve and Treasury were unable to legally bail out Lehman Brothers due to its real capitalization, as opposed to liquidity, problems. Paulson and other talented industry and government workers worked strenuously to find a buyer for Lehman Brothers in a matter of days, to no avail.

Due to large Lehman Brothers’ losses in the Reserve Primary Fund, the oldest US money market fund, the Fund reduced its share value. In response, US Treasury Secretary Henry Paulson announced that the Treasury would support all money market mutual funds for a fee (Weiner 2009). AIG, which had insured or purchased mortgage-backed securities to cover large losses in its securities lending program, then facing potentially further losses, was bailed out by the government one day after the Lehman Brothers failure. Equity prices fell dramatically across the world, particularly after the Lehman Brothers bankruptcy, which caused banks to hoard liquidity (Fender and Gyntelberg 2008). Figure 8.2 shows the fall in equity indexes during this period.

The sharp decline in stock indexes reflects real losses of value and a worldwide crisis of confidence in financial markets across the globe. Grammatikos and Vermeulen (2012) show that financials in Europe

Adjusted closing index prices

Figure 8.2 Adjusted closing index prices

became much more dependent on Greek-German credit default swap (CDS) spreads after the collapse of Lehman Brothers.

It is difficult to convey the extent to which the suddenness of the downturn took individuals and policy makers alike by surprise. Former US Federal Reserve Chairman Alan Greenspan himself was startled by the crisis. As he testified in October 20084: “In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology . . . This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed.”

In the US, it seemed as if the trouble would never end. Bank of America agreed to a $50 billion rescue package for Merrill Lynch. Morgan Stanley and Goldman Sachs converted from investment banks to traditional commercial banks. Washington Mutual, the largest savings and loan company in the US, was seized by federal regulators and sold to JP Morgan for $1.9 million (Guillen 2009). Wells Fargo acquired Wachovia Bank. Citigroup was bailed out in an asset relief package of $306 billion and eventually split into two entities. Larger financial institutions had engaged in much riskier behavior, mainly through increasing leverage (Bhagat et al. 2015). Tail risks of bank stocks surged in the US as the crisis hit (Straetmans and Chaudhry 2015).

The prospect of mounting failure created circular deterioration in balance sheets even among banks that did not hold claims against their cohorts. This is because, as overall asset prices declined due to the activities of some financial institutions, balance sheets of organizations that held such assets weakened, forcing the institutions to become overleveraged and reducing the size of their balance sheets (Brunnermeier et al. 2009).

In response to the crisis, and to prevent a downward spiral in asset prices, the US Federal Reserve’s reaction was to again lower interest rates and work closely with the Treasury to “stop the bleeding.” The first proposed solution was embodied in the Troubled Assets Relief Program (TARP), which initially set out to buy bad debts from failing institutions, but then was used to inject liquidity directly into failing institutions in return for government ownership of preferred stock. On behalf of the TARP, it was argued that the failure of large financial institutions would indeed cause a Great Depression rather than a large-scale recession. Large financial institutions were determined to be “too big to fail,” even as issues of insolvency at the bottom of the pyramid, among the subprime mortgage holders, increased.

The TARP incited concern and even rage from a number of parties, including the United Steelworkers Union. In a letter to Treasury Secretary Paulson, the Steelworkers wrote on the overvalued purchase of assets:

Your investments do nothing to deal with the causes of the current crisis. Now that even Chairman Greenspan has discovered a “flaw” in his theories, wouldn’t it make sense to have some reason to believe that the recipients of this government largesse won’t just take the money and do it all again? Perhaps there is some reason I do not understand that you have seemingly handed this chicken coop back to the very same foxes who have been pillaging it for the last two decades? (United Steelworkers Union 2008)

In retrospect, economists such as Simon Johnson,5 Joseph Stiglitz, and Paul Davidson have pointed out that policy measures such as the TARP contained critical flaws. Firstly, there was the failure to address the problem of risk after the crisis began. The main problem preventing resumption of normal financial activity was not of liquidity, which was provided in spades, but of risk, not knowing how much banks held in bad assets, since these could not even be quantified. Mortgages were allowed to remain on the books of financial institutions at face value, whereas the market value of these assets was obviously much, much lower.

Secondly, the TARP did not require financial institutions to refrain from paying out large bonuses to executives, which essentially transferred taxpayer funds to the wealthiest tier of American workers. There was much outcry over the payment of bonuses to top-level executives who were responsible for creating the crisis to begin with.

And finally, the underlying yet unstated contract behind the program itself was not really fulfilled. The idea was that the additional liquidity would be used to generate loans and alleviate the credit crunch. However, most of these funds were not lent despite prodigious growth in excess reserves, possibly because regulators or banks viewed themselves as undercapitalized due to higher expected losses (Edlin and Jaffee 2009).6

This series of events, particularly including the Lehman Brothers bankruptcy, as well as the AIG collapse, the run on the Reserve Primary Fund, and the political opposition faced by the TARP, had a significant negative impact on markets, and were reflected in the rising spread between the interest rate on interbank lending, measured by the London Interbank Offered Rate (LIBOR) on three-month eurodollar deposits, and the interest rate on three-month US Treasury bills, referred to as the “TED spread” (Mishkin 2011). Before this period, it appeared possible to contain the crisis. Afterward, however, it became apparent that the financial system was part of a huge “carry trade,” borrowing at low interest rates and purchasing assets that promised higher interest rates along with higher risk. The series of events also strongly challenged government response, and the rejection of the TARP plan significantly weakened the credibility of the government in handling the growing crisis.

The Federal Reserve’s creation of a temporary Term Auction Facility

(TAF) that enabled banks to borrow anonymously contributed positively to the view of government (Mishkin 2011). The Federal Reserve’s purchase of mortgage-backed securities beginning in November 2008 was also a significant step toward lowering residential mortgage rates and improving housing demand.

Much damage, however, was already done. The American automobile manufacturing industry was the biggest non-financial industry victim of the crisis. The industry, which suffered from ongoing reduced competitiveness and a sudden decline in demand due to the crisis, was forced to turn to the federal government for assistance. General Motors, Ford, and Chrysler faced difficult times, and General Motors and Chrysler filed for bankruptcy.

The climate of uncertainty seeped into every pore of the economy, and was transmitted to Europe and beyond. Global losses due to the credit crisis jumped to $510 billion by the end of August 2008 (Fender and Gyntelberg 2008). In the United Kingdom (UK), the mortgage lender Bradford & Bingley was taken over by the government. The Belgian banking and insurance company Fortis, and Germany’s Hypo Real Estate, received capital injections. Worse, as the carry trade, in which investors borrow in low- yield currencies and lend in high-yield currencies, reversed, currency crises loomed large in Eastern Europe. We next turn to the crisis abroad.

 
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