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NBER WORKING PAPER SERIES OVER THE CLIFF: FROM THE SUBPRIME TO THE GLOBAL FINANCIAL CRISIS Frederic S. Mishkin Working Paper 16609 http://www.nber.org/papers/w16609 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 December 2010 The views expressed here are my own and are not necessarily those of Columbia University or the National Bureau of Economic Research. I thank participants in a seminar at the Federal Reserve Bank of San Francisco and the editors of the Journal of Economic Perspectives for their helpful comments. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research. 2010 by Frederic S. Mishkin. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source. Over The Cliff: From the Subprime to the Global Financial Crisis Frederic S. Mishkin NBER Working Paper No. 16609 December 2010 JEL No. E58,G01,G18 ABSTRACT This paper examines what transformed a significant, but relatively mild, financial disruption into a full-fledged financial crisis. It discusses why, although the Lehman Brothers bankruptcy was a key trigger for the global financial crisis, three other events were at least as important: the AIG collapse on September 16, 2008; the run on the Reserve Primary Fund on the same day; and the struggle to get the Troubled Asset Relief Plan (TARP) plan approved by Congress over the following couple of weeks. The paper then looks at the policy responses to the financial crisis to evaluate whether they helped avoid a worldwide depression. The paper ends by discussing the policy challenges raised in the aftermath of the crisis. Frederic S. Mishkin Columbia University Graduate School of Business Uris Hall 817 3022 Broadway New York, NY 10027 and NBER fsm3@columbia.edu The financial crisis of 2007 to 2009 can be divided into two distinct phases. The first, more limited, phase from August of 2007 to August of 2008 stemmed from losses in one, relatively small segment of the U.S. financial systemnamely, subprime residential mortgages. Despite this disruption to financial markets, real GDP in the United States continued to rise into the second quarter of 2008, and forecasters were predicting only a mild recession. For example, the Congressional Budget Office (2008) released one of its periodic \"The Budget and Economic Outlook: An Update\" reports on September 8, 2008. It wrote: \"According to CBO's updated forecast for the rest of 2008 and for 2009, the economy is about halfway through an extended period of very slow growth. ... Whether or not that period of slow growth will ultimately be designated a recession is still uncertain. However, the increase in the unemployment rate and the pace of economic growth are similar to conditions during previous mild recessions.\" In keeping with that view, CBO projected that unemployment would rise modestly from 5.4 percent in 2008 to 6.2 percent in 2009, and that fourth-quarter to fourth-quarter real GDP would grow only 0.9 percent in 2008, but would rebound modestly to 1.8 percent growth in 2009. In summer of 2008, when I was serving on the Federal Reserve Board of Governors, there was even talk that the Fed might need to raise interest rates to keep inflation under control. In mid-September 2008, however, the financial crisis entered a far more virulent phase. In rapid succession, the investment bank Lehman Brothers entered bankruptcy on September 15, 2008, the insurance firm AIG collapsed on September 16, 2008; there was a run on the Reserve Primary Fund money market fund on the same day; and the highly publicized struggle to pass the Troubled Asset Relief Program (TARP) began. What caused the transformation from what appeared in mid-2008 to be a significant but fairly mild financial disruption into a full-fledged global financial crisis? Did the government responses to the global financial crisis help avoid a worldwide depression? What challenges do these government interventions raise for the world financial system and the economy going forward? Let's start with a brief step back to the first phase of the global financial crisis. \u0002 1 THE FIRST PHASE: THE SUBPRIME MORTGAGE CRISIS The first disruption of credit markets in the recent financial crisis is often dated to August 7, 2007, when the French bank BNP Paribas suspended redemption of shares held in some of its money market funds. A boom in U.S. housing prices had peaked around 2005. As housing prices started to decline, mortgage-backed financial securitiesin many cases, securities based on subprime residential mortgages but then divided into more senior claims that were supposedly safe and junior claims that were recognized to be riskybegan to experience huge losses. By early 2008, losses on these securities were estimated to be on the order of $500 billion dollars (for example, Greenlaw, Hatzius, Kashyap, and Shin (2008). What developed in late 2007 and into 2008 was a series of runs on financial institutions, but instead of the classic bank run, it was, as described by Gorton and Metrick (2009), a run on the shadow banking system. A bank has deposits that are short-term liabilities and assets that are long-term loans. Thus, in a classic bank run, when bank depositors run to withdraw deposits, the bank cannot readily convert its long-term assets into cash. In the shadow banking system, institutions has short-term liabilities in the form of short-term borrowing, like repurchase agreements (or repos), which use longer-term assets like mortgage-backed securities as collateral. A key element of this borrowing is the use of a \"haircut,\" that is, a requirement that borrowers post collateral that is valued at more than the loan. For example, if a borrower took out a $100 million loan in a repo agreement, it might have to post $105 million of mortgagebacked securities as collateral, and the haircut would then be 5 percent. As the value of mortgage-backed securities fell and uncertainty about their future value increased, haircuts to levels as high as 50 percent. The result was that the same amount of collateral would now support less borrowing, leading to deleveraging in which financial institutions had to sell off assets. The resulting \"fire sale\" dynamic (discussed by Shleifer and Vishny in this issue) led to an adverse feedback loop in which the decline in asset values lowered the collateral's value while further raising uncertainty, causing haircuts to rise further, which forced financial institutions to deleverage and sell more assets, and so on. One signal of the resulting credit market disruptions appears in the interest rate spreads between safe and risky financial instruments.. For example, the \"TED spread\" is the spread \u0002 2 between the interest rate on interbank lending (as measured by the LIBOR interest rate on threemonth eurodollar deposits) and the interest rate on three-month U.S. Treasury bills. The TED spread provides an assessment of counterparty risk from one bank lending to another, reflecting both liquidity and credit risk concerns. Figure 1 shows how the TED spread rocketed up from an average of around 40 basis points (0.40 percentage points) before August 7, 2007, to 240 basis points by August 20, 2007, before abating somewhat. The collapse of Bear Stearns in March 2008 was the most visible of these runs on the shadow financing system. Short-term financing for Bear Stearns dried up. Its long-term assets could not quickly be turned into ready cash at a fair price, and without access to short-term funding, it could not continue. The Federal Reserve brokered a deal a deal for J.P. Morgan/Chase to purchase Bear, which was not unprecedented, but as part of the deal the Fed also took onto its books $30 billion of Bear Stearn's toxic assets, which was unprecedented. However, this deal and the opening of new Federal Reserve lending facilities to investment banks helped restore some calm to the market. The TED spread surged to over 200 basis points in March 2008, but then fell back below 100 basis points. By summer 2008, credit markets were clearly impaired and credit risk was rising, as can be seen by the rise in the spread between interest rates on Baa corporate bonds and Treasury bonds in Figure 1. However, the financial crisis looked like it could be contained. The BaaTreasury spread had climbed to over 200 basis points, but these levels were similar to those that occurred in the aftermath of the mild recession in 2001. The TED spread, although elevated, was also below its peak values immediately after the revelations of problems at BNP Paribas and the Bear Stearns collapse. Many forecasters in the public and private hoped that the worst was over. After all, they reasoned that the subprime mortgage sector was only a small part of overall capital markets, and the losses in the related mortgage-backed securities, although substantial, seemed manageable. Indeed, the Congressional Budget Office (2008) was forecasting in early September 2008 that the Consumer Price Index would rise from 2.9 percent in 2007 to 4.7 percent in 2008. As discussed in Wessel (2009), there was talk in the Federal Reserve as to whether the easing phase of monetary policy might have to be reversed in order to contain inflation. \u0002 3 The story of this first phase of the 2007-2009 financial crisis has been discussed extensively in many places, including in symposia in the Winter 2009 and Winter 2010 issues of this journal. Here, the focus is on understanding what happened next. THE SECOND PHASE: GLOBAL FINANCIAL CRISIS In the space of a few short weeks in the fall 2008, everything changed. On Monday, September 15, 2008, after suffering losses in the subprime market, Lehman Brothers, the fourthlargest investment bank by asset size with over $600 billion in assets and 25,000 employees, filed for bankruptcythe largest bankruptcy filing in U.S. history. Conventional discussions of the evolution of the financial crisis often view the Lehman bankruptcy as the key event that morphed the subprime crisis into a virulent global financial crisis. Although the Lehman bankruptcy led a large increase in uncertainty and a wave of distressed selling of securities that caused a collapse in asset prices and a drying up of liquidity, I will argue that the collapse of Lehman was followed by three events that were at least as important in causing the subprime crisis to go global: the AIG collapse on September 16, 2008; the run on the Reserve Primary Fund on the same day; and the struggle to get the Troubled Asset Relief Plan (TARP) plan approved by Congress over the following couple of weeks. In considering these events, it's also important to remember that the financial system had been greatly weakened before September 2008 in ways that had not yet been fully recognized at that time. Just as a relatively small sound or vibration can trigger an avalanche, if the snow conditions have made the danger of such an avalanche high, it may be that with given the amount of systemic risk embedded in the financial system, some other stress or failure of a financial institution would also have revealed the fragility of the financial systemand then led to a chain reaction that could also have tipped the financial system over the cliff. \u0002 4 The Lehman Bankruptcy Many commentators have argued that the Treasury and the Fed's decision to allow Lehmann to go bankrupt was a colossal mistake that turned a mild financial disruption into a global financial crisis. With hindsight, it is hard to argue that allowing Lehman to go bankrupt was the right decision. But it's useful to remember that at the time, there was a plausible case for letting Lehman go into bankruptcy. First, in practical terms, the U.S. government or its regulatory authorities had no authority to put Lehman into a government conservatorship so it could keep functioning, as the Treasury was able to do with Fannie and Freddie Mac. Thus, the only possible solution was to broker a purchase of Lehman. Barclays was in discussions about buying Lehman, but British bank regulators were skeptical and the Fed refused to take more bad assets on to its balance sheet, as it had done with Bear Stearns. Barclays ended up buying parts of Lehman a week after it declared bankruptcy. Second, the bailout of Bear Stearns had extended the government safety net outside the banking system to investment banks, and the U.S. Treasury and the Federal Reserve were concerned about increasing moral hazard incentives on the part of a wider set of financial institutions to take on excessive risk. Indeed, as we now know, Lehman was going to extraordinary efforts, including engaging in shady accounting practices, to hide its leverage, even after the financial crisis started in August 2007.3 Letting Lehman fail would serve as a warning to other financial firms that they needed to reign in their risk taking. Third, it was an open secret in the financial markets and among government officials that if any of the major investment banks would run into trouble, Lehman would be at the top of the list. Lehman was among the most leveraged of the major investment banks; it was unwilling to raise capital; it had a poor reputation for risk management; and it had a high exposure to losses on subprime mortgages because it had large holdings of securities tied to valuations of these \u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002\u0002 3 As described in the Examiner's Report for the United States Bankruptcy Court, Southern District of New York, Valukas (2009), Lehman Brothers used a repo transaction, referred to as Repo 105, to reduce net leverage by $50 billion when reporting earnings at Q1 2008 and Q2 2008. In this transaction, repos were treated as sales, rather than borrowings, thereby taking them off the books. In addition, Lehman did not report that only $2 billion of $40 billion of liquid assets were readily accessible. \u0002 5 mortgages on its books (McDonald 2009; Sorkin, 2009). Sorkin (2009) documents that immediately after the Bear Stearns bailout, the U.S. Treasury Secretary immediately turned his attention to Lehman because he thought it would be the next trouble spot. With Lehman's vulnerability already well-known, it seemed that Lehman's was a natural test case to provide an object lesson to market participants that they should take measures to protect themselves. Indeed, many of the derivative contracts with Lehman's counterparties were unwound successfully after Lehman's bankruptcy. Finally, the financial system in mid-September 2008 was far more vulnerable than almost all policymakers and market participants realized at that time. There is a distinct possibility that the financial system would have imploded even if Lehman had been bailed out. The AIG Collapse The Financial Products Unit of American International Group (AIG) had written over $400 billion dollars of insurance contracts called credit default swaps, which had to make payments when subprime mortgage securities suffered losses. With the Lehman Brothers collapse, it seemed more likely that the AIG might have to make enormous payments under these contracts, so short-term funding to AIG dried up. On September 16, 2008, the Federal Reserve stepped in with an $85 billion loan to keep AIG afloat (with total loans from the Fed and the U.S. government eventually rising to over $170 billion). The enormous risk taking at AIG and its potential to blow up the financial system had been largely unrecognized by government officials, regulators, and markets. Once Bear Stearns had to be bailed out, it became apparent that a wider group of financial institutions could pose major systemic risks to the financial system. But in discussions at that time among regulators and academics about the need to regulate a wider group of financial institutions (in which I participated), AIG was not mentioned in the category of firms that would require special supervisory attention. This, along with Chairman Bernanke's later statement in Congressional testimony about how angry he was that AIG took on such risk, describing AIG as effectively running a huge hedge fund inside an insurance company (Torres and Son, 2009), indicates how much the AIG blow up was a surprise. \u0002 6 Reserve Primary Fund The same day of the AIG collapseSeptember 16, 2008also saw a run on the Reserve Primary Fund, a large money mutual market fund run by Bruce Bent, one of the originators of money market mutual funds in 1970. Before the crisis, Bent had publicly criticized the industry for taking on too much risk in its asset holdings. He stated in a letter to the Securities and Exchange Commission in September 2007 (Bent, 2007): \"When I first created the money market fund in 1970, it was designed with the tenets of safety and liquidity.\" He added that these principles had \"fallen by the wayside as portfolio managers chased the highest yield and compromised the integrity of the money fund.\" Alas, Bent did not follow his own advice, and the Reserve Primary Fund held $785 million of Lehman paper. With the Lehman bankruptcy, the fund could no longer afford to redeem its shares at the par value of $1a situation known as \"breaking the buck\"and shareholders pulled out their money, with the fund losing 90 percent of its assets. A run on money market funds followed, with assets in institutional money market mutual funds falling from $1.36 trillion to $0.97 trillion from September to October 2008. In turn, this run put pressure on the banks, since a significant amount of bank funding was coming from bank commercial paper and certificates of deposits held by money market mutual funds. TARP In the wake of these events, U.S. Treasury Secretary, Hank Paulson, then proposed on September 19, 2008, the Troubled Asset Relief Program (TARP) in an infamous three-page document. In its original form, it would have given the U.S. Treasury the authorization, with no accountability to the Congress, to spend $700 billion purchasing subprime mortgage assets from troubled financial institutions, but which subsequently was used to inject capital into banking institutions. It soon became clear that Congress would vote down the original bill, which it did on September 29. Eventually the bill was finally passed on October 3, but passage required numerous \"Christmas-tree\" provisions such as a tax break for makers of toy wooden arrows. \u0002 7 The Broader Context If the Federal Reserve had cut a deal with Barclays to rescue Lehman before bankruptcy, would the crisis have been defused? The underlying stresses in the financial system were all too real. A counterfactual history would have to take into account that a weakened Lehman, purchased before bankruptcy, might have later brought down Barclays. Rescuing Lehman would have increased moral hazard among other financial institutions, perhaps setting up a larger crash later. The costs of the AIG credit default swaps were eventually going to come due, quite possibly unexpectedly. Runs on various shadow banking institutions, like the run on Reserve Primary Fund and then on money market funds in general, were becoming more common. Here, rather than try to lay out a persuasive counterfactual history, I will emphasize two major changes that occurred by late September 2008. First, even though markets had been digesting bad news about mortgage-backed securities since mid-2007, the events of September 2008 showed that risk taking was far more extensive than markets had realized and the fragility of the financial system was far greater than most market participants could have imagined. The AIG blow up and the run on the Reserve Primary Fund revealed that the financial system was engaged in what could be described as one huge \"carry trade\". Technically carry trades are ones in which a trader borrows at a low interest rate to fund the purchase of assets that yield a high interest rate. Carry trades generate immediate profits, but may be very risky because the higher interest rate on the purchased assets may just reflect greater tail risk for that asset. AIG's issuing of credit default swaps is a classic example of a type of carry trade, because the firm was earning large profits on the premiums paid on these contracts until the tail risk became a realization. In a prescient and now-famous paper, Rajan (2005) warned that this carry-trade problem was a danger to the financial system because incentives in compensation schemes for financial firms were leading to financial market participants engaging in financial transactions that produced immediate income, but exposed the financial system to massive risks. Second, although markets had been watching government agencies scramble to deal with the financial crisis since late 2007, the events of September 2008 raised serious doubts that the U.S. government had the capability to manage the crisis. After all, the Fed and the U.S. Treasury proved unable to craft a solution so that Lehman would not fail. The AIG bailout was huge and \u0002 8 unexpected. TARP was originally proposed as a flimsy, three-page proposal, which raised concerns that the Treasury was unprepared, and the initial TARP proposal failed on a bipartisan vote. Even though the TARP legislation was eventually passed, the reputational damage was done. After September 2008, the pattern of runs on the shadow banking system intensified and worsened. Banks began to horde cash and were unwilling to lend to each other, despite huge injections of liquidity into the financial system by the European Central Bank, the Bank of England and the Federal Reserve, The subprime crisis had become a full-fledged, global financial crisis. The patterns of credit spreads tell the story. As shown in Figure 1, the TED spread rose from around 100 basis points during the week before the Lehman bankruptcy to over 300 basis points on September 17, the day after the liquidity squeeze on AIG and the Reserve Primary Fund materialized. The TED spread then dropped by 100 basis points, but as confidence in the ability and competence of the government to react quickly to contain the crisis weakened over the next couple of weeks, it climbed to over 450 basis points by October 10. The spread between interest rates on Baa corporate and Treasury bonds, shown in Figure 1, also rose by over 200 basis points and now rose well above levels that had been seen in 2001 during the prior recession period. The stock market crash also accelerated, with the week of October 6 showing the worst weekly decline in U.S. history . Conditions in the financial markets continued to deteriorate. The public anger that resulted from the TARP \"bailouts\" which involved injections of capital into financial institutions, with little restrictions on their use became so intense that it became increasingly clear that the new Obama administration, taking office in January 2009, would not be able to get additional funds beyond those already allocated to TARP if needed. Figure 1 shows that although the TED spread fell from its peak in October 2008 with the help of government support to the financial sector, the spread between Baa and Treasury bonds continued to rise, peaking at over 500 basis points in December 2009. By the end of 2008, the stock market had fallen by over half from its peak in the fall of 2007. \u0002 9 The Links from Financial Crisis to Recession Later data showed that the U.S. economy had turned down in the third quarter of 2008, falling at a -1.3 percent annual rate, but the recession that started in December 2007 became the worst economic contraction in the United States since World War II. Real U.S. GDP contracted sharply in the fourth quarter of 2008 and the first quarter or 2009, declining at annual rates of 5.4 and -6.4 percent, respectively. The unemployment rate skyrocketed, exceeding 10 percent by October 2009. A worldwide recession ensued as well. World economic growth fell at an annual rate of -6.4 percent in the fourth quarter of 2008 and -7.3 percent in the first quarter of 2009. A more extensive description of how financial crises lead to sharp economic downturns can be found in Mishkin (2011), but the basic story has three interrelated parts. First, a financial crisis widens credit spreads, like the difference between interest rates on Baa corporate and Treasury bonds shown earlier in Figure 1. The result is that conventional monetary policy is defanged: even if interest rates on Treasury bonds fall because of a weakening economy and easing of monetary policy, the interest rates relevant to household and business purchase decisions go up, causing a drop in aggregate demand. Panel (a) of Figure 2 shows that Baa corporate bond rates barely budged at the beginning of the financial crisis in 2007 or during the Bear Stearns episode in March 2008, but climbed substantially in September 2008. Second, the decline in asset prices during a financial crisis causes a decline in the value of collateral, which makes it harder for nonfinancial firms to borrow. In addition, the deterioration of balance sheets at financial firms, which have the expertise to mitigate adverse selection and moral hazard problems, causes their lending to fall, a process which is described by the term \"deleveraging\