The credit crunch: what happened?

While Ken 'worst is yet to come' Rogoff is trying his level best to scare global financial markets about the credit crunch, research is now starting to filter through about just what happened last year. A new IMF working paper by Nathaniel Frank, Brenda González-Hermosillo and Heiko Hesse, Transmission of Liquidity Shocks: Evidence from the 2007 Subprime Crisis, does some of the spadework. As they explain, liquidity crisis soon segued into a solvency crisis (think Northern Rock, Bear Sterns):

It is found that the interaction between market and funding illiquidity increased sharply during the recent period of financial turbulence, and that bank solvency became important. ...What started out as a liquidity crisis, turned into a solvency issue.

It wasn't simply credit that dried up, it was trust - the whole basis of interbank money markets. Banks were unwilling to trust the disclosures or assurances of their counterparties. As a result central banks had to pump hundreds of billions into financial markets to address the liquidity spiral and to ensure the solvency of key financial institutions.

So why did these interactions and correlations spike when the sub-prime crisis hit?

The analysis presented here suggests that increasing financial integration and innovation can make market and funding liquidity pressures readily turn into issues of insolvency.

The easy answer would be to blame the quants and financial engineers. But the real culprit was greed, reinforced by the lousy risk management and lax prudential standards of most major banks (and their clients, many of whom bought products they did not understand). While the money kept rolling in the door, senior managers were quite happy to avert their eyes to the ever-mounting risks.

I was not surprised by the sub-prime crisis; it was an accident waiting to happen. But I didn't expect the credit crunch to have been protracted, particularly once central banks interviened with such gusto.

Rogoff is probably right to say that we are only about half-way through the crisis. But the key issue for me is not whether another major bank goes bust (some of them clearly deserve to). It is whether the risk of US recession is now receding (a U-shaped downturn), or whether we are instead facing a 'W'-shaped downturn, with another growth dip looming. So far my controversial call of no US recession this year has held up, and I still think I am odds on to be proved correct. But the outlook for 2009 has becoming bleaker; there are now too many uncertainties to rule out an eventual recession.

Comments

[Blissex]

«It wasn't simply credit that dried up, it was trust - the whole basis of interbank money markets. Banks were unwilling to trust the disclosures or assurances of their counterparties. As a result central banks had to pump hundreds of billions into financial markets to address the liquidity spiral and to ensure the solvency of key financial institutions.» That's entirely ridiculous -- usually as in the recent event it is solvency issue that causes illiquidity. Once most banks realized that there were a trillion or two of losses in the banking system, that's when liquidity disappeared, not viceversa. Banks were unwilling to trust their counterparties because they knew most of them had to be insolvent, not just because they suddendly became paranoid. Central banks have put hundreds of billions to address that insolvency, not the liquidity problem, which is just a code-word for not wanting to say "insolvency". The basic problem is not that CDOs are illiquid and one has to hold them to maturity to get cash out of them, but that they are largely worthless and who holds them is insolvent, and once the ponzi scheme stopped because banks had run out of greater fools, they found themselves holding too much of the worthless paper they had created, or even worse, having lent too much money to those who were buying them. Vendor financing is a wonderful way for salesmen to tunnel money our of their companies...

[Andrew Garland]

Banks are intermediaries with one major job, to evaluate risk and make good loans. It became clear that they were fools, completely unaware (at best) how to run their central business. After proving this, why should they still be in business?

The "Banking Crisis" will only resolve after the managements of these banks are fired, either explicitly or by going out of business.

[Eva]

I wonder what is supposed to be so new about that analysis? Anyone working in the financial sector was aware of this around this time last year!

[jim]

Re: not in a recession

Only if you accept the veracity of the governments numbers. I submit that anyone that accepts and promulgates a recession argument using these politically manipulated figures is naive or corrupt. Either way, it's a statistic that has been engineered to become meaningless. It's the new depression.

[Arthur Eckart]

Obviously, U.S. government data are correct. For example, if inflation is understated, then so is nominal GDP.

The Panic of 2008

The Bush Administration and the Bernanke Fed recognize the problem. Bad debt locked-up lending to the point where banks wouldn't even lend to each other. The $700 billion injection of cash, in exchange for bad debt, will remove the reason banks are distrustful of lending. It's a brilliant policy, and supports my statements on the causes of this crisis.

The U.S. already captured the real assets and goods, in exchange for employment of export-led economies, and the U.S. government will sell those MBSs in the future when housing prices rise again, which this policy will facilitate. I've stated before, this is an appropriate response to the government policies of export-led economies, and the benefits of this policy will far exceed the costs.

[francis]

In simple terms, a crisis caused by banks being too nervous to lend money to us or each other. Where they will lend, they charge higher rates of interest to cover their risk. In the real world, that means more expensive mortgages, dearer credit cards, pain for pension savers and other investors as stock markets fluctuate wildly, and in the worst cases repossession and bankruptcy. There is often confusion between the two but they are not the same. A recession is usually taken to mean two successive quarters of negative economic growth. A credit crunch can be separate to or part of a recession. Years of lax lending inflated a huge debt bubble as people borrowed cheap money and ploughed it into property.Lenders were free with their funds, especially in the US, where billions of dollars of so-called Ninja mortgages - no income, no job or assets - were sold to people with weak credit ratings.
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[Will Cochran]

Now that government has created the housing bubble it is on to health care!

[Sade Jordan]

This analysis isn't new, nor that insightful. Anyone with an ounce of economic sense understands that the underlying force of inflating a "bubble" is greed and the deflating element is "fear".

[Sam]

Nobody ever relates the solvency crisis to when fast food restaurants started accepting credit as a form of payment, but it always turns back to housing. People have to eat too! There were a lot of Whoppers and Taco Grandes being eaten in those McMansions. Heck, that's practically why they're called McMansions!

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[Michelle Boudreau]

The analysis and qualitative survey shows how financial integration and innovation can make market and funding liquidity pressures readily turn into issues of insolvency .

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The analysis and qualitative survey shows how financial integration and innovation can make market and funding liquidity pressures readily turn into issues of insolvency .

[matbaa]

«It wasn't simply credit that dried up, it was trust - the whole basis of interbank money markets. Banks were unwilling to trust the disclosures or assurances of their counterparties. As a result central banks had to pump hundreds of billions into financial markets to address the liquidity spiral and to ensure the solvency of key financial institutions.» That's entirely ridiculous -- usually as in the recent event it is solvency issue that causes illiquidity. Once most banks realized that there were a trillion or two of losses in the banking system, that's when liquidity disappeared, not viceversa. Banks were unwilling to trust their counterparties because they knew most of them had to be insolvent, not just because they suddendly became paranoid. Central banks have put hundreds of billions to address that insolvency, not the liquidity problem, which is just a code-word for not wanting to say "insolvency". The basic problem is not that CDOs are illiquid and one has to hold them to maturity to get cash out of them, but that they are largely worthless and who holds them is insolvent, and once the ponzi scheme stopped because banks had run out of greater fools, they found themselves holding too much of the worthless paper they had created, or even worse, having lent too much money to those who were buying them. Vendor financing is a wonderful way for salesmen to tunnel money our of their companies...

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[Forex Trader]

Well its good to read past posts as this shows how close the global financial sector came to complete colapse. I hope the sub-prime market will never be allowed to exist again and something good can come out of all this mess.

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A concise account of how the credit crunch happened. I feel that the more people that understand how this happened, the closer we will be to preventing it happening once more.

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A rise in interest rates made housing prices plummet. Why did this situation force home owners to default on their mortgage payments? Was it because they couldn't keep borrowing against the value of their homes and using that money to make those mortgage payments? And if so, wouldn't these home owners have reached a point of no return, even if interest rates had remained low? You can't borrow from Peter forever to pay Paul. I'd be interested in an answer.

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[Preston Wilcott]

The real culprit was greed, reinforced by terrible risk management.