Deciphering the Liquidity and Credit
Crunch 2007–2008
Markus K. Brunnermeier
T
he ﬁnancial market turmoil in 2007 and 2008 has led to the most severe
ﬁnancial crisis since the Great Depression and threatens to have large
repercussions on the real economy. The bursting of the housing bubble
forced banks to write down several hundred billion dollars in bad loans caused by
mortgage delinquencies. At the same time, the stock market capitalization of the
major banks declined by more than twice as much. While the overall mortgage
losses are large on an absolute scale, they are still relatively modest compared to the
$8 trillion of U.S. stock market wealth lost between October 2007, when the stock
market reached an all-time high, and October 2008. This paper attempts to explain
the economic mechanisms that caused losses in the mortgage market to amplify
into such large dislocations and turmoil in the ﬁnancial markets, and describes
common economic threads that explain the plethora of market declines, liquidity
dry-ups, defaults, and bailouts that occurred after the crisis broke in summer 2007.
To understand these threads, it is useful to recall some key factors leading up
to the housing bubble. The U.S. economy was experiencing a low interest rate
environment, both because of large capital inﬂows from abroad, especially from
Asian countries, and because the Federal Reserve had adopted a lax interest rate
policy. Asian countries bought U.S. securities both to peg the exchange rates at an
export-friendly level and to hedge against a depreciation of their own currencies
against the dollar, a lesson learned from the Southeast Asian crisis of the late 1990s.
The Federal Reserve Bank feared a deﬂationary period after the bursting of the
Internet bubble and thus did not counteract the buildup of the housing bubble. At
the same time, the banking system underwent an important transformation. The
y Markus K. Brunnermeier is the Edwards S. Sanford Professor of Economics, Princeton
University, Princeton, New Jersey. His e-mail address is ͗markus@princeton.edu͘.
Journal of Economic Perspectives—Volume 23, Number 1—Winter 2009—Pages 77–100
traditional banking model, in which the issuing banks hold loans until they are
repaid, was replaced by the “originate and distribute” banking model, in which
loans are pooled, tranched, and then resold via securitization. The creation of new
securities facilitated the large capital inﬂows from abroad.
The ﬁrst part of the paper describes this trend towards the “originate and
distribute” model and how it ultimately led to a decline in lending standards.
Financial innovation that had supposedly made the banking system more stable by
transferring risk to those most able to bear it led to an unprecedented credit
expansion that helped feed the boom in housing prices. The second part of the
paper provides an event logbook on the ﬁnancial market turmoil in 2007–08,
ending with the start of the coordinated international bailout in October 2008. The
third part explores four economic mechanisms through which the mortgage crisis
ampliﬁed into a severe ﬁnancial crisis. First, borrowers’ balance sheet effects cause two
“liquidity spirals.” When asset prices drop, ﬁnancial institutions’ capital erodes and,
at the same time, lending standards and margins tighten. Both effects cause
ﬁre-sales, pushing down prices and tightening funding even further. Second, the
lending channel can dry up when banks become concerned about their future access
to capital markets and start hoarding funds (even if the creditworthiness of borrowers
does not change). Third, runs on ﬁnancial institutions, like those that occurred
at Bear Stearns, Lehman Brothers, and Washington Mutual, can cause a
sudden erosion of bank capital. Fourth, network effects can arise when ﬁnancial
institutions are lenders and borrowers at the same time. In particular, a gridlock
can occur in which multiple trading parties fail to cancel out offsetting positions
because of concerns about counterparty credit risk. To protect themselves against
the risks that are not netted out, each party has to hold additional funds.
Banking Industry Trends Leading Up to the Liquidity Squeeze
Two trends in the banking industry contributed signiﬁcantly to the lending
boom and housing frenzy that laid the foundations for the crisis. First, instead of
holding loans on banks’ balance sheets, banks moved to an “originate and distribute”
model. Banks repackaged loans and passed them on to various other ﬁnancial
investors, thereby off-loading risk. Second, banks increasingly ﬁnanced their asset
holdings with shorter maturity instruments. This change left banks particularly
exposed to a dry-up in funding liquidity.
Securitization: Credit Protection, Pooling, and Tranching Risk
To ofﬂoad risk, banks typically create “structured” products often referred to
as collateralized debt obligations (CDOs). The ﬁrst step is to form diversiﬁed portfolios
of mortgages and other types of loans, corporate bonds, and other assets like credit
card receivables. The next step is to slice these portfolios into different tranches.
These tranches are then sold to investor groups with different appetites for risk.
78 Journal of Economic Perspectives
The safest tranche—known as the “super senior tranche”—offers investors a (relatively)
low interest rate, but it is the ﬁrst to be paid out of the cash ﬂows of the
portfolio. In contrast, the most junior tranche—referred to as the “equity tranche”
or “toxic waste”—will be paid only after all other tranches have been paid. The
mezzanine tranches are between these extremes.
The exact cutoffs between the tranches are typically chosen to ensure a speciﬁc
rating for each tranche. For example, the top tranches are constructed to receive
a AAA rating. The more senior tranches are then sold to various investors, while the
toxic waste is usually (but not always) held by the issuing bank, to ensure that it
adequately monitors the loans.
Buyers of these tranches or regular bonds can also protect themselves by
purchasing credit default swaps (CDS), which are contracts insuring against the
default of a particular bond or tranche. The buyer of these contracts pays a periodic
ﬁxed fee in exchange for a contingent payment in the event of credit default.
Estimates of the gross notional amount of outstanding credit default swaps in 2007
range from $45 trillion to $62 trillion. One can also directly trade indices that
consist of portfolios of credit default swaps, such as the CDX in the United States
or iTraxx in Europe. Anyone who purchased a AAA-rated tranche of a collateralized
debt obligation combined with a credit default swap had reason to believe that
the investment had low risk because the probability of the CDS counterparty
defaulting was considered to be small.
Shortening the Maturity Structure to Tap into Demand from Money Market
Funds
Most investors prefer assets with short maturities, such as short-term money
market funds. It allows them to withdraw funds at short notice to accommodate
their own funding needs (for example, Diamond and Dybvig, 1983; Allen and Gale,
2007) or it can serve as a commitment device to discipline banks with the threat of
possible withdrawals (as in Calomiris and Kahn, 1991; Diamond and Rajan, 2001).
Funds might also opt for short-term ﬁnancing to signal their conﬁdence in their
ability to perform (Stein, 2005). On the other hand, most investment projects and
mortgages have maturities measured in years or even decades. In the traditional
banking model, commercial banks ﬁnanced these loans with deposits that could be
withdrawn at short notice.
The same maturity mismatch was transferred to a “shadow” banking system
consisting of off-balance-sheet investment vehicles and conduits. These structured
investment vehicles raise funds by selling short-term asset-backed commercial paper
with an average maturity of 90 days and medium-term notes with an average
maturity of just over one year, primarily to money market funds. The short-term
assets are called “asset backed” because they are backed by a pool of mortgages or
other loans as collateral. In the case of default, owners of the asset-backed commercial
paper have the power to seize and sell the underlying collateral assets.
The strategy of off-balance-sheet vehicles—investing in long-term assets and
Markus K. Brunnermeier 79
borrowing with short-term paper—exposes the banks to funding liquidity risk: investors
might suddenly stop buying asset-backed commercial paper, preventing these
vehicles from rolling over their short-term debt. To ensure funding liquidity for the
vehicle, the sponsoring bank grants a credit line to the vehicle, called a “liquidity
backstop.” As a result, the banking system still bears the liquidity risk from holding
long-term assets and making short-term loans even though it does not appear on
the banks’ balance sheets.
Another important trend was an increase in the maturity mismatch on the
balance sheet of investment banks. This change was the result of a move towards
ﬁnancing balance sheets with short-term repurchase agreements, or “repos.” In a
repo contract, a ﬁrm borrows funds by selling a collateral asset today and promising
to repurchase it at a later date. The growth in repo ﬁnancing as a fraction of
investment banks’ total assets is mostly due to an increase in overnight repos. The
fraction of total investment bank assets ﬁnanced by overnight repos roughly doubled
from 2000 to 2007. Term repos with a maturity of up to three months have
stayed roughly constant at as a fraction of total assets. This greater reliance on
overnight ﬁnancing required investment banks to roll over a large part of their
funding on a daily basis.
In summary, leading up to the crisis, commercial and investment banks were
heavily exposed to maturity mismatch both through granting liquidity backstops to
their off-balance sheet vehicles and through their increased reliance on repo
ﬁnancing. Any reduction in funding liquidity could thus lead to signiﬁcant stress
for the ﬁnancial system, as we witnessed starting in the summer of 2007.
Rise in Popularity of Securitized and Structured Products
Structured ﬁnancial products can cater to the needs of different investor
groups. Risk can be shifted to those who wish to bear it, and it can be widely spread
among many market participants. This allows for lower mortgage rates and lower
interest rates on corporate and other types of loans. Besides lower interest rates,
securitization allows certain institutional investors to hold assets (indirectly) that
they were previously prevented from holding by regulatory requirements. For
example, certain money market and pension funds that were allowed to invest only
in AAA-rated ﬁxed-income securities could now also invest in a AAA-rated senior
tranche of a portfolio constructed from BBB-rated securities. However, a large part
of the credit risk never left the banking system, since banks, including sophisticated
investment banks, were among the most active buyers of structured products (see
for example, Dufﬁe, 2008). This suggests that other, perhaps less worthy motives
were also at work in encouraging the creation and purchase of these assets.
In hindsight, it is clear that one distorting force leading to the popularity of
structured investment vehicles was regulatory and ratings arbitrage. The Basel I accord
(an international agreement that sets guidelines for bank regulation) required that
banks hold capital of at least 8 percent of the loans on their balance sheets; this
80 Journal of Economic Perspectives
capital requirement (called a “capital charge”) was much lower for contractual
credit lines. Moreover, there was no capital charge at all for “reputational” credit
lines—noncontractual liquidity backstops that sponsoring banks provided to structured
investment vehicles to maintain their reputation. Thus, moving a pool of
loans into off-balance-sheet vehicles, and then granting a credit line to that pool to
ensure a AAA-rating, allowed banks to reduce the amount of capital they needed to
hold to conform with Basel I regulations while the risk for the bank remained
essentially unchanged. The subsequent Basel II accord—which went into effect on
January 1, 2007, in Europe but is yet to be fully implemented in the United
States—took some steps to correct this preferential treatment of noncontractual
credit lines, but with little effect. Basel II implemented capital charges based on
asset ratings, but banks were able to reduce their capital charges by pooling loans
in off-balance-sheet vehicles. Because of the reduction of idiosyncratic risk through
diversiﬁcation, assets issued by these vehicles received a better rating than did the
individual securities in the pool.1
In addition, issuing short-term assets improved
the overall rating even further, since banks sponsoring these structured investment
vehicles were not sufﬁciently downgraded for granting liquidity backstops.
Moreover, in retrospect, the statistical models of many professional investors
and credit-rating agencies provided overly optimistic forecasts about structured
ﬁnance products. One reason is that these models were based on historically low
mortgage default and delinquency rates. More importantly, past downturns in
housing prices were primarily regional phenomena—the United States had not
experienced a nationwide decline in housing prices in the period following World
War II. The assumed low cross-regional correlation of house prices generated a
perceived diversiﬁcation beneﬁt that especially boosted the valuations of AAA-rated
tranches (as explained in this symposium in the paper by Coval, Jurek, and
Stafford).
In addition, structured products may have received more favorable ratings
compared to corporate bonds because rating agencies collected higher fees for
structured products. “Rating at the edge” might also have contributed to favorable
ratings of structured products versus corporate bonds; while a AAA-rated bond
represents a band of risk ranging from a near-zero default risk to a risk that just
makes it into the AAA-rated group, banks worked closely with the rating agencies
to ensure that AAA tranches were always sliced in such a way that they just crossed
the dividing line to reach the AAA rating. Fund managers, “searching for yield,”
were attracted to buying structured products because they seemingly offered high
expected returns with a small probability of catastrophic loss. In addition, some
1
To see this, consider a bank that hypothetically holds two perfectly negatively correlated BBB-rated
assets. If it were to hold the assets directly on its books, it would face a high capital charge. On the other
hand, if it were to bundle both assets in a structured investment vehicle, the structured investment
vehicle could issue essentially risk-free AAA-rated assets that the bank can hold on its books at near zero
capital charge.
Deciphering the Liquidity and Credit Crunch 2007–2008 81
fund managers may have favored the relatively illiquid junior tranches precisely
because they trade so infrequently and were therefore hard to value. These managers
could make their monthly returns appear attractively smooth over time
because they had some ﬂexibility with regard to when they could revalue their
portfolios.
Consequences: Cheap Credit and the Housing Boom
The rise in popularity of securitized products ultimately led to a ﬂood of cheap
credit, and lending standards fell. Because a substantial part of the risk will be
borne by other ﬁnancial institutions, banks essentially faced only the “pipeline risk”
of holding a loan for some months until the risks were passed on, so they had little
incentive to take particular care in approving loan applications and monitoring
loans. Keys, Mukherjee, Seru, and Vig (2008) offer empirical evidence that increased
securitization led to a decline in credit quality. Mortgage brokers offered
teaser rates, no-documentation mortgages, piggyback mortgages (a combination of
two mortgages that eliminates the need for a down payment), and NINJA (“no
income, no job or assets”) loans. All these mortgages were granted under the
premise that background checks are unnecessary because house prices could only
rise, and a borrower could thus always reﬁnance a loan using the increased value of
the house.
This combination of cheap credit and low lending standards resulted in the
housing frenzy that laid the foundations for the crisis. By early 2007, many observers
were concerned about the risk of a “liquidity bubble” or “credit bubble” (for
example, Berman, 2007). However, they were reluctant to bet against the bubble.
As in the theoretical model presented in Abreu and Brunnermeier (2002, 2003), it
was perceived to be more proﬁtable to ride the wave than to lean against it.
Nevertheless, there was a widespread feeling that the day of reckoning would
eventually come. Citigroup’s former chief executive ofﬁcer, Chuck Prince, summed
up the situation on July 10, 2007 by referring to Keynes’s analogy between bubbles
and musical chairs (Nakamoto and Wighton, 2007): “When the music stops, in
terms of liquidity, things will be complicated. But as long as the music is playing,
you’ve got to get up and dance. We’re still dancing.” This game of musical chairs,
combined with the vulnerability of banks to dry-ups in funding liquidity, ultimately
unfolded into the crisis that began in 2007.
The Unfolding of the Crisis: Event Logbook
The Subprime Mortgage Crisis
The trigger for the liquidity crisis was an increase in subprime mortgage
defaults, which was ﬁrst noted in February 2007. Figure 1 shows the ABX price
index, which is based on the price of credit default swaps. As this price index
82 Journal of Economic Perspectives
declines, the cost of insuring a basket of mortgages of a certain rating against
default increases. On May 4, 2007, UBS shut down its internal hedge fund, Dillon
Read, after suffering about $125 million of subprime-related losses. Later that
month, Moody’s put 62 tranches across 21 U.S. subprime deals on “downgrade
review,” indicating that it was likely these tranches would be downgraded in the
near future. This review led to a deterioration of the prices of mortgage-related
products.
Rating downgrades of other tranches by Moody’s, Standard & Poor’s, and Fitch
unnerved the credit markets in June and July 2007. In mid-June, two hedge funds
run by Bear Stearns had trouble meeting margin calls, leading Bear Stearns to
inject $3.2 billion in order to protect its reputation. Then a major U.S. home loan
lender, Countrywide Financial Corp., announced an earnings drop on July 24. And
on July 26, an index from the National Association of Home Builders revealed that
new home sales had declined 6.6 percent year-on-year, and the largest U.S. homeFigure
1
Decline in Mortgage Credit Default Swap ABX Indices
(the ABX 7-1 series initiated in January 1, 2007)Jan07
M
ar07
M
ay07
Jul07
Sep07
N
ov07
Jan08
M
ar08
M
ay08
Jul08
Sep08
N
ov08
Jan09
100
80
60
40
20
0
ABXprice
AAA
AA
A
BBB
BBBSource:
LehmanLive.
Note: Each ABX index is based on a basket of 20 credit default swaps referencing asset-backed securities
containing subprime mortgages of different ratings. An investor seeking to insure against the default of
the underlying securities pays a periodic fee (spread) which—at initiation of the series—is set to
guarantee an index price of 100. This is the reason why the ABX 7-1 series, initiated in January 2007,
starts at a price of 100. In addition, when purchasing the default insurance after initiation, the
protection buyer has to pay an upfront fee of (100 – ABX price). As the price of the ABX drops, the
upfront fee rises and previous sellers of credit default swaps suffer losses.
Markus K. Brunnermeier 83
builder reported a loss in that quarter. From then through late in 2008, house
prices and sales continued to drop.
Asset-Backed Commercial Paper
In July 2007, amid widespread concern about how to value structured products
and an erosion of conﬁdence in the reliability of ratings, the market for short-term
asset-backed commercial paper began to dry up. As Figure 2 shows, the market for
non-asset-backed commercial paper (be it ﬁnancial or nonﬁnancial) during this
time was affected only slightly—which suggests that the turmoil was driven primarily
by mortgage-backed securities.
IKB, a small German bank, was the ﬁrst European victim of the subprime crisis.
In July 2007, its conduit was unable to roll over asset-backed commercial paper and
IKB proved unable to provide the promised credit line. After hectic negotiations,
a €3.5 billion rescue package involving public and private banks was announced.
On July 31, American Home Mortgage Investment Corp. announced its inability to
fund lending obligations, and it subsequently declared bankruptcy on August 6. On
August 9, 2007, the French bank BNP Paribas froze redemptions for three investment
funds, citing its inability to value structured products.
Following this event, a variety of market signals showed that money market
participants had become reluctant to lend to each other. For example, the average
Figure 2
Outstanding Asset-Backed Commercial Paper (ABCP) and Unsecured Commercial
Paper
Amountoutstanding($billions)
ABCP
Non-ABCP
1200
1000
800
600
Jan04
Jul04
Jan05
Jul05
Jan06
Jul06
Jan07
Jul07
Jan08
Jul08
Jan09
Source: Federal Reserve Board.
84 Journal of Economic Perspectives
quoted interest rate on asset-backed commercial paper jumped from 5.39 percent
to 6.14 percent over the period August 8–10, 2007. All through August 2007, rating
agencies continued to downgrade various conduits and structured investment
vehicles.
The LIBOR, Repo, and Federal Funds Markets
In addition to the commercial paper market, banks use the repo market, the
federal funds market, and the interbank market to ﬁnance themselves. Repurchase
agreements, or “repos,” allow market participants to obtain collateralized funding
by selling their own or their clients’ securities and agreeing to repurchase them
when the loan matures. The U.S. federal funds rate is the overnight interest rate at
which banks lend reserves to each other to meet the central bank’s reserve
requirements. In the interbank or LIBOR (London Interbank Offered Rate)
market, banks make unsecured, short-term (typically overnight to three-month)
loans to each other. The interest rate is individually agreed upon. LIBOR is an
average indicative interest rate quote for such loans.
An interest rate spread measures the difference in interest rates between two
bonds of different risk. These credit spreads had shrunk to historically low levels
during the “liquidity bubble” but they began to surge upward in the summer of
2007. Historically, many market observers focused on the TED spread, the difference
between the risky LIBOR rate and the risk-free U.S. Treasury bill rate. In times
of uncertainty, banks charge higher interest for unsecured loans, which increases
the LIBOR rate. Further, banks want to get ﬁrst-rate collateral, which makes
holding Treasury bonds more attractive and pushes down the Treasury bond rate.
For both reasons, the TED spread widens in times of crises, as shown in Figure 3.
The TED spread provides a useful basis for gauging the severity of the current
liquidity crisis.
Central Banks Step Forward
In the period August 1–9, 2007, many quantitative hedge funds, which use
trading strategies based on statistical models, suffered large losses, triggering
margin calls and ﬁre sales. Crowded trades caused high correlation across quant
trading strategies (for details, see Brunnermeier, 2008a; Khandani and Lo, 2007).
The ﬁrst “illiquidity wave” on the interbank market started on August 9. At that
time, the perceived default and liquidity risks of banks rose signiﬁcantly, driving up
the LIBOR. In response to the freezing up of the interbank market on August 9, the
European Central Bank injected €95 billion in overnight credit into the interbank
market. The U.S. Federal Reserve followed suit, injecting $24 billion.
To alleviate the liquidity crunch, the Federal Reserve reduced the discount
rate by half a percentage point to 5.75 percent on August 17, 2007, broadened the
type of collateral that banks could post, and lengthened the lending horizon to
30 days. However, the 7,000 or so banks that can borrow at the Fed’s discount
window are historically reluctant to do so because of the stigma associated with
Deciphering the Liquidity and Credit Crunch 2007–2008 85
it—that is, the fear that discount window borrowing might signal a lack of creditworthiness
on the interbank market. On September 18, the Fed lowered the federal
funds rate by half a percentage point (50 basis points) to 4.75 percent and the
discount rate to 5.25 percent. The U.K. bank Northern Rock was subsequently
unable to ﬁnance its operations through the interbank market and received a
temporary liquidity support facility from the Bank of England. Northern Rock
ultimately fell victim to the ﬁrst bank run in the United Kingdom for more than a
century (discussed in this symposium in the paper by Shin).
Continuing Write-downs of Mortgage-related Securities
October 2007 was characterized by a series of write-downs. For a time, major
international banks seemed to have cleaned their books. The Fed’s liquidity injections
appeared effective. Also, various sovereign wealth funds invested a total of
more than $38 billion in equity from November 2007 until mid-January 2008 in
major U.S. banks (IMF, 2008).
But matters worsened again starting in November 2007 when it became clear
that an earlier estimate of the total loss in the mortgage markets, around $200
billion, had to be revised upward. Many banks were forced to take additional, larger
Figure 3
The TED Spread
Percentagepoints
5
4
3
2
1
0
Apr07M
ay07Jun07Jul07Aug07Sep07O
ct07N
ov07D
ec07Jan08Feb08M
ar08Apr08M
ay08Jun08Jul08Aug08Sep08O
ct08N
ov08D
ec08Jan09
Source: Bloomberg.
Note: The line reﬂects the TED spread, the interest rate difference between the LIBOR and the
Treasury bill rate.
86 Journal of Economic Perspectives
write-downs. The TED spread widened again as the LIBOR peaked in midDecember
of 2007 (Figure 3). This change convinced the Fed to cut the federal
funds rate by 0.25 percentage point on December 11, 2007.
At this point, the Federal Reserve had discerned that broad cuts in the federal
funds rate and the discount rate were not reaching the banks caught in the liquidity
crunch. On December 12, 2007, the Fed announced the creation of the Term
Auction Facility (TAF), through which commercial banks could bid anonymously
for 28-day loans against a broad set of collateral, including various mortgage-backed
securities. For banks, the effect was quite similar to borrowing from the discount
window—except it could be done anonymously. As described in more detail by
Cecchetti in this symposium, this step helped resuscitate interbank lending.
The Monoline Insurers
Amid ongoing bank write-downs, the investment community’s primary worry
by January and early February 2008 was the potential downgrading of the “monoline
insurers.” Unlike insurance companies which are active in many business lines,
monoline insurers focused completely on one product, insuring municipal bonds
against default (in order to guarantee a AAA-rating). More recently, however, the
thinly capitalized monoline insurers had also extended guarantees to mortgagebacked
securities and other structured ﬁnance products.
As losses in the mortgage market mounted, the monoline insurers were on the
verge of being downgraded by all three major rating agencies. This change would
have led to a loss of AAA-insurance for hundreds of municipal bonds, corporate
bonds, and structured products, resulting in a sweeping rating downgrade across
ﬁnancial instruments with a face value of $2.4 trillion and a subsequent severe
sell-off of these securities. To appreciate the importance, note that money market
funds pledge never to “break the buck”—that is, they promise to maintain the value
of every dollar invested and hence demand that underwriters of assets agree to buy
back the assets if needed. However, this buy-back guarantee is conditional on the
underlying assets being AAA-rated. Consequently, a rating downgrade would have
triggered a huge sell-off of these assets by money market funds.
On January 19, 2008, the rating agency Fitch downgraded one of the monoline
insurers, Ambac, unnerving worldwide ﬁnancial markets. While U.S. ﬁnancial
markets were closed for Martin Luther King Day, share prices dropped precipitously
worldwide. Emerging markets in Asia lost about 15 percent, and Japanese
and European markets were down around 5 percent. The sell-off continued in the
morning of Tuesday, January 22, in Asia and Europe. Dow Jones and Nasdaq
futures were down 5 to 6 percent, indicating a large drop in the U.S. equity market
as well. Given this environment, the Fed decided to cut the federal funds rate by
0.75 percentage point to 3.5 percent—the Fed’s ﬁrst “emergency cut” since 1982.
At its regular meeting on January 30, the Federal Open Market Committee cut the
federal funds rate another 0.5 percentage point.
Markus K. Brunnermeier 87
Bear Stearns
In early March 2008, events put pressure on the investment bank Bear Stearns.
First, the credit spreads between agency bonds (issued by Freddie Mac and Fannie
Mae) and Treasury bonds started to widen again. The widening spreads hurt
Carlyle Capital, an Amsterdam-listed hedge fund, which was heavily invested in
agency bonds. When Carlyle could not meet its margin calls, its collateral assets
were seized and partially liquidated. This action depressed the price of agency
bonds further. Not only did Bear Stearns hold large amounts of agency paper on
its own, but it was also one of the creditors to Carlyle.
A second event was that of March 11, 2008, when the Federal Reserve announced
its $200 billion Term Securities Lending Facility. This program allowed investment
banks to swap agency and other mortgage-related bonds for Treasury bonds for up to
28 days. To avoid stigmatization, the extent to which investment banks made use of this
facility was to be kept secret. However, some market participants might have (mistakenly)
interpreted this move as a sign that the Fed knew that some investment bank
might be in difﬁculty. Naturally, they pointed to the smallest, most leveraged investment
bank with large mortgage exposure: Bear Stearns.
Moreover, after trading hours ended on March 11, 2008, a hedge fund sent
Goldman Sachs an e-mail asking it to step into a contractual relationship that would
increase Goldman’s direct exposure to Bear Stearns. Given the late request, Goldman
only “novated” (accepted) the new contract on the morning of March 12. In
the meantime, the late acceptance was (wrongly) interpreted as a refusal and was
leaked to the media, causing unease among Bear Stearns’s hedge fund clients. This
incident might have contributed to the run on Bear by its hedge fund clients and
other counterparties. Bear’s liquidity situation worsened dramatically the next day
as it was suddenly unable to secure funding on the repo market.
Bear Stearns had about 150 million trades spread across various counterparties.
It was therefore considered “too interconnected” to be allowed to fail suddenly.
Some big party had to step in to minimize counterparty credit risk. Over the
weekend, ofﬁcials from the Federal Reserve Bank of New York helped broker a
deal, through which JPMorgan Chase would acquire Bear Stearns for $236 million,
or $2 per share (ultimately increased to $10 per share). By comparison, Bear
Stearns’s shares had traded at around $150 less than a year before. The New York
Fed also agreed to grant a $30 billion loan to JPMorgan Chase. On Sunday night,
the Fed cut the discount rate from 3.5 percent to 3.25 percent and for the ﬁrst time
opened the discount window to investment banks, via the new Primary Dealer
Credit Facility (PDCF), an overnight funding facility for investment banks. This step
temporarily eased the liquidity problems of the other investment banks, including
Lehman Brothers.
Government-Sponsored Enterprises: Fannie Mae and Freddie Mac
Mortgage delinquency rates continued to increase in the subsequent
months. By mid-June 2008, the interest rate spread between “agency bonds,” of
88 Journal of Economic Perspectives
the government-sponsored enterprises Fannie Mae and Freddie Mac, and Treasury
bonds had widened again. Fannie Mae and Freddie Mac at that time were
two publicly traded but government-chartered institutions that securitized a
large fraction of U.S. mortgages and had about $1.5 trillion in bonds outstanding.
After IndyMac, a large private mortgage broker, was put in conservatorship
by the Federal Deposit Insurance Corporation (FDIC) on Friday, July 11,
problems at Fannie and Freddie ﬂared up, prompting Treasury Secretary Henry
Paulson on the evening of Sunday, July 13, to announce plans to make their
implicit government guarantee explicit. Despite this support, the stock prices of
Fannie and Freddie slid further in the subsequent weeks, ultimately forcing
government ofﬁcials to put them in federal conservatorship on September 7.
This step constituted a “credit event” for a large number of outstanding credit
default swaps, triggering large payments to those who had bought these swaps.
Note that Ginnie Mae, the third government-sponsored enterprise, always
enjoyed full government guarantee.
Lehman Brothers, Merrill Lynch, and AIG
Unlike Bear Stearns, Lehman Brothers had survived the fallout in March 2008,
but only narrowly. It subsequently made heavy use of the Fed’s new Primary Dealer
Credit Facility, but did not issue new equity to strengthen its balance sheet. It felt
that stepping forward as a single bank to issue enough new shares (without a
concerted effort across all banks) would be very costly, because it would be
perceived as a signal of desperation. As Lehman’s share price eroded, and especially
as it became clear on September 9, 2008, that the state-controlled Korea
Development Bank would not buy the ﬁrm, Lehman’s shares plunged. Timothy
Geithner, president of the Federal Reserve Bank of New York, convened a weekend
meeting with all major banks’ most senior executives on September 12–14 to secure
Lehman’s future. Initially, Barclays and Bank of America were named as possible
suitors. However, they refused to take over Lehman without a government guarantee.
Eventually, Treasury and Fed ofﬁcials decided not to offer a guarantee
funded by taxpayers, especially since Lehman, as well as its clients and counterparties,
had had ample time to prepare for the liquidity shortage. Consequently,
Lehman had to declare bankruptcy early Monday morning. In the meantime,
reading the signs, Merrill Lynch had already announced on Sunday that it had sold
itself to Bank of America for $50 billion.
The effects of Lehman’s bankruptcy would ripple throughout the global
ﬁnancial markets, but not before AIG, a large international insurance company,
disclosed that it faced a serious liquidity shortage. Like investment banks, AIG had
been increasingly active in the credit derivatives business, including credit default
swaps. On Tuesday, September 16, 2008, AIG’s stock price fell more than 90 percent,
capping off a large decline from the previous days. Owing to AIG’s interconnectedness
in the credit derivatives business, the Federal Reserve quickly organized
a bailout of $85 billion in exchange for an 80 percent equity stake. The AIG bailout
Deciphering the Liquidity and Credit Crunch 2007–2008 89
was extended by a further $37 billion in October and another $40 billion in
November.
The ripple effects of Lehman’s demise were difﬁcult to predict, because
Lehman had counterparties across the globe. First, and most importantly, many
money market funds suffered losses. Some “broke the buck”—their share price
dropped below $1—while others supported their funds via cash injections. To avoid
the broad repercussions of a run on money market funds, the U.S. Treasury set
aside $80 billion to guarantee brokers’ money market funds. Second, the prices
paid for credit default swaps that offer protection against defaults of the remaining
banks soared, as each bank tried to protect itself against counterparty credit
risk—that is, the risk that other banks would default. Third, ﬁnancial non-assetbacked
commercial paper experienced a sharp fall (see Figure 2), which led to the
introduction of the Commercial Paper Funding Facility by the Fed.
Coordinated Bailout, Stock Market Decline, Washington Mutual, Wachovia, and
Citibank
As can be seen by the extreme spike in the TED spread in Figure 3, the credit
markets deteriorated signiﬁcantly in subsequent weeks.2
Washington Mutual suffered
a “silent” bank run. Instead of publicly queuing in front of bank tellers,
customers and fund managers withdrew funds electronically. Soon afterwards,
Washington Mutual was placed in receivership by the Federal Deposit Insurance
Corporation (FDIC), and then sold to JPMorgan Chase. In a move also facilitated
by the FDIC, Wachovia announced on September 29 that it was selling its banking
operation to Citibank, but after a bidding contest, Wachovia ultimately fell into the
hands of Wells Fargo.
The overall stock market fell off a cliff, losing about $8 trillion in the year after
its peak in October 2007. More importantly, Wall Street’s problems seemed to spill
over to Main Street. Credit for ﬁrms and local and state governments tightened,
infecting the global economy. It became more and more clear that a proactive,
coordinated action across all solvent banks had to replace the reactive piecemeal
approach. After news broke on September 19, 2008, that the Treasury Secretary
would propose a $700 billion bailout plan, a political quarrel started and ultimately
led to a bailout plan that included foreclosure-mitigation elements for homeowners,
provisions to purchase troubled mortgage assets, and a coordinated forced
recapitalization of banks. Despite this, Citibank needed additional support in
November and several facilities were established to enable the Fed to buy commercial
paper and almost any type of asset-backed security and agency paper. The Fed’s
balance sheet roughly doubled from about $1.2 trillion in November 2007 to about
2
Focusing on the TED spread here is somewhat misleading since part of the rise in LIBOR is due to
central banks’ increase in collateralized lending. Collateralized lending enjoys seniority and hence
makes the more junior unsecured LIBOR lending more risky and therefore more expensive.
90 Journal of Economic Perspectives
$2.3 trillion in December 2008. On December 16, 2008, the Fed set its target
interest rate between zero and a quarter percent.
Economic events and political actions and reactions have continued to unfold.
But for the purposes of this paper, the key question is how the original loss of
several hundred billion dollars in the mortgage market was sufﬁcient to trigger
such an extraordinary series of worldwide ﬁnancial and economic consequences.
Amplifying Mechanisms and Recurring Themes
The sequence of events described above is a vivid reminder of how shocks can
get ampliﬁed to a full-blown ﬁnancial crisis when liquidity evaporates. Liquidity
dries up when frictions limit optimal risk sharing and hinder ﬂows of funds to
expert investors (that is, funds are separated from expertise). It is useful to divide
the concept of liquidity into two categories: funding liquidity and market liquidity
(Brunnermeier and Pedersen, forthcoming).
Funding liquidity describes the ease with which expert investors and arbitrageurs
can obtain funding from (possibly less informed) ﬁnanciers. Funding liquidity
is high—and markets are said to be “awash with liquidity”—when it is easy to
raise money. Typically, when a leveraged trader, such as a dealer, hedge fund, or
investment bank, purchases an asset, the trader uses the purchased asset as collateral
and borrows (short term) against it. However, the trader cannot borrow the
entire price. The difference between the security’s price and its value as collateral—
the margin or haircut—must be ﬁnanced by the trader’s own equity capital. Margin
lending is short term since margins and haircuts can be adapted to market
conditions on a daily basis. Outside equity or long-term debt ﬁnancing is typically
more expensive and difﬁcult to obtain when the trader suffers from the debtoverhang
problem.3
As a consequence, traders tend not to carry much excess
capital and thus increasing margins and haircuts force traders to de-leverage their
positions (that is, to sell part of their assets).
Financial institutions that rely substantially on short-term (commercial) paper
or repo contracts have to roll over their debt. An inability to roll over this debt—if,
for example, the market for commercial paper dries up—is equivalent to margins
increasing to 100 percent, because the ﬁrm becomes unable to use the asset as a
basis for raising funds. Similarly, withdrawals of demand deposits or capital redemptions
from an investment fund have the same effect as an increase in margins.
Funding liquidity risk can thus take three forms: 1) margin/haircut funding risk, or
the risk that margins and haircuts will change; 2) rollover risk, or the risk that it will
be more costly or impossible to roll over short-term borrowing; and 3) redemption
3
The debt-overhang problem arises when even informed ﬁnanciers refrain from injecting additional
equity since the proceeds of the investment are primarily going to existing debt holders rather than the
new equity holders (Myers, 1977).
Markus K. Brunnermeier 91
risk, or the risk that demand depositors of banks—or even equity holders of hedge
funds, for example—withdraw funds. All three incarnations of funding liquidity risk
are only detrimental when the assets can be sold only at ﬁre-sale prices—that is,
when market liquidity is low.
Market liquidity is low when it is difﬁcult to raise money by selling the asset
(instead of by borrowing against it). In other words, market liquidity is low when
selling the asset depresses the sale price and hence it becomes very costly to shrink
the balance sheet. Market liquidity is equivalent to the relative ease of ﬁnding
somebody who takes on the other side of the trade. The literature distinguishes
between three sub-forms of market liquidity (Kyle, 1985): 1) the bid–ask spread,
which measures how much traders lose if they sell one unit of an asset and then buy
it back right away; 2) market depth, which shows how many units traders can sell or
buy at the current bid or ask price without moving the price; and 3) market
resiliency, which tells us how long it will take for prices that have temporarily fallen
to bounce back. While a single trader might move the price a bit, large price swings
occur when “crowded trades” are unwound—that is, when a number of traders
attempt to exit from identical positions in unison.
At an abstract level, we can think about market liquidity and funding
liquidity in the following way: market liquidity refers to the transfer of the asset
with its entire cash ﬂow, while funding liquidity is like issuing debt, equity, or
any other ﬁnancial contract against a cash ﬂow generated by an asset or trading
strategy.
The mechanisms that explain why liquidity can suddenly evaporate operate
through the interaction of market liquidity and funding liquidity. Through these
mechanisms, a relatively small shock can cause liquidity to dry up suddenly and
carry the potential for a full-blown ﬁnancial crisis. This section outlines several
mechanisms that amplify the initial shock.
Borrower’s Balance Sheet Effects: Loss Spiral and Margin Spiral
A loss spiral arises for leveraged investors because a decline in the value of
assets erodes the investors’ net worth much faster than their gross worth
(because of their leverage) and the amount that they can borrow falls. For
example, consider an investor who buys $100 million worth of assets on 10
percent margin. This investor ﬁnances only $10 million with its own capital and
borrows $90 million. The leverage ratio is 10. Now suppose that the value of the
acquired asset declines temporarily to $95 million. The investor, who started out
with $10 million in capital, now has lost $5 million and has only $5 million of
its own capital remaining. Holding the leverage ratio constant at 10, this
investor is forced to reduce the overall position to $50 million—which means
selling assets worth $45 million exactly when the price is low. These sales
depress the price further, inducing more selling and so on. This loss spiral arises
as an equilibrium because some other potential buyers with expertise may face
similar constraints at the same time (as pointed out in the seminal paper by
92 Journal of Economic Perspectives
Shleifer and Vishny, 1992) and also because other potential buyers ﬁnd it more
proﬁtable to wait out the loss spiral before reentering the market. In more
extreme cases, other traders might even engage in “predatory trading,” deliberately
forcing others to liquidate their positions at ﬁre-sale prices (Brunnermeier
and Pedersen, 2005).
The margin/haircut spiral reinforces the loss spiral, as shown in Figure 4. As
margins or haircuts rise, the investor has to sell even more because the investor
needs to reduce its leverage ratio (which was held constant in the loss spiral).
Margins and haircuts spike in times of large price drops, leading to a general
tightening of lending. In Brunnermeier and Pedersen (forthcoming), my coauthor
and I show that a vicious cycle emerges, where higher margins and haircuts force
de-leveraging and more sales, which increase margins further and force more sales,
leading to the possibility of multiple equilibria. Adrian and Shin (forthcoming)
conﬁrm this spiral empirically for investment banks.
The documented fact that margins and haircuts as well as lending standards
increase after large price drops seems counterintuitive because a price reduction
that results from a lack of liquidity is likely to be temporary, and investors with the
necessary expertise face a great buying opportunity. Hence, one might think that
lenders would be willing to lend more freely by lowering margins after prices have
dropped.
Figure 4
The Two Liquidity Spirals: Loss Spiral and Margin Spiral
Prices Move Away
from Fundamentals
Reduced Positions
Initial Losses
e.g. credit
Funding Problems
Higher Margins
Losses on
Exisiting Positions
Source: Brunnermeier and Pedersen (forthcoming).
Note: Funding problems force leveraged investors to unwind their positions causing 1) more losses
and 2) higher margins and haircuts, which in turn exacerbate the funding problems and so on.
Deciphering the Liquidity and Credit Crunch 2007–2008 93
There are at least three reasons why exactly the opposite is true.4
First,
unexpected price shocks may be a harbinger of higher future volatility (Brunnermeier
and Pedersen, forthcoming). And when volatility increases, margins and
haircuts increase. An extreme example was the situation in August 2007, when the
asset-backed commercial paper market dried up completely. Prior to the crisis,
asset-backed commercial paper was almost risk-free because of overcollateralization.
However, in August 2007, the overcollateralization cushion evaporated, making
the assets much more risky. Consequently, investors were unwilling to let
structured investment vehicles roll-over their debt. The second reason why margins
increase when prices drop suddenly is that asymmetric-information frictions
emerge. Financiers become especially careful about accepting assets as collateral if
they fear receiving a particularly bad selection of assets. They might, for example,
be worried that structured investment vehicles sold the good, “sellable” assets and
left as collateral only the bad, less valuable, “lemons.” Finally, if lenders naively
estimate future volatility using past data, then a large price drop leads to higher
volatility estimates and higher margins—even though a price drop potentially
reﬂects a great buying opportunity.
It is individually rational to expose oneself to the risk of getting caught in a
liquidity spiral by holding highly levered positions with a mismatch in asset-liability
maturities, although it can be socially costly. Each individual speculator takes
future prices as given and hence does not take into account that unloading
assets will cause some adverse effects on other speculators by forcing them to
sell their positions as well. This “ﬁre-sale externality” is the primary reason for
bank regulation.5
The loss spiral is more pronounced for stocks with low market liquidity,
because selling them at a time of ﬁnancial distress will bring about a greater price
drop than selling a more liquid asset would. For many structured ﬁnance products,
market liquidity is so low that no reliable price exists because no trade takes place.
As a consequence, owners have considerable discretion in what value to place on
the asset. Selling some of these assets in a ﬁnancial crisis would establish a low price
and force the holder to mark down remaining holdings. Hence, investors are
reluctant to do this—and instead prefer to sell assets with higher market liquidity
ﬁrst.6
4
A number of academic papers focus on the loss spiral. Most models produce a cushioning effect of
margins and haircuts since margins decrease at times of crisis in these models (for example, Gromb and
Vayanos, 2002; He and Krishnamurthy, 2008). In Kiyotaki and Moore (1997), the ratio between asset
value and credit limit is constant. In Bernanke and Gertler (1989) and Fisher (1933) lending standards
deteriorate; in Geanakoplos (2003) margins increase during crises.
5
While most current risk measures like Value-at-Risk (VaR) focus on the risk of an individual ﬁnancial
institution, in Adrian and Brunnermeier (2008), my coauthor and I develop a new risk measure,
“CoVaR,” that explicitly takes the risk spillovers into account.
6
Funding constraints need not be binding for liquidity spirals to arise. Simply the fear that funding
constraints might be binding in the future makes speculators and arbitrageurs reluctant to invest in a
94 Journal of Economic Perspectives
Lending Channel
So far, we have focused on the balance sheets of the borrowers and have
assumed that lenders have deep pockets. When lenders also have limited capital,
they restrict their lending as their own ﬁnancial situation worsens. We can
distinguish two main mechanisms: moral hazard in monitoring and precautionary
hoarding.
Most lending is intermediated by banks that have expertise in monitoring a
borrower’s investment decisions. For intermediators to exert sufﬁcient effort in
monitoring, they must have a sufﬁciently high stake of their own. Moral hazard
arises when the net worth of the intermediaries’ stake falls because intermediaries
may then reduce their monitoring effort, forcing the market to fall back to direct
lending without monitoring (Holmstro¨m and Tirole, 1997, 1998).
Precautionary hoarding arises if lenders are afraid that they might suffer from
interim shocks and that they will need funds for their own projects and trading
strategies. Precautionary hoarding therefore increases when 1) the likelihood of
interim shocks increases, and 2) outside funds are expected to be difﬁcult to
obtain.
The troubles in the interbank lending market in 2007–08 are a textbook
example of precautionary hoarding by individual banks. As it became apparent that
conduits, structured investment vehicles, and other off-balance-sheet vehicles
would likely draw on credit lines extended by their sponsored bank, each bank’s
uncertainty about its own funding needs skyrocketed. At the same time, it became
more uncertain whether banks could tap into the interbank market after a potential
interim shock since it was not known to what extent other banks faced similar
problems. These effects led to sharp spikes in the interbank market interest rate,
LIBOR, relative to the Treasury bill rate.7
Runs on Financial Institutions
In the days before deposit insurance, everybody had an incentive to be the ﬁrst
to withdraw funds from a possibly troubled bank, because those who withdraw their
money early get their full amount while those who move late might not. Late
movers receive less for two reasons: 1) if the run occurred for fundamental
reasons—say, the bank invested in bad projects—there may not be enough asset
value left to pay those who withdraw late, and 2) if the run occurred for fundingway
that will correct mispricing and provide market liquidity. This idea is similar to the concept of the
“limits to arbitrage” explored in Shleifer and Vishny (1997).
7
While the above described mechanisms rely on ﬁnancial frictions and lack of expertise, Caballero and
Krishnamurthy (2008) argue that investors have a difﬁcult time assigning probabilities to the different
possible outcomes in times of crises. This argument seems reasonable, especially for structured products,
since only limited historical data is available for forecasting. Thus, investors become even more wary
than the observed increase in volatility might seem to justify, and they will demand an additional
uncertainty premium for holding potentially risky assets.
Markus K. Brunnermeier 95
liquidity reasons, early withdrawals force a bank to liquidate long-maturity assets at
ﬁre-sale prices because market liquidity for those assets is low. The sale of longmaturity
assets below their fair value leads to an erosion of the bank’s wealth and
thus leaves less for those who withdraw their money late. Under both scenarios,
every investor has an incentive to preempt others and run to the bank.8
A ﬁrstmover
advantage triggers a dynamic preemption motive, which can lead to socially
inefﬁcient outcomes.
Deposit insurance has made bank runs almost obsolete, but runs can occur on
other ﬁnancial institutions. Not rolling over commercial paper is, in effect, a run on
the issuer of asset-backed commercial paper. Furthermore, Bear Stearns essentially
experienced a bank run in March 2008 when hedge funds, which typically park a
sizable amount of liquid wealth with their prime brokers, pulled out those funds. In
September 2008, AIG faced a “margin run” as explained in Gorton (2008). Several
counterparties requested additional collateral from AIG for its credit default swap
positions. These requests would have brought the ﬁrm down if the Fed had not
injected additional funds.
While classic models of bank runs focus on debt holders, one may argue that
the problem also extends to equity holders, such as investors in a hedge fund or
mutual funds (Shleifer and Vishny, 1997). Equity holders who withdraw their
capital receive a share of the hedge fund’s net asset value. In this case, an
early-mover advantage arises to the extent that fund managers sell liquid assets ﬁrst.
To see this point, consider a fund that holds $50 million in highly liquid cash and
$50 million in hard-to-sell illiquid securities that at short notice can be sold for only
$30 million. If the fund services early withdrawals using its cash cushion, then early
withdrawers receive their full share of the mark-to-market net asset value of $100
million. But once the fund has to sell the illiquid assets under pressure to pay out
the remaining investors, net asset value declines and late withdrawers receive only
a percentage share of the sale price of the remaining assets, which is $30 million,
not $50 million. In sum, a ﬁrst-mover advantage can make ﬁnancial institutions in
general, not only banks, subject to runs.
Network Effects: Counterparty Credit Risk and Gridlock Risk
All our settings so far have assumed a distinct lending sector that lends to a
distinct borrowing sector. In reality, however, most ﬁnancial institutions are lenders
and borrowers at the same time. Modern ﬁnancial architecture consists of an
interwoven network of ﬁnancial obligations.9
In this section, we show how an
8
Diamond and Dybvig (1983) is the seminal paper on bank runs. Allen and Gale (2007) and Freixas and
Rochet (1997), and references therein, are further useful starting points. Bernardo and Welch (2004)
and Morris and Shin (2004) study runs on ﬁnancial markets.
9
One piece of supporting evidence is that the number of outstanding derivatives contracts vastly
exceeds the number of underlying securities. For example, the notional amount of credit default swap
contracts totaled between $45 and $62 trillion in 2007, while the value of the underlying corporate bond
96 Journal of Economic Perspectives
increase in counterparty credit risk can create additional funding needs and
potential systemic risk.
Network risk is best illustrated by an example related to the Bear Stearns
crisis in March 2008. Imagine a hedge fund that has an interest rate swap
agreement with Goldman Sachs—that is, both parties had agreed to swap the
difference between a ﬂoating interest rate and a ﬁxed interest rate. Now
suppose that the hedge fund offsets its obligation through another swap with
Bear Stearns. In the absence of counterparty credit risk, the two swap agreements
can be viewed as reduced to a single one between Goldman and Bear
Stearns. However, it would be unwise for Goldman to renew the contract if it fears
that Bear might default on its commitment. As noted earlier, Goldman was asked to
increase its direct exposure to Bear after the trading hours on March 11, 2008.
Goldman’s responsible manager did renew the contract in the morning of March 12
and what looked like a delay in response was mistakenly interpreted as a hesitation on
Goldman’s behalf and thus as a sign that Goldman was afraid Bear Stearns might be in
trouble. This misinterpretation was leaked to the media and might have contributed to
the run on Bear Stearns.
Let us extend this example to see how an increase in perceived counterparty
credit risk can be self-fulﬁlling and create additional funding needs. Suppose that
Bear Stearns had an offsetting swap agreement with a private equity fund, which in
turn offset its exposure with Goldman Sachs.10
In this hypothetical example,
illustrated in Figure 5, all parties are fully hedged and, hence, a multilateral netting
arrangement could eliminate all exposures. However, because all parties are aware
only of their own contractual agreements, they may not know the full situation and
therefore become concerned about counterparty credit risk. If the investment
banks refuse to let the hedge fund and private equity fund net—that is, cancel
out—their offsetting positions, both funds have to either put up additional liquidity,
or insure each other against counterparty credit risk by buying credit default
swaps. This happened in the week after Lehman’s bankruptcy, September 15–19,
2008. All major investment banks were worried that their counterparties might
default, and they all bought credit default swap protection against each other. The
already high prices on credit default swaps of the major investment banks almost
doubled. The price of credit default swaps for AIG was hit the worst; it more than
doubled within two trading days.
Network and counterparty credit risk problems are more easily overcome if
a clearinghouse or another central authority or regulator knows who owes what
market was only $5 trillion. The discrepancy arises because many of the outstanding obligations between
ﬁnancial institutions would be netted out in multilateral agreements.
10
A number of other papers consider network effects in ﬁnancial markets. For example, Eisenberg and
Noe (2001) shows that there exists a (unique) clearing payment vector that clears the obligations in a
setting with complete information. Allen and Gale (2000) consider a simple network in a banking model
a´ la Diamond and Dybvig (1983).
Deciphering the Liquidity and Credit Crunch 2007–2008 97
to whom. Then, multilateral netting agreements, such as the service provided by
SwapClear, can stabilize the system. However, the introduction of structured
products that are typically traded over the counter has made the web of
obligations in the ﬁnancial system more opaque, consequently increasing systemic
risk.
Conclusion
An increase in mortgage delinquencies due to a nationwide decline in
housing prices was the trigger for a full-blown liquidity crisis that emerged in
2007 and might well drag on over the next few years. While each crisis has its
own speciﬁcities, the current one has been surprisingly close to a “classical
banking crisis.” What is new about this crisis is the extent of securitization,
which led to an opaque web of interconnected obligations. This paper outlined
several ampliﬁcation mechanisms that help explain the causes of the ﬁnancial
turmoil. These mechanisms also form a natural point from which to start
thinking about a new ﬁnancial architecture. For example, ﬁre-sale externalities
and network effects suggest that ﬁnancial institutions have an individual incentive
to take on too much leverage, to have excessive mismatch in asset–liability
maturities, and to be too interconnected. In Brunnermeier (2008b), I discuss
the possible direction of future ﬁnancial regulation using measures of risk that
take these domino effects into account.
Figure 5
A Network of Interest Rate Swap Arrangements
fixed
floating
Bear Sterns
Private Equity
Fund
Goldman
Hedge Fund
Note: Figure 5 shows a network of interest rate swap arrangements in which, theoretically, all
positions could be fully netted out in a multilateral netting agreement. However, in over-the-counter
markets each party only knows its own contractual obligations, and fear of counterparty credit risk
might prevent netting.
98 Journal of Economic Perspectives
y My views were shaped by conversations with Viral Acharya, Tobias Adrian, Franklin Allen,
Patrick Bolton, Michael Brennan, Smita Brunnermeier, Sylvain Champonnois, Ing-Haw
Cheng, John Cochrane, Doug Diamond, Jacob Goldﬁeld, Joel Hasbrouck, John Kambhu,
Arvind Krishnamurthy, Augustin Landier, David Lando, Jamie McAndrews, Konstantin
Milbradt, Stefan Nagel, Filippos Papakonstantinou, Lasse Pedersen, Lucas van Praag,
Raghu Rajan, Ricardo Reis, Jose´ Scheinkman, Til Schuermann, Hyun Shin, James Vickery,
Glen Weyl, Wei Xiong, and Moto Yogo. Special thanks go to the editors, James Hines, Andrei
Shleifer, Jeremy Stein, and Timothy Taylor, and also to Martin Oehmke. Rachel Goodwin,
Martin Schmalz, and Hao Wu provided excellent research assistance. I am grateful for
ﬁnancial support from the Alfred P. Sloan Foundation.
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