Deciphering the Liquidity and Credit Crunch Journal of Economic Perspectives Vol. 23, Number 1-Winter 2009 pp., Markus L. Brunnermeier Princeton University

Bursting of housing bubble forced banks to write down several hundred billion dollars in bad loans caused by mortgage delinquencies Stock market capitalization of major banks declined by more than twice as much: $8 trillion of U.S. stock market wealth lost between Oct and Oct Factors leading up to the housing bubble: low interest rate environment, Fed didnt counteract the buildup of the housing bubble, and transformation of banking model

Parts of the paper: 1. Trend towards originate and distribute model 2. Event Logbook 3. Causes: Housing Crisis Financial Crisis – Borrowers Balance Sheet Effects – Lending Channel – Runs on Banks – Network Effects

Trends 1. Rather than holding loans, banks repackaged them and passed them on to various other financial investors: Structured products Sliced into tranches: – Super senior(least risk) --mezzanine– equity (toxic) Buyers can protect themselves by buying CDS (credit default swaps): insure against the default of a particular bond or tranche Estimated value of CDSs in : $45-$62 Trillion!!!

2. Banks shortened maturity of assets In traditional banking model, banks finance loans with deposits This changed into a shadow banking system that was made up of off balance sheet investment vehicles financed by asset backed commercial paper. Shadow banks (Structured Investment Vehicles/SIV) exposed to funding liquidity risk if investors stop buying, – Sponsoring banks grant credit lines to these SIVs

Rise in popularity Securitized and structured products led to lower interest rates – Senior tranches of structured products become investment grade – allowed certain funds to invest in assets they previously could not buy Regulatory and ratings arbitrage Over-optimism regarding structured finance products: based on historically low mortgage default and delinquency rates Rating at the edge – banks worked closely with the rating agencies to ensure that AAA tranches were always sliced so the just crossed the dividing line to reach the AAA rating This rise in popularity of securitized products let to a flood of cheap credit---falling lending standards

Subprime Mortgage Crisis Asset Backed commercial paper The LIBOR, Repo, and Federal Funds Market Central Banks Step Forward- August 2007 – Hedge funds suffer large losses perceived default and liquidity risk rises freezing up of markets credit injections from European Central bank and US Fed, reduced discount rate. – Reduce again September 18 th Continuing Write-downs of Mortgage – related securities

Monoline insurers downgrade-January 2008 – Ambac – Markets down worldwide – Feds first emergency rate cut since bps to 3.50% Bear Stearns-March 2008-acquired by JP Morgan Chase Fannie Mae & Freddie Mac Lehman Brothers, Merrill Lynch, and AIG Bailout, Stock Market Decline… – $8 trillion in wealth disappeared since the peak of the market in October 2007 $700 bn. Bailout plan, Feds balance sheet almost doubled from $1.2 trillion to $2.3 trillion (toxic assets)

Liquidity Events demonstrate that shocks can be amplified into crisis when liquidity goes away. Liquidity dries up when frictions limit optimal risk sharing and hinder flows of funds to expert investors. Funding liquidity-the ease with which expert investors can obtain funding from financiers – Risk associated with this type of liquidity is only detrimental when market liquidity is low Market Liquidity-difficulty or ease with which as asset can be sold. How easy it is to find someone on the other end of a trade.

Borrowers Balance Sheet Effects Loss spiral-for leveraged investors, occurs because the decline in value of assets erodes the investors net worth faster than their gross worth (they can borrow less, are forced to sell, which causes the price of the assets to drop even further) Margin/haircut spiral-reinforces the loss spiral. As margins (haircuts) rise, investors forced to sell even more to reduce their leverage ratio Most structured assets have low market liquidity, so sale causes a greater price drop (distress) – no reliable price because not often traded

Lending Channel, a la Bernanke – When lenders also have limited capital, they are forced to restrict lending. – Mechanisms Moral Hazard in monitoring Precautionary hoarding Runs on Financial Institutions – Virtually nonexistent for commercial banks due to deposit insurance – can occur to other financial institutions (on instruments backed with illiquid assets)

Network Effects Most banks are both lenders and borrowers Interwoven risk: banks hedge risk against each other.

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 on had been surprisingly close to a classical banking crisis. What is new about this crisis is the extent of securitizations which led to an opaque we b of interconnected obligations…