Key Terms Related to the Financial Crisis
- Asset-backed commercial paper (ABCP). Commercial paper is created when nonfinancial firms with high credit ratings raise capital by issuing short-term debt. ABCP is the bundling of longer-term debt from mortgages, credit card receivables, and other loans. When ABCP reaches its maturity date, it is rolled over and bundled into new ABCP.
- Bank run or “run”. A bank run occurs when depositors withdraw cash from a bank thinking the bank is about to fail. A run can also be used as a generic term describing the withdrawal of cash by investors from any type of financial intermediary [e.g., a pension plan (depositor) withdrawing cash from a money market mutual fund (MMF)]. This example would be a run on the MMF.
- Shadow bank. A shadow bank is a financial institution other than a regulated depository institution. Examples of regulated depository institutions are commercial banks, thrifts, and credit unions. Examples of shadow banks are private equity funds, investment banks, hedge funds, mortgage lenders, and insurance companies.
- Repurchase agreements (repos). Repos involve an institutional investor making a short-term deposit of cash with a shadow bank that in turn pays the investor interest on the cash (called the repo rate). The shadow bank also gives the investor some type of collateral that the investor could sell in the event that the shadow bank does not return the investor’s cash.
- Haircut. A haircut is the amount of collateral in a repo agreement in relation to a deposit. For example, if an institutional investor deposits $90 million with a shadow bank and the investor receives collateral worth $100 million, the haircut is 10%.
Historical Background Of the 2007–2009 Financial Crisis
The main trigger of the financial crisis was the prospect of losses on subprime mortgages. In the first half of 2007, housing prices in the United States started to decline, causing several subprime mortgage lenders to file for bankruptcy and subsequently fail. These losses became amplified as they had a ripple effect that spread to the main vulnerabilities of the crisis, asset-backed commercial paper (ABCP) and repurchase agreements.
The Build-up to the Financial Crisis
When housing prices declined and homeowners defaulted on their mortgage loans, it reduced the value and prices of ABCP. These declining prices resulted in bank runs on shadow banks and money market mutual funds (MMFs) and signaled the start of a liquidity crisis.
The liquidity crisis continued to spread into repo agreements with the average haircut going from near zero at the beginning of 2007 to 25% by September of 2008 (Lehman Brothers bankruptcy).
Lehman Brothers Failure
The Lehman Brothers bankruptcy filing in September 2008 is considered the tipping point in the financial crisis. It eroded confidence and caused a run on MMFs. This lack of confidence spread across markets and countries, amplifying losses in the subprime mortgage market.
The Historical Background leading to the Recent Financial Crisis
The recent financial crisis was not unique compared to previous banking crises. It followed a similar pattern of increased public and private debt, increased credit supply, and increased housing prices preceding and leading to the crises.
The Two Main Panic Periods
The two main panic periods of the financial crisis were August 2007 and September 2008 through October 2008. The first panic period in August 2007 occurred when there were runs on ABCP. The start of the second panic period was September 2008 when Lehman Brothers filed for bankruptcy.
Lehman’s failure caused a run on a particular MMF called Reserve Primary, which contained commercial paper issued by Lehman. The run on Reserve Primary spread to other MMFs, which started a contagion effect that spread to other assets that were falling in price in tandem with rising haircuts.
Financial Crisis Policy Response And Global Effects
The International Monetary Fund (IMF) studied 13 developed countries and their responses to the financial crisis. This resulted in 153 separate policy actions that were divided into 5 subgroups consisting of interest rate change, liquidity support, recapitalization, liability guarantees, and asset purchases.
Global Effects on Firms and the Economy
Studies done on the effects of the global financial crisis on corporations and consumers pointed out that as the global recession strengthened, the demand for credit decreased.
