The Global Financial Crisis

Notes on a MOOC by Andrew Metrick and Timothy Geithner.

Trevor Chow

These are some notes from the Global Financial Crisis course taught by Andrew Metrick and Timothy Geithner. This is mostly for my future self to refer back to, although it is hopefully fleshed out enough to be helpful to someone else.


In the run up to the global financial crisis, there had been a long period of economic growth and moderation. This created a sense of stability that saw house prices rise continuously, encouraging lots of mortgages to be made. As there is a limited market for people with good credit scores, this expanded into sub-prime mortgages for people who were less likely to be able to pay it back. Simultaneously, there was a glut in savings from countries around the world, which meant that there was a lot of demand for safe assets. Because government debt was saturated, financial institutions were incentivised to create mortgage-backed securities to act as safe assets. They were able to do so due to the increasing amount of mortgages.

Eventually, the housing bubble popped as people began to be unable to pay back their mortgages. This led to sub-prime mortgage securities losing their value and BNP Paribas declaring that it was unable to value these securities. At this point it was a problem within the sub-prime mortgage securities market only. But alongside the growth of MBSs were several other financial institutions and instruments that caused contagion beyond that single market.

Firstly, there was the creation of a market for asset-backed commercial paper - functionally, this used various financial instruments such as MBSs to fund short-term liabilities. Now just as a run on a bank occurs due to people believing that the bank’s assets can’t cover their deposits, people began a run on the ABCP market, because they believed the MBSs couldn’t cover the money they had invested in ABCP. Because these ABCP vehicles were backed by banks, this created a strain on the inter-bank lending market.

Secondly, the exposure to MBSs meant that investment banks like Bear Stearns and Lehman Brothers faced a run on their assets - the former got bought out in Mach 2008, while the latter went bankrupt in September. These investment banks sold lots of ABCP to money market mutual funds, which were just cash pools for large institutional investors. Their job was simply to make sure the investments they made was worth 100 cents on every dollar put in. This exposure meant that the Reserve Primary Fund, a large and longstanding MMMF, ‘broke the buck’ and failed to do so - this caused a run on lots of MMMFs, arrested only by government intervention.

Thirdly, the combined pressures on the unsecured lending market of ABCP, the unsecured inter-bank lending market of LIBOR and the unsecured MMMFs meant that those requiring short-term funding were left with one option - the repo market, which was a secured lending market. That meant that in order to borrow, you needed to hand over some sort of collateral just as your house acts as collateral in a mortgage. Because all other sources of borrowing were collapsing, the repo market itself came under a lot of pressure, and the costs of borrowing skyrocketed.

This was exacerbated by the fact that as the MBS market collapsed, firms exposed to MBS would sell their other assets to compensate, pushing the price of those assets downwards. This meant that even institutions without MBS exposure were left with depleted balance sheets - and this uncertainty about everyone’s balance sheets meant that the only accepted form of lending was secured repo lending.

A particular issue with repo lending was that in many cases, there was an intermediary - instead of me handing some money to you and getting some collateral in return, we would go through a clearing bank. I would give them the money, which they would give you - and they would hold the collateral from you. This meant that clearing banks faced a lot of exposure themselves.

Fourthly, the insurance industry faced its unique problems. AIG was a large insurance firm that had insured and invested in various securities. As those markets collapsed, it faced similar funding pressures as Bear and Lehman, and ended up requiring a government bailout.

All together this led to a world where there were lots of financial institutions, many of which had solvency problems. But because we cannot determine which ones, we begin asking for collateral and cash on hand - this leads to liquidity problems that cause mass panic, overwhelming institutions one by one. The consequence is that the financial system, which is the circulatory system of the economy, began to seize up and affect the real economy. One example would be the monolines. They were insurance firms that insured municipal bonds and mortgage securities. Because they didn’t have anywhere close to the capital required, the collapse of these MBSs meant a loss of confidence in monolines. People tried to sell the municipal bonds insured by them to no avail - and because of the way these were structured, an inability to sell them led to higher interest rates for municipalities who often couldn’t pay.

Introduction to Financial Crises

What is a financial crisis?

What are the general causes of financial crises?

What were the specific causes of the 2008 financial crisis?

In August 2007, US was very vulnerable to a financial crisis. The belief in a more stable future fed a long boom, which was financed by runnable sources and fueled an increase in debt to income ratio.

Belief in more stable future fed a long boom, coupled with increase in debt to income ratio and financed by runnable sources.

What did we miss and how did we miss it?

Constraints on authorities and limited tools made it harder to limit risks and vulnerabilities. Restricted institutions got outcompeted by those in the shadows, who accumulated risk.

There was a fundamental failure in imagination of a run on a non-bank institution.

Housing and Mortgages

How do housing bubbles relate to financial crises?

What are the different types of mortgages?

There are different ways to structure mortgages.

Mortgages are also distinguished by whether they are prime or non-prime.

There are many types of non-prime mortgages.

What are foreclosures?

Safe Assets and the Global Savings Glut

What is the shadow banking system?

What are safe assets?

How did the demand for safe assets change?

How did the supply of safe assets change?

The Housing Crisis

There are three hypotheses for why the housing crisis occurred.

What is the hypothesis of moral hazard?

What is the hypothesis of government failure?

What is the hypothesis of bubble thinking?

Anxiety and Panic

In order to understand how a rise in mortgages and mortgage-backed safe assets led to a financial crisis, we need to understand a few things. Firstly, we need to see how the ABX and LIBOR-OIS reflect the general state of affairs in 2007. Secondly, we focus in on the way in which anxiety in following BNP Paribas caused pressure on the inter-bank markets via asset-backed commercial paper. Thirdly, we consider the practical case studies of Northern Rock, monolines and Bear Stearn to build context. Finally, we see how the shadow banking system was structured in a way that eventually led to the demise of Lehman Brothers and AIG.

What were some catalytic events in 2007?

What did the ABX demonstrate?

How did anxiety spread into the financial system?

What is the LIBOR-OIS and what did it demonstrate?

How did the anxiety around the sub-prime market create pressure on the interbank system?

A run on a bank occurs when depositors are unsure if the value of long-term assets can pay for their short-term deposits and thus take their money out. The collapse after BNP Paribas was functionally a run on the ABCP market - people didn’t think their securitised bonds could pay for their 90-day ABCP debts.

What happened with Northern Rock?

But the real question is why sophisticated lenders operating in capital markets would refuse lending to a bank that had a solid asset book and virtually no sub-prime lending.

What happened with the monolines?

The monolines were insurance companies that offered a single type of insurance - primarily, they insured municipal bond offerings, allowing a higher AAA rating. In the 2000s, the enormous activities in structured products meant that these monolines decided to expand into insuring mortgage securitisations, in the same way GSEs made promises on prime mortgages. However, these companies were not terribly well capitalised to be in this business.

These monolines had impacts on the real economy via auction rate securities.

What happened with Bear Stearns?

In June 2007 when Bear Stearns liquidated its funds, what it did was pay off all the lenders and take all of the fund onto its own balance sheet - what it was saying was that Bear Stearns will stand behind its products.

The result was that the Federal Reserve supported a buyout of Bear Stearns by JP Morgan on March 13th. This may have led to a false sense of complacency that there would always be support for firms that were too big to fail, contributing to the collapse of Lehman Brothers six months later in a very similar fashion.

How did the shadow banking system contribute?

Let’s recap how the shadow banking system works. Traditional banking involves a depositor handing money to a bank - any amount that is below $100,000 will be insured. The bank loans out money to a borrower, and they can collect the loan over time.

Repo is unique in its structure.

The GSE’s of Fannie Mae and Freddie Mac guaranteed or owned nearly half of the mortgage market in 2008. Although they couldn’t guarantee sub-prime loans, they did buy lots of them as investments - around 30 to 40% of the sub-prime market. By July 2008, they were in trouble - their stock prices fell to near 0 by August. On September 7th, they went into government conservatorship.

What happened with Lehman Brothers?

Although sophisticated actors had 6 months to think about what would happen based on the experience with Bear Stearns, one area that was missed was the connection with MMMFs. - MMMFs are unique in that they can only own short term highly rated securities - it is because of this that the SEC allows them to report that their portfolio is worth 100 cents on the dollar, even if it is only worth 99.5 cents. - On September 16, a large and longstanding MMMF called the Reserve Primary Fund broke the buck as it fell below 99.5 cents on the dollar. This was due to their exposure to Lehman Brother’s commercial paper. This was problematic, because people had treated MMMFs as safe assets - this caused a run by institutional investors on all types of similar MMMFs. - The reason no one saw this coming was because with the first ABCP runs in August 2007, MMMFs that struggled had parent entities that transferred money to support them. When people saw this in their SEC filings, instead of this being a reminder of MMMF fragility to ABCP, they took this to mean that these MMMFs were too big to fail. In fact, the assets under management at MMMFs actually grew after August 2007. - MMMFs were massive- by the eve of the crisis in 2008, they held </span>4 trillion in assets, which is not small compared to the <span>10 trillion held by banks. Following September 15th, there was a drop in the assets under prime MMMFs that took all sorts of highly rated securities to the order of $400 billion, only stemmed by a government guarantee.

What happened with AIG?

AIG was the next domino after the MMMFs - they insured various things, including structured products.

Combined, this led to an enormous cash drain on AIG - on September 12th, the NY Federal Reserve had a meeting to ascertain what was necessary. Because of AIG’s size, there was no one who had the money to provide the capital and liquidity necessary for it to survive. This resulted in a $85 billion relief package from the Federal Reserve, supplemented later by more from both the Federal Reserve and the Troubled Assets Relief Program.

How did the run on repo manifest?

We’ve seen how the unsecured lending market of ABCP faced a run. We’ve seen how the unsecured inter-bank lending market of LIBOR collapsed. We’ve seen how a run on unsecured MMMFs was only narrowly arrested by government action. All of this created enormous pressure on the repo market - the last available option, and one that would pressure every single institution relying on short-term funding markets. For example, until July 2007, the average haircut on structured debt was 0%. By the end of 2008, it had hit 45%. As the repo market came under pressure, dealers had to engage in fire sales of even healthy securities that had no sub-prime exposure.

Responses to Crisis

What policymakers do and do not do have a huge effect on how dangerous crises are. To break panics, you have to figure out how to stop people’s individual incentives to run on a bank. A country’s ability to do so depends on its financial capacity - your degrees of freedom are affected by your level of public debt, your central bank’s credibility and the size of your financial system relative to the size of your economy. But even with that strong financial capacity, the USA’s tools were determined by the legal authority it had to engage in this firefighting - the legal mandate available was limited by and large to traditional banks and the </span>4.5 trillion in insured deposits. Unfortunately, most of the financial system was outside that scope - <span>7.8 trillion in uninsured bank liabilities, </span>4.1 trillion in holding companies and broker dealers, <span>6.7 trillion in GSEs, </span>3.4 trillion in money market mutual funds, <span>4.3 trillion in ABSs and $1.7 trillion in commercial paper.

Given that context, the response can be separated into four phases. Throughout all four phases, there are several policy questions that need to be decided in the context of extreme uncertainty.

And because it is hard to know how bad a crisis can be and hard to know what will work, there is an acute sense of fear and confusion. Consequently, the judgement becomes one of deciding which mistakes are better to make and easier to correct for.

There are basically a few types of policy tools available. The first is fiscal policy, which needs to be large, quick and sustained. The second is monetary policy, with the key being to get real interest rates negative and allow the deleveraging required. The third is the use of liquidity tools to fix the financial system and in some cases, let institutions fail.

What was the first phase of letting it burn?

The first phase goes from the summer of 2007 to March 2008. In that phase, house prices and MBSs were falling, although the economy and jobs were still growing. In this period, the main tool was aggressive monetary policy and reducing the discount window rate to get liquidity into the financial system. We also deployed lines of credit for foreign central banks and engaged in a moderate tax rebate. But we didn’t step in to support other funding markets, with two dozen mortgage lenders failing in this period. As such, we let the fires burn without a huge amount of liquidity support.

What was the second phase of early escalation?

The second phase goes from March 2008 to summer 2008. Here, house prices keep falling, but crucially, MBSs begin collapsing alongside employment numbers. The response was significant - for the first time since the Great Depression, liquidity was provided to the rest of the financial system, including supporting GSEs and arranging JP Morgan’s merger with Bernstein. But fiscal and monetary tools remained constant.

What was the third phase of breaking the panic?

The third phase goes from September 2008 to the beginning of 2009. With continued and dramatic falls in all the indicators above, the full force of policy is deployed and is deployed creatively. That meant providing liquidity not just to non-bank institutions but also crucial markets like the commercial paper market and the money market industry, as well as bolstering the foreign swap lines. It also involved financing to the automobile industry, which was facing some recessionary risks.

In the early part of the crisis, a thin fire break is drawn around the system, but the fire is hot enough that it jumps the fire break. This was the stage where the core of the economy is sufficiently at risk that a much larger and more comprehensive fire break is drawn, with an enormous escalation in the amount provided within liquidity facilities.

There are useful lessons to learn from the US governments actions in a period of 4 weeks in September 2008.

Why was there this seeming inconsistency around the triage within the crisis - of deciding who to save and who to allow to fail? Was it due to fog of war, concern about moral hazard, a lack of appreciation for the fragility of the system, political opposition or lack of creativity in finding solutions?

What was the fourth phase of resolution?

The fourth phase begins in 2009 - and despite the incredible amount of effort put in during the previous autumn, there was still a frozen financial system, a collapsing economy and five financial timebombs that were unstable - AIG, Fannie, Freddie, Citi and Bank of America. The reason for this was partly due to a limited level of fiscal escalation - but it was also due to the policy zigzags of the past that left the market unclear on how far the government would go. This meant that people couldn’t be sure it was safe to stay, maintaining the incentive to run. The consequence is that there were incredible numbers of job losses.

The response was one aimed at using overwhelming force. Fiscal policy was properly put in place for the first time in the crisis, alongside even more Federal Reserve creativity via quantitiative easing. There was also a coordinated set of stress tests to recapitalise financial markets and a coordinated global response to deploy stimulus across the world.

The stress test was crucial - because in the early part of 2009 the financial system was still viewed as insolvent and people couldn’t tell the difference between different firms, the financial system was still on bypass, sucking oxygen out of the economy. The stress tests involved the Federal Reserve estimating the losses from a prolonged recession to the scale of the Great Depression on each firm - these firms would be given a window to get private funding, and if that was unsuccessful, from emergency resources provided by Congress.

The result was that we avoided the Sweden case of comprehensively nationalising the banking sector and the Japan case of very tentative and slow progress. Instead, the economy went from shrinking at 8% a year in the last quarter of 2008 to growing by the middle of 2009.

What happened to the housing response?

Probably the biggest gap between our attempts and outcomes was the housing market. The response here had three objectives.

With initial estimate of around 3 to 4 million people potentially being able to benefit from a modification of their mortgage, we ended up with around 8 million people receiving these helpful adjustments. But most of this was not directly from the government. By and large, this was again due to restrictions on authority as set out by Congress. However, it is worth recognising that even if it had been politically possible, it is unclear how much value per dollar it would have provided.

What have we learnt?

Firstly, policy failures before and after the crisis were varied.

Secondly, if we compare the size of the initial shock, the negative effect on household wealth was 5 times greater than in the Great Depression. Nonetheless, the peak-to-trough change in GDP was one-fifth as large and job losses were less than half as large. Indeed, the return of employment was faster than many of the crises in recent history, and GDP levels rebounded much faster compared to many countries within this crisis.

Thirdly, when compared to estimates in the early part of 2009 that said that recapitalising the financial market alone would cost $2 trillion, not to mention the costs of the crisis more generally, the fact that the capital support programs all delivered a substantial positive return to the taxpayer is a win.

Fourthly, there was a significant amount of restructuring for Wall Street and a significant amount of support for Main Street in the American Recovery Act and afterwards. This was not a case of only protecting financial institutions, but actively reforming them, their various capital requirements, their dependence on short-term funding and the problems of too big to fail. For example, larger firms are forced to hold more capital per dollar than smaller ones, and the FDIC has greater power to dismember banks safely.

But there are some scars that have been left. Poverty and the economic harms remain and have persisted. And although shock absorbers are more powerful, the firefighting capability of the Federal Reserve, of the Treasury and of the FDIC have been weakened. The financial oversight system remains too fractured.

What is the playback for next time?

Europe and the Eurozone

Europe’s crisis and response was different because of its differing monetary structure. This meant that it become a Eurozone crisis.

What was the European context?

The euro is the single currency for 19 countries in Europe - this Eurozone is part of the 28-member European Union. The GFC caused a deep recession, with a brief recovery that was quickly reversed by the Eurozone crisis.

There were three economic crises combined for the Eurozone. The GFC was the catalyst, but it was the tripartite of the banking, sovereign debt and growth crisis that caused the continuing problems.

It was the interaction between the three that forced a program of austerity onto Europe.

What was the timeline of the European GFC?

By and large, the crisis mirrored the USA - but the diversity of countries meant different responses. On October 8th in the UK, there was a £200 billion liquidity plan for banks, a bank recapitalisation fund of £50 billion and an inter-bank lending guarantee of £250 billion pounds. This was followed by similar guarantees all across European, adding up to €1.3 trillion committed by October 13th. Although an enormous amount of aid was provided, not all countries could actually afford this.

Ireland had seen total lending at €400 billion compared to a GDP of only €180 billion by 2008. This was a faster buildup than Europe, which itself was seeing a lending boom. In particular, there was a €129 billion gap between deposits and loans - and is analogous to foreign borrowing rising by $7 trillion in the USA. This was an incredible gap - and the Irish government decided to cover all liabilities of the 7 largest banks on September 30th. This was equivalent to two times Irish GDP. Although overwhelming force is in principle a good idea, you do need to be able to back it up. And because Ireland was unable to do so, it would ultimately need an international bailout in November 2010.

By contrast, Iceland was dominated by the three banks of Glitnir, Haupthing and Landsbanki. In 2003, the GKL assets were already 2 times GDP. By June 2008, it was 10 times GDP. By and large, GKL used wholesale funding, but later expanded to online accounts available to all of Europe, which paid much higher interest than local banks. As the pressure on wholesale funding mounted and online accounts ditched, Iceland nationalised its banks over the week of October 6th. But because they were unable to pay off all its depositors, they decided to only pay domestic customers.

What caused the Eurozone crisis?

We’ve seen the shock from the GFC, which exacerbated structural weaknesses. In Ireland and Spain, it was banking problems. In Italy, Portugal and Greece, it was fiscal and sovereign debt issues.

The first phase from December 2009 to July 2011, the emphasis was on the weakness and bailouts of smaller peripheral countries - Greece, Ireland and Portugal. The second phase from July 2011 to July 2012 was the spread to the larger countries of Italy and Spain, causing a double dip recession. The third phase began in July 2012, and is still continuing as countries feud over austerity.

Phase one was the three countries falling like dominoes.

Phase two was the contagion spreading to the two larger countries.

Phase three, which in many ways still persists, is driven by backlash to austerity.

Why have the consequences been so much worse in Europe?

The main reason is that the Eurozone is not an optimal currency area. It is useful to have multiple currencies in the world, because it allows monetary policy to react to a shock. But because a single currency can reduce transaction costs and reduce uncertainty around exchange rates, the Euro was adopted in 1992. The problem is that if there are different countries with different business cycles and monetary policy can’t be used for each of those countries, other things need to adjust - that might mean labour moving, fiscal transfers or deflation.

In the USA, a shock in New York would automatically lead to more federal funding going there, and it would be easy for labour to move out of New York to another state. This is less easy for people to move between countries within the Eurozone. There is also no fiscal federalism - there’s no direct tax-and-transfer process taking money from France and Germany and giving it to Greece. Instead, there is a need to get a bailout.

Instead, countries are forced to rely on deflation - and unlike adjusting prices all at once via currency depreciation, you instead need businesses and individuals to reduce prices and wages. This deflation is incredibly difficult, especially as it makes paying off debts are even more difficult and means the return on investments is reduced.

The 1992 agreement was a bet that they would achieve a sufficient level of cultural and fiscal unity before a large enough shock hit - that hasn’t occurred. The consequence was that while Iceland was able to recover by depreciating their currency, Ireland was unable to do so due to being in the Eurozone, requiring a bailout and leaving it with relatively slow growth thereafter. Furthermore, while both countries had to face some sort of adjustment, Ireland’s deflation caused the problems described above, while Iceland’s actually made its exports more competitive because it had devalued its currency.

What does this mean for the Euro?

The Eurozone crisis has parallels to the Great Depression. This is because, prior to WWI, many countries were on the gold standard - functionally a single currency due to the gold-to-currency exchange rate being fixed. In the 50 years before the war, there had been financial stability - and when the gold convertibility was suspended in the war, this was with precedent and had been done during the Napoleonic Wars.

The problem came after WWI - it was a symbol of confidence to regain the same gold-to-currency rate as before the war. But because the war had created large imbalances, relative prices were misaligned. This was exacerbated by the large wartime debts and reparations. The consequence of all of this is the Great Depression, with countries that left the gold standard recovering faster. This is similar to the way in which the Euro has caused relative price problems.