The Global Financial Crisis

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.

TL;DR

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?

Most wealth is in long-lived assets that pay off over time, with a fraction of that backing up short-term safe assets i.e. money.
In a panic, many people try and convert our long-term assets into money at the same time.
A financial crisis is when a panic, or the fear of a panic affects the financial system.

What are the general causes of financial crises?

Financial systems are fragile. A bank takes savings and loans/invests them for a return. The cushion of equity they keep is thin, while most of the remaining funds can be withdrawn much faster than the bank can get from selling assets.
Financial distress can transmit into the real economy. The two are closely linked. When asset price growth slows due to an adverse shock, people withdraw from weak institutions. Institutions sell their assets and withdraw loans, leading to a cycle. People thus spend less.
Policymakers can mismanage the response, acting too slowly due to disbelief, inexperience and tendency towards gradual reactions. This is made worse by the concerns over the political costs and moral hazard engendered by bailouts.

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.

The Great Moderation since the 1980s was characterised by low volatility in GDP changes. Housing prices rose 4x between 1970 and 2005. They combined to increase the willingness to lend and to borrow larger portions of one’s income.
Household debt a % of GDP reached nearly 100% by 2007. There was a substantial rise in borrowing relative to income.
The means of financial borrowing were mostly via the shadow banking sector rather than conventional banks. They more vulnerable to bank runs and outside the financial safety net set up post-1930s.
There was an increase in short-term deposit-like liabilities by 5x from 2000 to 2007.

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.

The capital and liquidity requirements on banks were overshadowed because banks became a small share of financial system.
We were unable to limit leverage and risk in investment banks, government-sponsored financial enterprises, non-bank financial institutions and money markets funds.
We were unable to set margin requirements on derivatives and limit the amount individuals could borrow relative to the value of their home.

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

Regulators were too focused on compliance issues e.g. money laundering, rather than stability and systemic risks.
Regulators didn’t request authority to set capital and leverage limits in places where that didn’t already exist.
Regulators failed to limit risk taking in home loans, banks, repo, securities, finance and other crucial markets.

Housing and Mortgages

How do housing bubbles relate to financial crises?

The five biggest crises since WWII in the developed countries of Spain 1977, Norway 1987, Finland 1991, Sweden 1991, Japan 1992, as well as the 13 other bank-centred crises in developed countries all had one common factor. Housing price appreciation was significant in all of them - that is, an average of 20% appreciation in the 4 year run up for Big 5 and 10% for the rest.
It was 30% in the US prior to 2007, making it a significant risk.

What are the different types of mortgages?

There are different ways to structure mortgages.

The standard US mortgage has a fixed interest rates paid across 30 years. There are also adjustable rate mortgages, with the interest rate being adjustable for some period of the term of payment. This adjustable rate can be pegged to a spread above a certain base rate e.g. London Interbank Offered Rate. For example, a 5/25 adjustable rate mortgage would have a low fixed interest rate for 5 years, followed by an adjustable rate for the last 25 years.
This can be good if you plan on selling your house before the adjustable rate kicks in.
There are also more complex structures, like negative amortisation loans and big balloon payments, all with the goal of lowering payments in earlier years.

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

A prime mortgage conforms to Government Sponsored Enterprise standards - that is, regulations set by Fannie and Freddie. This means the maximum loan size is $417,000, there is a limit on the loan-to-value ratio, there is a limit on the borrower’s credit score and there are rules about occupancy.
If a mortgage is prime, Fannie and Freddie will buy and guarantee it. They can then be packaged into mortgage-backed securities that are as safe as government bonds, because they are government-backed.
Clearly it is impossible to guarantee people won’t prepay mortgages or that interest rates will fall. However, in terms of ensuring the timely payment of the interest and the principal, it is as safe as you get.

There are many types of non-prime mortgages.

Sub-prime loans are for borrowers with a bad credit history and little savings available for down payments. They are riskier, especially since they are without a government guarantee.
Near-prime or Alt-A loans are for borrowers with minor credit history issues or those unable to provide full documentation of assets and income. For example, self-employed people cannot provide a W2 form that is necessary for a prime mortgage.
Sub-prime’s share of the mortgage market went from 7.6% to 23.5% from 2001 to 2006. In many cases, they seemed like they were made to fail - that is, borrowers faced high interest rates they couldn’t pay. This forced them to refinance and pay the penalty for doing so - the only way this works is if housing prices keep rising and so you can pay off the penalty when you refinance.

What are foreclosures?

Foreclosures are when banks take the house as collateral to sell when you cannot pay them back.
This predominantly occurred in the sand states in the USA - that is, in places like Arizona, California, Florida and Nevada. From 2007 onwards, there were serious levels of delinquency, which is where mortgage payments are 90 days late or the house is in foreclosure. By 2009, the national average in the USA was 8.7%, while it stood at 13.6% in sand states.
These were concentrated among sub-prime loans and adjustable rate mortgages, with over 40% delinquency in 2009 for sub-prime adjustables. Crucially, it was below sub-prime fixed up till 2006, as it was before the adjustable rates kicked in and borrowers were still paying low teaser interest rates.
Rates for sub-prime fixed and prime adjustable converged by 2009 at around 20%, and even prime fixed went up to 5% by 2009.
In 2007, everyone had average rates of under 2%. By 2009, it had reached 8% in the USA, while the UK and Spain maintained around 2% and Australia and Canada didn’t face a foreclosure crisis.

Safe Assets and the Global Savings Glut

What is the shadow banking system?

When depositors given banks money, they loan it out to borrowers. This creates a short-term debt from the bank to the depositor, and a long-term debt from borrowers to the bank.
Because the FDIC only insures the first $100,000 of your savings, there is a demand for a shadow banking system.

What are safe assets?

Safe assets have information insensitivity - that is, although it is not risk free, you can get no advantage on its worth via finding out more information. For example, a $1 bill is a safe asset.
Some things can go from being information insensitive to information sensitive. If you lose faith in the integrity of a bank, this may undermine the safety of their assets. Other assets are always information sensitive e.g. shares in the stock market, the private debt of third party or the government debt of an unstable country.

How did the demand for safe assets change?

Notice that between 2003 and 2007, short-term interest rates in the US increased by 4%. This ought to increase longer-term rates. However, the 10-year Treasury bond rate stayed pretty static.
The 30-year fixed mortgage interest rate is traditionally around 1.5 to 2 percentage points more than the 10-year Treasury rate. Because the Treasury rate stayed low, so did mortgage rates. This created a booming housing market.
Before he was Chairman of the Federal Reserve, Ben Bernanke suggested that this conundrom was due to a global savings glut. That is, emerging markets and commodity rich countries with large current account surpluses need to put their money somewhere, and they chose to buy lots of safe US government assets, keeping the Treasury rates low. This weakened the link between short and long-term interest rates.
For example, most of the China’s 2003-2007 $900 billion current account surplus was spent on US Treasury securities, with around half of the $600 billion current account surplus of the rest of Asia and $100 billion from OPEC spent likewise. European countries also increased their demand for various types of safe assets. All of this combined to $2.5 trillion in safe assets being bought, while the US government and GSEs only produced $1 trillion and $1.5 trillion in debt respectively.
The consequence was that domestic investors needed other AAA debt to invest in, and since safe corporate debt was rare, they went for residential mortgage-backed securities. This was exacerbated by the growth of institutional cash pools, with estimates suggesting that it rose from $3 trillion to over $4 trillion from 2003 to 2007. Unlike foreign investors, these domestic institutional investors were especially interested in short-term assets.

How did the supply of safe assets change?

Safe assets, with the exception of precious metals, primarily involve the debt and currency of stable countries. Because of the scarcity as seen above, there was a demand for making new safe assets.
So if I gave you a certificate that said you now owned 1% of my $300,000 house, that'd be a terrible safe asset to use in a purchase. Anyone who received would have to go value my house and they might not even be able to sell the house if they need the money. Instead I offer the first $3,000 of the value of my house - either I have to pay you $3,000, or if I can't and my house gets sold, you get the first $3,000 of that sale. That seems pretty safe, especially if the debt-to-value ratio is low enough such that no one has an incentive to analyse the probability this might be over or under-valued. This creates information insensitivity and thus a safe asset.
If we take a set of assets from an originating firm e.g. a bank with mortgages or an auto company with auto leases, we can put them in a trust pool, which is a separate entity. This is set up as a trust, which cannot go bankrupt. If it does run out of money to meet its obligations, it distributes the proceeds from selling the assets it has to claimants based on the rules decided when it was set up.
When it is set up, it issues bonds called asset-backed securities, in order to get the money to buy the initial assets from the originating firm. These bonds are split into tranches that go from AAA at the top, which gets paid first. AAA bonds are supposed to be safe - if they constitute 75% of the trust, the value of the asset pool would have to drop 25% for there to be a danger of non-payment. Because there is now a pool of assets, it is safer than every individual asset within the trust and can be sold to people.
For mortgages, these became mortgage-backed securities. Although many MBSs were guaranteed by Fannie and Freddie, by 2003 there was so much demand that private label MBSs were created - these were a mixture of residential MBSs, which contained mortgages that did not qualify for GSE guarantees, as well as commercial MBSs, since there was no government program to guarantee commercial mortgages.
Non-mortgage asset-backed securities were also becoming more popular in the early 2000s. It often involved companies bundling their loans into a trust, such as car companies providing loans to help people finance their car purchase. In fact, by 2005, the size of corporate ABSs had converged with the size of the corporate bond market at around $750 billion each. This was because it is difficult to issue lots of corporate bonds at AAA level, which is much easier with ABSs.

The Housing Crisis

There are three hypotheses for why the housing crisis occurred.

What is the hypothesis of moral hazard?

This says that mortgage demand came from misled buyers taking out self-destructive mortgages, encouraged by financial intermediaries with no skin in the game who provided the mortgage supply - brokers got their commissions regardless and banks resold the loan anyways. However, the evidence does not support this hypothesis.
Firstly, non-prime loans did quite well for many years. For loans with FICO credit scores below 620, the failure rate was falling till 2004/2005, and the originations increased 3x from 2000 to 2005. For loans that have a loan-to-value ratio of 100% - that is, with no down payment, the failure rate stayed at 10% till 2005/2006. For loans with little to no documentation, the failure rate was falling till 2004/2005 from 10% downwards, and the originations increased 10x from 2000 to 2005. In fact, even for the most insane loans that start in 2003, with negative amortisation, low to no documentation and LTV>90%, the failure rate is around 10% till the problems in 2005 onwards. Though there are good reasons why the failure rates remained low - that is, increasing housing prices allowed refinancing, it seems plausible to assume that they were safe based off of the data.
Secondly, the mortgage defaults seemed unrelated with interest rate resets. If these loans were set up to fail, there would be cluster of failures once the reset kicks in for adjustable rate mortgages and people are forced to foreclose or refinance. January 2005 vintage mortgages had an average interest rate of 7.5%, resetting in January 2007 up to 11.5%, and yet there was no spike in failures, never increasing to over 20%. January 2006 vintages had an 8.5% average interest, and reset to 9.5%, and yet there was a greater rise, reaching a 45% default rate by late 2009. January 2007 vintages had an 8.5% average interest, and reset to a lower interest rate, and yet the default rate kept increasing to 45% by late 2009.
Thirdly, insiders were harmed too. Citigroup lost $42.9 billion, UBS $38.2 billion, Merrill Lynch $37.1 billion, with 20 institutions losing at least $6 billion across the crisis. For the non-GSE AAA loans, there was $1.6 trillion worth, and nearly everyone was exposed to it - that is, US banks had $383 billion, overseas institutions had $400 billion, GSEs had $308 billion and money managers had $225 billion. This culminated in $10.7 trillion of exposure in various types of loans for institutions across the world.

What is the hypothesis of government failure?

This says that homeowner demand was due to government subsidies, such as tax deductions for mortgage interest payments. Meanwhile, the mortgage supply came from GSEs - due to a 1992 law for fair housing goals, there was a desire to push low-income people into owning homes and take more risks. This was facilitated by ineffectual regulators not noticing the build-up of risk and incentive for banks to move loans off their balance sheet. However, the evidence does not support this hypothesis.
Firstly, the most government involvement in the mortgage market began after WWII, rather than recently. From 1945 to the end of the 1960s, the average LTV from a bank mortgage never hit 80%, while those from the Federal Housing Administration goes from 80% to 90% and the Veteran’s Administration goes from 90% to 95%. In that period, the FHA and VA went from less than 25% of the mortgage market to around 45%, driven by soldiers coming back from war and going to the VA.
Secondly, GSE policy changes do not explain the timings of the market. GSEs did indeed buy non-prime mortgages, though they didn’t lend or guarantee such loans. Clearly, it being on a pseudo-governmental balance sheet implies some level of government guarantee, which is not great. GSEs owned 20% of the sub-prime market in 2000, rising to 40% by 2002 and staying there till 2006, before rapidly increasing to 80% by 2007. Though this looks bad, it is worth noting that the sub-prime market was fairly small for quite a while after the 1992 law, only becoming significant from 2003. Furthermore, the share of that market by GSEs slides a bit from 2004, and the rise mentioned above coincides with the total market decreasing rapidly.
Thirdly, housing booms occurred in many other countries, such as Spain and Ireland. These occurred at times different from the US, but they did not have the same laws. The commonality between them is the global savings glut.

What is the hypothesis of bubble thinking?

This says that mortgage demand was due to consumers seeing housing as an investment that doesn’t go down in value. The mortgage supply was due to banks or institutional investors believing the same thing, facilitated by the long period of stability that created faith in the housing and financial system not to fail.
Home owners and retail investors expected home prices to increase on average by 12% across 10-years in 2004, and even by 2008, it was still 8%. Given that in the past 100 years, real home prices stayed flat, this is a pretty bold prediction.
Mortgage suppliers thought prices were unlikely to drop. Lehman Brothers put a 50% probability on a base case of 5% house price appreciation by end of 2005, a 15% probability on a pessimistic case of 0% HPA for 3 years followed by 5% thereafter, and a 5% probability on -5% HPA for three years followed by 5% thereafter. Even JP Morgan, which did the best out of the crisis, kept expecting stabilising house prices right up till July 2007, a month before the financial crisis beginning.
The risk of asset bubbles is always lurking, and the longer we go without one popping, the more people don’t believe it can occur. The reason this bubble occurred between 2003 and 2007 was because of a global macroeconomic environment that demanded enormous amounts of the underlying securities, fueled by investors who couldn’t see the risk in taking these securities onto their portfolio.

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?

New Century, a real estate investment trust with a $1.75 billion market cap in January, was delisted in March 12th and bankrupt by April 2nd.
In June, credit rating agencies began downgrading 2005 and 2006 bonds, though the market was already aware.
Bear Stearns was the 5th largest independent investment bank in 2007. It had several funds managing money for other investors rather than Bear Stearns shareholders, and they were unable to pay back the $10 billion borrowed to make leveraged investments in June. This led to some collateral being seized and sold, with Bear Stearns suspending redemptions on June 7th and liquidating the funds by the end of July, taking the risk onto their own balance sheets.
On August 9th, BNP Paribas, a bank with over $1 trillion in assets, declared their inability to value sub-prime securities and thus suspended redemptions for their funds which had sub-prime securities.

What did the ABX demonstrate?

The ABX index tracked various securities, and the ABX-HE looked at home equities. In particular, it focused on credit default swaps on sub-prime mortgage securitisations. CDSs are insurance on sub-prime, and so the ABX-HE shows the perceived risk on those securities.
For BBB ratings, the spread was between 100 to 200 basis points in 2006 for insuring against the tranche defaulting. By March 2007, it had hit 700 basis points. It dips back to around 400 basis points, and neither the New Century bankruptcy nor the Bear Stearns fund redemption suspension have a huge impact. For AAA, it went from 25 basis points at the start of the year to 45 basis points in March, but creeps back down to 30 basis points by June, with neither event having an impact.
For the latter part of the year, BBB increases to just under 2000 basis points by the time of BNP Paribas, and that itself has no effect. From late September onwards, it increases to a peak of 4000 basis points by the end of the year. Simultaneously, AAA reaches over 150 basis points just before BNP Paribas, lulling for a while afterwards, and then increasing in Q4 to over 350 basis points.
This demonstrates the initial belief that sub-prime was limited to BBB, but by Q4 2007, people realised it was affecting AAA too.

How did anxiety spread into the financial system?

Bernanke in May 2007 said that he did not ‘expect significant spill-over from the sub-prime market to the rest of the economy or to the financial system’. Now clearly he was deeply wrong, but what turned a large but controllable loss into a financial crisis?
This was caused by spread of anxiety through the market - although the sub-prime problems were well-known, what we didn’t know was where that risk was, because the financial system is not equipped to analyse what were thought to be safe assets.
Consequently, if you had money in sub-prime securities and were worried about solvency, you didn’t try to figure out your funds financial situation, you just pulled your money out.

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

The London Interbank Offered Rate is a survey of the interest rates at which banks charge other banks for unsecured dollar funding across various periods of time. Unsecured means that if they aren’t repaid, there is no collateral they can seize and the way they get their money back depends on the other bank liquidating or pursuing bankruptcy procedures.
The Overnight Index Swap is a financial derivative that allows one to swap fixed and floating interest rate obligations. It basically acts as a good proxy for what a risk-free interest rate would be over various periods of time. Yields on government bonds could be used as a proxy, but because they become in huge demand during a crisis, they aren’t the most representative.
If LIBOR represents an unsecured interest rate while OIS represents a secured risk-free rate, the LIBOR-OIS spread, which is the difference between the two, reflects the market’s view on the risk of lending to banks.
In normal times this is quite low at below 10 basis points. It stays there until BNP Paribas, where it jumps to 100 basis points. When institutions are leveraged 25 to 1 or even 35 to 1, even small increases in the costs of borrowing have significant effects on your returns. The spread stays at 50 to 100 basis points until September 15th 2008, when Lehman Brothers collapses. This led to the spread spiking at an unprecedented level of over 350 basis points.
If banks cannot borrow unsecured and people are concerned about their solvency, no one will view safe assets as safe, effectively creating a run on the banking system.

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

Asset-backed commercial paper is a way of maturity transformation - that is, a way of funding a pool of long-term assets with short-term liabilities. This is similar to what banks do - they fund their long-term assets of mortgage debts that will mature over 30 years via issuing the short-term liabilities of bank deposits.
Money market mutual funds had $4 trillion under management in September 2008. These funds were required to make short-term investments. If there were not enough of these investments, a financial institution called an ABCP Conduit could buy up long-term investments such as sub-prime bonds and issue short-term debt for these mutual funds to buy. To ensure the conduit is safe, they are backed by a credit enhancement provider and a liquidity provider.
In many ways this is similar to securitisation, but the difference is that here, the investment size and asset types can fluctuate over time. Furthermore, it engages in maturity transformation, and unlike a securitisation, it can last forever and debts can keep being rolled over.
ABCPs grew in the 1990s and again in the global savings glut, peaking at $1.2 trillion of commercial paper just before the BNP Paribas announcement, after which it collapsed. People got anxious that they were exposed to sub-prime in the same way BNP Paribas was. Crucially, the ABCP sponsors, who took a pile of long-term assets on their books and transformed it into short-term debt, were incredibly varied.

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.

Runs were endemic from August 2007, and research suggests that once you enter a run you rarely leave, with 40% of programs in a run state by December 2007 compared to less than 5% beforehand. Not all programs had runs because not all programs were exposed to sub-prime.
But once in a run, the likelihood you could escape was low. This meant that they had to call upon the liquidity support of banks due to their inability to roll over debt. By the end of 2007, the amount of commercial paper had dropped from pre-BNP peak by $350 billion. Unable to finance the securities with unsecured debt, sponsoring banks needed to lend them money and themselves had to either borrow on the more expensive interbank markets or take the collateral and send it as a collateralised loan. This created pressure on interbank markets.
It is also worth noting that the average maturity of new ABCP fell from the average of 30 days to under 15 after BNP Paribas - that means even for programs that were surviving, investors were scared to hand over their money for long periods of time, with the time scale shifting towards two weeks, one week or even overnight. This is a problem because that means even short-term fluctuations can have big effects. Coupled with this was the higher risk spreads these programs had to pay - it was seen as fairly risk-free at 10 basis points, but after BNP Paribas, it averaged 50 basis points.

What happened with Northern Rock?

Northern Rock was the 5th largest bank in the UK in June 2007. It focused on prime lending and had minimal sub-prime exposure, especially in the UK where the housing market was strong. However, its rapid growth meant it outstripped the pace provided by traditional deposits, and thus required non-traditional funding sources.
These sources began to dry up in the summer of 2007, with efforts for a private rescue failing and a growing gap between investments and the deposit base. Once the Bank of England announced it was providing assistance to Northern Rock, panic began to spread - individual depositors and wholesale funders began taking their money out. This was exacerbated by the lack of a FDIC-equivalent in the UK, with only the first £2,000 in bank deposits being covered compared to the FDIC’s $100,000.

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.

Northern Rock was in many ways a microcosm of the GFC. It grew rapidly in the years before the crisis via non-traditional funding. In June 1998 it had around £20 billion in liabilities, with around £10 billion available from retail deposits. By its peak in 2007, it had £113 billion in liabilities, with under £20 billion in retail deposits available.
Between June and December 2007, the biggest change in its liabilities was the £51 billion in retail deposits and wholesale financing dropping to £22 billion, with the difference being almost completely made up by a loan from the Bank of England.

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.

In January 2007, the two largest insurers in this space, of MBIA and Ambac, had $265 billion in structured product guarantees. This is a factor of a hundred greater than their equity - and yet they maintained their AAA ratings.
In the middle of 2007, it became clear to markets that the AAA layers of these structured products were in some danger, and so were the insurers. Around the troubles of the Bear Stearns funds, the stock prices for these monolines collapsed, reaching near 0 by January 2008.

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

Traditional securities involve an investment bank gathering some debt and issue bonds - but the amount being offered, even if it is $100 million, is still fairly small for institutional investors. This means there isn’t a huge amount of trade in that bond market, which makes it an illiquid market people might not want to get into in the first place.
For auction rate securities, instead of waiting for buyers and sellers to go to investment banks, would hold an auction at a regular basis, which makes the process smoother. The broker dealers or investment banks who are involved in these transactions are incentivised to hold some of these securities on their books, because they know that come the next auction they can sell it. Although this means they take on more risk than usual, they improve their reputation because they are standing behind the sales they make.
Primarily, this occurred for quieter securities, such as municipal bonds and student loan pools.
Once people lost faith in insurers, people tried to auction off their debt. However, no one came to buy it - and although in normal times broker dealers might be willing to buy it for reputational reasons, they decided this was no longer worth the money.
By February 2008, more than 80% of these auctions are failing, and so because transactions aren’t occurring, the interest rates on the bonds aren’t being reset. That means municipalities have to pay higher interest rate costs.

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.

Although a hit, Bear Stearns had $400 billion in assets, and so this didn’t come close to knocking them out. But Bear Stearns was also a significant player in all parts of the sub-prime space - they originated mortgages, they traded sub-prime securities and they had funds that specialised in buying those securities.
Bear Stearns’s liquidity went from around $15 to $29 billion per day throughout February 2008, plummeting to near 0 in the week beginning March 9th. This is an investment bank, so there’s no obvious retail deposits to run - and yet it basically disappeared in a single week.
Firstly, there were prime brokerage withdrawals. In the same way banks can loan out your deposits, if you buy securities with a broker, they can loan out your securities to others - prime brokerage is like that but for savvy institutional clients like hedge funds. When Lehman collapsed, clients got nervous and took their securities out, which was a significant reduction in a source of cash for Bear Stearns.
Secondly, there were novations. A novation is where someone stands in between two parties in a derivative transaction. Suppose I have some transaction with Bear Stearns but get nervous about them - I can ask another investment bank and take over this position from Bear Stearns. Now this causes a lot of chatter among traders, and in many cases people will force you to post more collateral - just as a bank who hears your business is doing badly may call for more collateral because they are worried you won’t repay the loan, the same thing occurred for Bear Stearns due to these tremors.
Thirdly, just as maturity shortened in the ABCP market, Bear Stearns was facing shortening maturing in its loans within the sale and repurchase market. That meant that many of their loans were overnight, increasing their susceptibility to a run.

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.

In the shadow banking sector, we have retail investors giving money to a money market mutual fund instead of banks, because they have more money than covered by the FDIC. In return, they receive shares from the MMMF, whose job is to keep the value of every dollar of your investment at a dollar. If it falls below that too much, they would have to prop it up by putting money in - but until the financial crisis, MMMFs would never break the buck.
The MMMF hands money to the bank in return for collateral because the money isn’t insured. This is a sales and repurchase agreement - better known as repo. Now because banks may not have the collateral required, they will use the loans they have and securitise it into asset-backed securities. They can use these ABSs as collateral to give to MMMFs. The reason they can make loans in the first place is because they use the money from MMMFs to lend out to borrowers. In some cases, MMMFs can directly purchase securitised bonds instead going via a bank
We can generalise this - instead of a MMMF, this can be an institutional cash pool. Instead of a bank, this is an institution that is engaged in making loans, warehousing loans and recycling them. The important characteristic is that off-balance sheet financing serves the same economic function as traditional on-balance sheet financing. Shadow banking is banking, and faces the same problems.

Repo is unique in its structure.

Firstly, because of a change in the Bankruptcy Code in 2005, there was an allowance of unilateral termination by the non-defaulting party for repo. Suppose a MMMF gave $100 million of cash to an investment bank in exchange for $100 million in collateral. Instead of having to pursuea long bankruptcy process to get its money back if the investment bank refuses to pay, the MMMF can just take the collateral and sell it.
Secondly, there are two types of repo - bilateral and tri-party. The former just involves two parties, while the latter has a bank in the middle. For example, a MMMF could hand its money to JP Morgan, who would hand it over to the investment bank. In exchange, the investment bank would give the collateral to JP Morgan, which accrues some risks for JP Morgan.
Thirdly, collateral can go through rehypothecation - that is, the MMMF can take the collateral and sell it or lend it out. This means that repo has become a type of money, and it was used in that way in the years before the financial crisis.
Fourthly, the collateral usually exceeded the amount of cash by an amount called a haircut - this is to compensate for the risk of it falling in value. If haircuts go up, that is tantamount to a withdrawal from the bank.
The five largest independent investment bank broker dealers at the beginning of 2008 were Morgan Stanley, Goldman Sachs, Lehman Brothers, Merrill Lynch and Bear Stearns. Of the $1.5 trillion in financial instruments they owned, around 42% was financed by repo.

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?

By March 2008, the situation at Lehman was just as precarious as at Bear Stearns - they only survived longer due to some shady accounting. It was widely recognised they wouldn’t survive unless they raised additional capital.
The Federal Reserve created the Primary Dealer Credit Facility around that time. It was designed to produce liquidity to non-bank dealers - unlike banks, they couldn’t go to the Federal Reserve’s discount window. In those six months, Lehman attempted to improve their position, though they often ended up borrowing from the PDCF.
On September 10th, they announced $28 billion in shareholder equity. However, this was based on the valuation of their real estate assets at $54 billion, with market participants estimating it was worth half that, which would have wiped out al that equity. All this uncertainty meant that their counterparties in derivatives, commercial paper and repo were pulling back in similar ways as Bear Stearns faced in March.
These demands for cash were especially from JP Morgan, which was the clearing bank for Lehman in tri-party repo. All of this pressure meant that by September 12th to 14th, the US government was looking for a private rescue for Lehman - they refused to use public money because they thought it was important to get the markets to step up.
When Bank of America, the best candidate for purchase, decided to buy Merrill instead, there was no possible domestic buyer. Although Barclays agreed in principle, the enormous complications of getting shareholder and regulatory support in the UK meant that fell through. Without any options, Lehman filed for bankruptcy on September 15th, lighting the powder keg of the panic.

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 $4 trillion in assets, which is not small compared to the $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.

They produced credit default swaps - these basically insured various securities. As securities markets collapsed, AIG was accumulating insurance losses.
At the same time, they invested into securities lending, which they took losses on - as such, they faced the same funding pressures in commercial paper and repo as Bears and Lehman did.
Insurance companies derive a lot of their value from their credit ratings - but because they got downgraded, they were forced by their contracts to post collateral.
They had liquidity puts - puts allows the holder the option to sell a security back to the writer of that option. Because they had written liquidity puts into lots of their structured products contracts, they were forced to come up with cash for securities they didn’t even want to hold.

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 $4.5 trillion in insured deposits. Unfortunately, most of the financial system was outside that scope - $7.8 trillion in uninsured bank liabilities, $4.1 trillion in holding companies and broker dealers, $6.7 trillion in GSEs, $3.4 trillion in money market mutual funds, $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.

How far do we let the financial fires burn?
How fast do we escalate in deploying protection?
How do we break the panic once it starts?
How do we conduct triage on where to draw the periphery of support?
How do we resuscitate the financial system?
How do we balance the risk of moral hazard with the economic costs of financial collapse?

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.

It put Fannie and Freddie into conservatorship, protecting their creditors.
It encouraged the acquisition of Merrill Lynch by JP Morgan.
It failed to find a buyer for Lehman and let it collapse.
It prevented the collapse of the large global insurance company AIG.
It imposed losses on the creditors of a major bank, Washington Mutual, as part of its acquisition by JP Morgan.

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?

In reality, it was mostly a reflection of the limits on authority. The Federal Reserve couldn’t lend to a non-bank except in very limited circumstances where it was past the point of no return and where there was a reasonable prospect the money lent could be repaid.
This meant that Lehman Brothers could not get that support, and had to look for a private buyer. By contrast, AIG had a sufficiently large set of income streams across the globe to be lent to.
In the case of Washington Mutual, the FDIC did have that authority - but because of concerns over moral hazard, it imposed some of losses on creditors. In many ways, this choice helped spread the crisis to the core of the banking system - unsurprisingly, the FDIC took a different course of action in the cases it faced afterwards.

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.

Arrest the drop in home prices to prevent the further loss of wealth. With expectations in January 2009 that house prices could decline another 30%, this catastrophic outcome was averted and house prices stabilised.
Keep mortgage rates low to make sure the markets were still open. This was successful, with government mortgage providers stepping in so that many Americans could still refinance.
Provide targeted relief to prevent foreclosures for those who had a reasonable chance of staying in their home. The process of determining whether or not people could afford to stay in their homes is a difficult one.

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.

Home equity and capital cushions were too thin and too narrow in scope.
There was too much issuance of short-term deposit-like liabilities without regulatory constraints and access to the safety net.
We escalated too slowly and the authority we had was too limited.

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?

If you want peace, prepare for war. We are always going to be bad at anticipating financial crises ex ante - the design should not be to prevent failure, but to build resilience in the face of failure.
Design shock absorbers for the extreme crisis and apply them broadly across the financial system, with a tougher regime for larger institutions.
Reduce the inherent vulnerability by limiting the size of the financial system relative to the economy.
Maintain a strong financial capacity and powerful firefighting arsenal - that means liquidity for vulnerable parts of the system and guarantee authority for institutions.
When a fire burns, let it burn - but build a credible firebreak around the core to limit contagion and be ready to escalate quickly.
When it’s time to escalate, apply the Powell Doctrine of using overwhelming force in a threat to economic integrity, with a clear exit strategy in mind.
Plan for a long war - recoveries are slow and fragile. The support has to be sustained.
Impose conditions on the rescue - make it expensive to be propped up when conditions stabilise and make it easy to restructure such that non-viable firms don’t get supported.
Discriminate the idiosyncratic financial shock from the systemic.
Keep some perspective on moral hazard.

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.

A banking crisis creates banking failures - too much of that will bankrupt sovereigns that try to prop these banks up.
A sovereign debt crisis will cause a default or debt restructuring, which is often held by local banks. A debt crisis also leads to austerity, that reduces growth, which in turn makes the debt crisis bigger.
The growth and competitiveness crisis damages the balance sheets of banks, who then reduce lending which slows growth.

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.

In December 2009, Greece acknowledged an accounting irregularity, and said that their debt was actually 113% of GDP, which exceeded the eurozone limit of 60%. Ireland had its debt issues due to the bank bailout. Portugal had debt problems due to slow growth. In all three countries, these render them unable to deal with the shock from the GFC.
This led to the entry of the troika of the International Monetary Fund, European Central Bank and European Commission. They provided bailouts of €110 billion, €85 billion and €78 billion to the three respectively. These were paid at specified intervals, conditional upon countries following up on austerity programs and various other market reforms.

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

The second Greek bailout fails to calm fears, and so spreads on Spanish and Italian sovereign debt spike in summer 2011.
The ECB, despite having the legal mandate only to control inflation, promises it would buy these bonds to maintain their stability on August 7th. Italy and Spain unconditionally decide to pursue austerity.
By early 2012, the financial situation was fairly stable, though unemployment was nearing 20% in Spain and Greece. In March 2012, Greece entered a technical default on their bonds. In July 2012, ECB president Mario Draghi stated he would do whatever it takes to preserve the Euro - those three words calmed the financial markets, in spite of the continuing Greek crisis.

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.