Ten years on: Anatomy of the global financial meltdown
Reflecting on the 10th anniversary of the crisis helps to distil its essentials
For some, today marks the 10th anniversary of the start of the global financial crisis. August 9 2007 was the day when BNP Paribas, the French bank, froze three investment funds. Investors whose money was placed in suddenly toxic securities linked to US real estate, were no longer permitted to cash out their investments. The FT marks the anniversary with a chart-rich series on what the crisis did to the global economy, starting this week.
Admittedly, such dating is always a little arbitrary. Some swear by June 22 2007, which was when Bear Stearns had to bail out two hedge funds it had marketed, which were making big losses on mortgage-backed securities. As my colleagues John Authers and Alan Smith point out in their contribution to the FT series, the summer months of 2007 saw a rapid deterioration of the market values of many financial products — a sign that the Bear Stearns episode raised broader fears in the market leading up to the BNP event.
But we should keep both dates in mind, because jointly they outline a useful basic anatomy of the financial crisis. They do so even better when coupled with one more date: April 2006, when US house prices peaked, and an unprecedented — and unexpected — nationwide decline began.
The effect of the falling value of houses on the quality of the loans that had paid for them is what pre-determined the June 22 event. Bear Stearns’ move was the first clear admission that the assets its funds had invested in were worth much less than almost everyone had thought. It was the first clear sign of unrealised losses in the US and, by extension, the global financial system. In short, it was the first clear exposure of a solvency problem.
The August 9 event marked the next phase, where doubts about solvency turned into a liquidity problem. As Stephen Cecchetti and Kermit Schoenholtz nicely show, BNP’s halting of redemptions was followed by an immediate tightening of lending between financial institutions. Below is their graph of the Libor-OIS spread, which measures the difference between the rate at which big banks reported to be lending to one another over a measure of the safest market interest rate. From almost zero this spread suddenly shot up 10 years ago today. The European Central Bank reacted with an immediate liquidity injection into the banking system.
This three-point timeline — summer 2006, June 2007 and August 2007 — and the chain of events it represents forms a schema of debt crises generally. First, the value appreciation fuelled by a credit boom fizzles out and goes into reverse. Second, the absence of the value investors had expected to find becomes exposed (the solvency problem). And third, the presence of solvency problems, whose exact magnitude and location are uncertain, leads to a liquidity crisis, as each nervous investor tries to be the first to reach safety before the money runs out.
The June 22 solvency event can thus be seen as the forerunner of Bear Stearns’ total collapse in March 2008. The August 9 liquidity event can be seen as the forerunner of the bank run on Northern Rock in the UK a month later. And together they presage the demise of Lehman Brothers and Washington Mutual in September 2008, with the chain reaction that followed for financial institutions of all stripes around the world.
So there is use in reflecting on anniversaries. Not just because of the storytelling thrill of going through the fast-paced events of 10 years ago, for which Cecchetti and Schoenholtz’s timeline is very useful, as is the retrospective live-tweeting on the Real Time Crisis account. But also because it helps to distil the essentials of a crisis.
These essentials are twofold. First is the readjustment of expectations about how much economic value there is to go around, and in particular the realisation by market participants that it is insufficient to honour all the claims racked up in the boom. Second is the proliferation of uncertainty through the web of short-term liquid funds that financial institutions provide one another with, a story that is well told by Adam Tooze in a recent essay.
There is also an inkling here of what it takes to handle a crisis well. The dawning certainty that losses will have to happen, combined with rising uncertainty about where the losses will fall, are what can paralyse the system. The lesson is that the sooner losses can be crystallised in full, the better. That requires difficult political decisions — but as the past 10 years have surely shown, indecision ultimately imposes a much greater cost.
- The eurozone recovery continues apace: unemployment in Portugal tumbled in the second quarter and is now lower than the average for monetary union countries.