Chapter 2. How a small problem became a big one

References [ CPB | General | Scientific ]     Summary

Authors

Michiel Bijlsma & Gijsbert Zwart
Contact: Gijsbert Zwart

In this chapter

How could a relatively small loss on subprime mortgage loans escalate into a global banking crisis?

Since nobody knew which banks were in trouble, banks suddenly started refusing one another loans from one day to the next.

Banks' great financial leverage meant that the collapse of the subprime market translated into a significant loss of the banks' equity capital.

To restore the balance between equity capital and assets, banks were forced to join forces in reducing their leverage. They did so by issuing fewer loans and by selling some of their assets.

However, nobody wanted to buy these assets and this led to a further decline in the market value and deepened the banks' problems. This resulted in a vicious cycle.

References

CPB

Centraal Economisch Plan 2009, Chapter 5, De kredietcrisis - oorzaken en gevolgen.

Special chapter in the Central Economic Plan 2009, about the credit crisis.

Michiel Bijlsma and Wim Suyker, The credit crisis and the Dutch economy... in eight frequently asked questions, CPB memorandum 210, December 2008.

The answers to eight important questions about the credit crisis.

General

George A. Akerlof, 2001, Behavioral macroeconomics and macroeconomic behaviour, Nobel Prize lecture.

Lecture given by Akerlof upon his acceptance of the Nobel Prize. He describes his ideas on the emergence of information asymmetries.

Bank of England, 2008, Financial Stability Report, Issue No. 24, 28 October.

Extensive account of the run-up to the crisis, focusing on the banks in the United Kingdom. With images and charts that provide one-on-one visual support for the arguments.

Michiel Bijlsma, Albert van der Horst and Suzanne Kok, De kredietcrisis - oorzaken, gevolgen en beleid, Tijdschrift voor Politieke Economie, 2009, 3(1), pp. 48-67.

About the cause and consequences of the credit crisis.

Jon Hilsenrath, Deborah Salomon and Damian Paletta, 2008, Crisis Mode, Paulson, Bernanke Strained for Consensus in Bailout, Wall Street Journal 10 November.

The Wall Street Journal sketches the role of the various government institutions in the collapse of Lehman Brothers, a bank.

IMF, 2008, Global Financial Stability Report, October.

Six-monthly report by the International Monetary Fund on the stability of the financial sector. This issue contains a comprehensive description of the run-up to the crisis, with a host of data on prices, risks and the structure of financial markets.

Scientific

Olivier Blanchard, 2008, The Crisis: Basic Mechanisms, and Appropriate Policies, Munich Lecture.

Accessible analysis of the crisis and proposals for solutions.

Markus K. Brunnermeier, 2009, Deciphering the Liquidity and Credit Crunch 2007–2008, Journal of Economic Perspectives 23(1), pp 77–100.

A description of the emergence and expansion of the credit crunch. Brunnermeier devotes a great deal of attention to the manner in which the problems infected other financial institutions.

Anil K. Kashyap, Raghuran G. Rajan and Jeremy C. Stein, 2008, Rethinking capital regulation, Jackson Hole.

Analysis of the causes of the crisis. The authors present a type of disaster insurance for banks as a possible alternative to the costly increase of capital requirements.

Marco Pagano and Paolo Volpin, 2009, Credit Rating Failures: Causes and Policy Options, in: Macroeconomic Stability and Financial Regulation: Key Issues for the G20, edited by Mathias Dewatripont, Xavier Freixas en Richard Portes, 2 March.

Analysis of the causes of the poor risk evaluation by credit rating agencies and suggestions for policy measures.

Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, 2008, Did Securitization Lead to Lax Screening? Evidence from Subprime Loans, EFA Athens Meetings Paper, 25 December.

Empirical analysis of the effect of securitisation on the quality of loans. The authors argue that securitised loans are of significantly lower quality than non-securitised loans.

Raghuram G. Rajan, 2005, Has Financial development made the world riskier?, paper presented at ‘the Greenspan era, lessons for the future’ conference.

Notably visionary analysis of the problems that could arise in the world due to financial innovation.

Maximilian J.B. Hall, 2008, The sub-prime crisis, the credit squeeze and Northern Rock: the lessons to be learned, Journal of Financial Regulation and Compliance 16(1), pp 19-34.

An overview of the collapse of the British bank, Northern Rock.

Douglas W. Diamond en Philip H. Dybvig, 1983, Bank runs, deposit insurance and liquidity, Journal of Political Economy, 91(3), pp 401-419.

Classic article exploring bank runs and the role of deposit guarantees.

George Akerlof, 1970, The Market for Lemons: Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics 84(3), pp 488-500.

The classic article in which Akerlof explains how adverse selection could lead to a dysfunctional market. He uses the market for used cars (good cars versus 'lemons' or bad cars) as an example to illustrate that the market can stagnate if nobody recognises the value of the cars.

David Greenlaw, Jan Hatzius, Anil Kashyap and Hyun Song Shin, 2008, Leveraged losses: lessons from the mortgage market meltdown, U.S. Monetary Policy Forum.

Banks finance a large part of the debts with relatively little of their own equity capital. The authors analysed the role of this lever in the spread of the crisis.

Andrei Shleifer and Robert Vishny, 1997, The limits of arbitrage, The Journal of Finance, 52(1).

How the forced sale of assets can lead to long-term undervaluation of financial assets.

Nobuhiro Kiyotaki and John Moore, 1997, Credit Cycles, Journal of Political Economy 105(2), pp 211-248.

How the depreciation of companies' production resources can trigger an accelerator effect that further intensifies the decline in value.

Nobuhiro Kiyotaki and John Moore, 2002, Balance-Sheet Contagion, The American Economic Review, Vol. 92, No. 2, Papers and Proceedings, pp 46-50.

A sketch of two ways in which shocks can be spread through economy via the balance sheets of businesses.

Olivier de Bandt and Philipp Hartmann, 2002, Systemic risk in banking: a survey, in C.A.E. Goodhart and G. Illing (eds), Financial crises, contagion and the lender of last resort - A reader, London, Oxford University Press, pp 249-298.

An overview of the theoretical and empirical literature regarding systemic risk.

Summary

How did the shock to the subprime mortgage market develop into a worldwide crisis? The increasing level of defaults on subprime mortgage payments caused securitised assets based on subprime mortgage loans to fall in value. Banks were exposed to this shock because they held securitised assets on their balance sheets, or because they implicitly or explicitly guaranteed the shadow banks that bought these assets. The corresponding decline in value of bank assets led to a reduction of bank capital.

When the U.S. government, against the market's expectations, did not bail out Lehman Brothers, creditors suddenly became concerned about the solvency of the banks they lent their money to. Although it was clear that banks had incurred significant losses, no-one knew the amount of toxic assets on individual banks' balance sheets. This lemon led the interbank market to freeze up overnight.

Banks, which increasingly used these interbank markets as a means for short-term funding, found themselves unable to roll over their loans. To reduce their leverage, banks had to obtain fresh capital, or sell some of their assets. For the same reason that the interbank market dried up, attracting fresh capital was difficult. Therefore, banks started hoarding cash and reducing their balance sheet by selling assets, leading to fire-sale prices. Banks reduced credit availability, required more collateral and raised interest rates. As a consequence, firms that depended on bank financing had to cut costs by reducing investment and firing workers.

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