Former U.S. Secretary of the Treasury Timothy F. Geithner and Professor Andrew Metrick survey the causes, events, policy responses, and aftermath of the recent global financial crisis.
Lecture: Module 8 Summary
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From the course by Yale University
The Global Financial Crisis
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Meet the Instructors
Andrew MetrickMichael H. Jordan Professor of Finance and Management
Yale School of Management
Timothy GeithnerLecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury
Yale School of Management
[MUSIC]
>> We've now spent the last few modules going piece by piece through
some pressures that existed during the anxiety and
then panic phase of the financial crisis.
This is a good time summarize what those different pressures are, and
then to note that actually these are relatively new things.
They're new relatively to financial crises we've seen in the past.
And to understand perhaps why they took so
many market participants and government regulators by surprise.
The first was just rising spreads and runs on unsecured debt.
So that's the asset backed commercial paper, and
then later the money market mutual funds that we see having runs starting in 2007.
The second is
fire sales of assets that we're going to have to have in liquidation.
So, as the institutions that held on to asset-backed
securities start to fail or be under pressure because they can no longer borrow
the same way they could before, they need to sell these things.
If they can't borrow on them, they need to sell them.
And when they sell them, like the fire sales that we see in any industry,
there's going to be pressure on those values.
And then, of course,
those assets are being held by other institutions that thought they were safe.
These types of fire sales create uncertainty about the values on
everybody's balance sheets.
So, if you have an institution that doesn't actually have, for example,
any sub-prime securities on its balance sheet, but there are other institutions
that hold the non sub-prime securities of that original institution and
are selling them because they need to get money from somewhere,
then that puts pressure on that second institution.
Think of what would happen, for example, if your neighbor ran into financial
trouble and was forced to sell all of the objects that were in their house.
This would probably be not so good for
those same objects if they were in your house.
Even though that was not the reason they were in trouble in the first place.
All of this together meant that the only way things could be financed in many cases
was with a secured lending transaction that's called repo.
And, specifically, what we saw evidence for
was that in the bilateral repo market where there's transactions going in
between just two counter parties the haircuts which are the discounts
relative to the collateral that is being used for the loan were increasing rapidly.
That effectively plays the same role as deposits just being taken out of the bank.
In the tri-party form of repo where there's a clearing
bank that stands in between those two counter parties, that clearing bank,
which during the crisis was predominately either done by JP Morgan or by the Bank of
New York, clearing bank realizes that they have an awful lot of exposure.
If the borrowing counter party goes bankrupt sometime in the middle of the day
the clearing bank is left holding the bag.
What that means is that the clearing bank starts to demand a lot more collateral,
collateral in the form of cash that the borrowers simply don't have.
Finally, what we see particularly in the case of AIG,
is that when you are a large player in financial markets and
you've given insurance all over the markets, and suddenly people start getting
worried that you're not actually gonna be able to pay off on all of that insurance,
worried perhaps because your credit rating has just been downgraded, then
all of your counter parties at once will come to you and demand more collateral.
And they may be contractually allowed to demand more collateral.
Again, this is simply collateral that you don't have.
And at a time when short term funding markets have completely frozen,
you have no way to go and get it.
So we have a complicated situation where
there may be solvency problems at some of these institutions.
We can't tell for sure, but the liquidity problems,
the inability to come up with the extra collateral,
the inability to roll over loans, overwhelms any question about solvency and
leads to a chain reaction where the institutions one by one will fail.
These mechanisms that are just listed here are new.
They're new as of the crisis of 2007 and 2008.
Leading up to this time, the experience that regulators and
economists had with financial crises were either the old-fashioned types
of bank runs that we saw in money centers like New York and London that
happened for centuries, but really had not happened since the Great Depression.
Or, they were linked crises between sovereign debt and
the banking system that happened in emerging market countries, and
happened quite frequently throughout the 70s, 80s, and 90s.
But what we had not seen was
something that looked like a good old fashioned bank run, but
happening in the shadow banking system instead of the traditional banking system.
And as it turns out, the tools that were available to
policy makers to fight that kind of a run, were very, very lacking.
And the understanding that market participants and policy makers had of what
those mechanics were, and how we could try to fix them, was also very weak.
However, policy makers did try their best.
And we will hear in the next lecture from Secretary Geithner about
the different tools that were developed during the crisis and
the different ideas that people had to come up with on the fly and
test as quickly as possible to try to fight this panic.
[MUSIC]
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