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.