GettinguptoSpeedontheFinancialCrisis:AOneWeekendReadersGuide

GaryGorton,YaleandNBER AndrewMetrick,YaleandNBER January11,2012 Abstract All economists should be conversant with what happened? during the financial crisis of 20072009. We select and summarize 16 documents, including academic papers and reports from regulatory and internationalagencies.Thisreadinglistcoversthekeyfactsandmechanismsinthebuildupofrisk,the panicsinshorttermdebtmarkets,thepolicyreactions,andtherealeffectsofthefinancialcrisis. Thanks to Janet Currie (the editor) and Patrick McCabe for helpful comments, and to Jeanne Helene Gobat, Campbell Harvey, Arvind Krishnamurthy, Nellie Liang, Patrick McCabe, Zoltan Pozsar, Carmen Reinhart,KennethRogoff,andAlanTaylorforassistancewiththefigures.

Electronic copy available at: http://ssrn.com/abstract=1974662

1 1. Introduction Thefirstfinancialcrisisofthe21stcenturyhasnotyetended,butthewaveofresearchonthecrisishas alreadyexceededanysinglereaderscapacity,withthepaceofnewworkonlymakingthistaskharder. Many professional economists now find themselves answering questions from their students, friends, and relatives on topics that did not seem at all central until a few years ago, and we are collectively scramblingtocatchup. Thisarticleisintendedtoserveasastartingpointforeconomistswhowanttogetuptospeedonthe literature of the crisis, without having to go into a cave and read for a whole year. To this end, the readinglistisrestrictedto16documents,alistthatanambitiousreadercouldcoverinoneweekendor atamoreleisurelypaceoverafewweeks.Thus,thisarticleisnotacompletesurveyinanyshapeor form,andmanyinterestingpapershavebeenomitted.Thecoverageisfrom2007to2009,andwhile thescopeisglobalduringthistimeperiod,itdoesnotincludeanypapersordiscussionaboutthestill ongoing Eurocurrency and sovereigndebt crisis. The list is also confined to readings with significant empiricalcontent,aswehopethatthiscollectioncanatleastanswerthewhathappened?question aboutthecrisis,evenifthewhy?isnotyetsettled.Inadditiontoagoodnumberofpapersfromtop journals, the final collection includes several reports from international agencies, a speech and a congressional testimony from Chairman Bernanke, and several asyetunpublished papers. We have tried hard to avoid repetition, and on several occasions chose one paper among several worthy contendersonthesametopic.Thus,thisisanunusualpaperfortheJournalofEconomicLiteraturein thatcitationsandthereferencelistincludeonlythe16documentscoveredinthereview. Theproposedreadinglistandarticlearedividedintoeightsections.Followingthisintroduction,Section 2providesanoverviewandtimelineofthecrisis,withsuggestedreadingsthatcoverthatsamebroad range.Thethreedocumentsinthatsectioncanbethoughtofasanevenbrieferreadinglist,forpeople whoonlyhaveanafternoontospendontheproject:2010testimonyfromBenBernankeinfrontofthe FinancialInquiryCrisisCommission,andreportchaptersfromtheInternationalMonetaryFund(2010) andBankforInternationalSettlements(2009)containingoverviewsofdifferentaspectsofthecrisis. Section3givesahistoricalperspectiveonfinancialcrises,whichwebelievecrucialforunderstandingthe recentone.Thetwopaperscoveredhere,ReinhartandRogoff(2011)andSchularickandTaylor(2012), are the products of Herculean data collection efforts on long historical time series about government and private debt. Both of these papers demonstrate the strong association between accelerations in

Electronic copy available at: http://ssrn.com/abstract=1974662

2 economywide leverage and subsequent banking crises. That finding deserves emphasis as the main empiricalfactabouthistoricalpredicatestofinancialcrises. Section4coversthebuilduptothecrisis.Inretrospect,theexperienceofthe2000slooksominously like the prelude to other large crises. Pozsar (2011) documents the important role played by institutionalcashpools,whichgrewrapidlyinthedecadebeforethecrisis.Thesepools,withascale uniquetohistory,createdalargedemandforsafeandliquidshorttermdebt,ademandmetinpartby securitization and other financial innovations. Bernanke (2005) foreshadowed some dynamics of the crisiswhendescribingandnamingtheglobalsavingsglut.Theresultinggrowthinsovereignwealth funds,anewinstitutionofthe21stcentury,alsoadded tothe demandforshorttermdebt. By2007, systemwideleveragehadreachedcriticallevels,butthehistoricalaggregatecreditdatanecessaryfor earlywarning models would not be built until after the damage was done. Coincident with the increaseinleveragewasalargerunupinhousingprices.Whilehistoricalcrosscountrydataonhousing pricesisnotascomprehensiveasthedataoncreditaggregates,ReinhartandRogoff(2008)findsharp increasesinhousingpricespriortothefivelargestfinancialcrisesofrecenthistory,withtheprevious decadeintheUnitedStatescomparable(orworse)thanthosepreviouscrises.CaseandShiller(2003), in a remarkably prescient paper, provide evidence that the United States was already experiencing a housingbubblewellbeforethecrisisbegan. Section 5 discusses three papers about the two panic phases of the crisis August 2007 and SeptemberOctober2008betweenwhichthecrisisexpandedfromarelativelynarrowsliceoffinancial marketsfocusedonsubprimemortgagesintoabroadbasedrunonmanytypesofshorttermdebt.The threepapersinthissectionfocusonthreedifferentcomponentsofshorttermfundingmarkets:Covitz, Liang,andSuarez(2011)onassetbackedcommercialpaper,McCabe(2010)onmoneymarketmutual funds,andGortonandMetrick(2012)onrepurchaseagreementsandsecuritization.Thecombination ofthesethreepapersprovidesanarrativeofcontagionwhereeachstepdrainsthebankingsystemof hundredsofbillionsofdollarsandinduceshigherriskpremiaforbankstoreplacethosefunds. Section6analyzesthevariousgovernmentresponses,whereopinionremainsdividedbetweenviewsof governmentassaviororculprit.Therearenowmanypapersfocusingonspecificpolicyactions,butfew comprehensivesurveys.WechoseChapterIIIoftheIMFsFinancialStabilityReportofOctober2009, whichincludesataxonomyandanalysesofpolicyactionsacross13countriesfrom2007to2009.The report finds a few bright spots for policy, with actions to support the liquidity of shortterm debt marketsmosteffectiveduringthepreLehmanperiodofthecrisis(beforeSeptember2008),andcapital

3 injectionsintobanksmosteffectiveinthepostLehmanperiod. Forsomeeconomists,thefinancialcrisisonlybecomesinterestingifithaseffectsfortherealeconomy, atopicdiscussedinSection7.Tomeasuresucheffects,itisimportanttodistinguishbetweenshocksto credit supply (where a direct line can be drawn to the crisis) and to credit demand (which may have othercauses).Thepapersinthissectionallattackthisproblemincreativewaysandpresentpersuasive evidenceofthechannelfromfinancialshockstorealactivity.ScharfsteinandIvashina(2010)analyze the syndicated loan market in the United States and find that decreases in lending were related to a banks reliance on shortterm funding and by indirect exposure to a Lehman bankruptcy shock. Puri, Rocholl,and Steffen (2012)exploitdifferentialexposuresofGermanbanks tosubprimesecuritiesand findthatshockstocreditsupplyreducedthepropensitytomakeconsumerloans.Campello,Graham, andHarvey(2010)usedetailedsurveyevidencetoshowthatfirmswithcreditconstraintspulledback oninvestment. Section8concludesthepaper. 2.OverviewandTimelineoftheCrisis TheFinancialCrisisof20072009beganinearlyAugustwithrunsinseveralshorttermmarketsformerly considered safe. As Ben Bernanke (2010) put it: Should the safety of their investments come into question,itiseasierandsafertowithdrawfundsrunonthebankthantoinvesttimeandresources toevaluateindetailwhethertheirinvestmentis,infact,safe(p.3).Table1isanabbreviatedtimeline ofthemajoreventsofthecrisis.ThecrisishadbeenbuildingforsometimebeforeAugust:Duringthe firsthalfof2007problemsinthesubprimemarketbecameincreasinglyvisibleandincludedthefailure of several subprime originators. And even before that there was a credit boom, steeply rising home prices,andglobalimbalancesinforeigntrade. Inthissectionwewillbrieflyprovideanoverviewofthecrisis,focusedonthreedocuments.Thefirstis BenBernankestestimonybeforetheFinancialCrisisInquiryCommission,September2,2010.Bernanke provides a lucid overview of the crisis, the causes, the policy responses, and the ongoing issues. The second is Chapter II from the International Monetary Funds (IMF) Financial Stability Report (2010), Systemic Liquidity Risk: Improving the Resilience of Financial Institutions and Markets. Finally, the third is Chapter II of the Bank for International Settlements (BIS) 79th Annual Report, The Global FinancialCrisis.Fromjustthesethreeitems,aclearpictureofthecrisisemerges.

4 Bernanke makes several important points in developing the idea that the crisis was a like an old fashioned run. First, he distinguishes between triggers and vulnerabilities. Losses on subprime mortgages,ormoreaccurately,theprospectofsuchlosses,afterhousepricesstartedtodecline,werea triggerforthecrisis.But,theycannotexplainthecrisis.AsBernankeputsit,...judgedinrelationto thesizeofglobalfinancialmarkets,prospectivesubprimelosseswereclearlynotlargeenoughontheir own to account for the magnitude of the crisis (p. 2). Somehow the prospective losses had to be amplifiedtogeneratethecrisis. A second point that Bernanke makes is that the systemic vulnerabilities in large part were due to changesthathadoccurredinthefinancialsectoroftheeconomy.Thefinancialcrisiswasabankrun,but in sectors of the money markets where financial institutions provided banklike debt products to institutionalinvestors.Thesefinancialinstitutionsweremostlyshadowbanks.Bernanke(2010,p.4): Shadow banks are financial entities other than regulated depository institutions (commercial banks, thrifts, and credit unions) that serve as intermediaries to channel savings into investment Before the crisis, the shadow banking system had come to playamajorroleinglobalfinance;withhindsight,wecanseethatshadowbankingwas alsothesourceofkeyvulnerabilities.(p.4;emphasisinoriginal) The main vulnerability was shortterm debt, mostly repurchase agreements and commercial paper. These markets had grown enormously. Bernanke notes that repo liabilities of U.S. broker dealers increased2timesinthefouryearsbeforethecrisis(p.5).And,theIMFalsonotesthatTherepo markethasrepresentedthefastestgrowingcomponentofthewholesalefundingmarkets...(p.64). Notonlywerethesemarketslarge,buttheywereunregulated,asbothBernankeandtheIMFpointout. A repo transaction is a collateralized deposit in a bank, as follows. The depositor or lender puts money in the bank for a shortterm, usually overnight. The bank promises to pay the overnight repo rateonthedepositedmoney.Toensurethesafetyofthedeposit,thebankprovidescollateralthatthe depositor takes possession of. Depositors are large institutional investors, money market funds, non financialfirms,statesormunicipalities,andotherlargeinvestors.Thesizeoftheirdepositsistoobigfor aninsuredaccountatabank,andhencetheneedforcollateraltotrytoprotectthedeposit.Ifthebank fails,thenthedepositorcansellthecollateraltorecoverthevalueofthedeposit.Ifthedepositis$100

5 millionandthecollateralhasamarketvalueof$100million,thenthereissaidtobenohaircutonthe collateral.Ifthedepositis$90million,andthecollateralis$100million,thenthereissaidtobea10 percenthaircut.TheIMF(2010,p.71,73)discussessomedetailsabouthowtherepomarketworks. Thoughnotasubjectofacademicresearch(priortothecrisis),therepomarketisnotasmall,esoteric, market.IMF(2010)estimatestotaloutstandingrepoinU.S.marketsatbetween20and30percentof U.S. GDP in each of the years from 2002 to 2007. Their estimates for the European Union are even higher, with a low of 30 percent and a peak just above 50 percent of E.U. GDP during the same time period. While these measurements are imprecise, it is clear that the repo market is sizeable in the advancedeconomies. ItwasnotonlyintheUnitedStatesthattherewereproblemsofthissort.DisruptionsintheU.S.short termdebtmarketscreatedashortageofU.S.dollarsinglobalmarkets.IMF(p.61):U.S.dollarfunding was required especially by banks in Europe (e.g., Dutch, German, Swiss, and U.K. banks), but also by banks in Korea, to roll over shortterm funding of longerterm U.S. dollar assets. The shortage in U.S. dollars also affected the foreign exchange swap market, with the U.S. dollar being used as the main swapcurrencyforcrosscurrencyfunding. The bankruptcy filing of Lehman Brothers in September 2008 (see the Timeline) enormously exacerbatedthesituation.TheBISsummarizeswhathappened: ThetippingpointcameonMonday15September,whenLehmanBrothersHoldingsInc. filed for Chapter 11 bankruptcy protection: what many had hoped would be merely a year of manageable market turmoil then escalated into a fullfledged global crisis. Suddenly, with markets increasingly in disarray, a growing number of financial institutions were facing the risk of default. The resulting crisis of confidence quickly spreadacrossmarketsandcountries...(p.23). Most importantly, the failure of Lehman led to a run on money market mutual funds after one large fundbrokethebuck(seeIMF,p.65ff;BIS,p.2526).TheU.S.Treasurythenannouncedatemporary guaranteeofmoneymarketmutualfunds.ConfidenceinthestabilityofthefinancialsystemsintheU.S. andEuropewaslost.Theresultingturmoilledtobankshoardingliquidity,andthiswillplayanimportant roleintransmittingthecrisistotherealsectorandinternationally.Inthisway,theprospectivelossesin

6 the subprime market were amplified. Bernanke: Ultimately, the disruptions to a range of financial marketsandinstitutionsprovedfarmoredamagingthanthesubprimelossesthemselves(2010;p.3). Central banks engaged in unprecedented interventions and the U.S. Congress eventually passed the TroubledAssetReliefProgram(TARP).OnOctober8,2008therewasacoordinatedreductioninpolicy ratesbysixmajorcentralbanks;seeBIS,p.30.But,thiswasnottheend.AstheBISexplained: Althoughtheglobalcrisisofconfidencehadcometoanend,policyactioncontinuedon an international scale as governments sought to support market functioning and to cushiontheblowofrapideconomiccontraction.Evenso,withmanydetailsunspecified, questionsaboutthedesign,impactandconsistencyofthesemeasuresremained.Asa result,financialmarkets wereroiled byincreasinglydiremacroeconomic datareleases and earnings reports, punctuated by shortlived period of optimismoften in response totheannouncementoffurthergovernmentinterventions.(p.31). Eventually,thereweresignsofstabilization,frommidMarch2009;seeBIS,p.34ff.But,therealeffects havepersisted. 3.HistoricalBackground TherecentcrisisisoftendescribedasbeingtheworstglobalcrisissincetheGreatDepression,andthe evidencesupportsthislabel.Butthegapbetweencrisesofthismagnitudemeanswemustlooktowards longhistoricaltimeseriestogainperspectiveonpatternsofglobalcrises.Wearefortunatethatseveral teamsembarkeduponmassivedatagatheringprojectspriortothiscrisis,sothatsomeoftheirresults are available now to give us that necessary perspective. In this section, we review two important contributions to this literature: Reinhart and Rogoff (2011) and Schularick and Taylor (2012). Both papersidentifyaccelerationsindebtasthekeyantecedenttobankingcrises,withReinhartandRogoff focusingonpublicandprivatedebtandSchularickandTayloronthestructureofbankingsector.Both setsofauthorshavedevelopedimportantnewdataseriestoenabletheiranalyses,andbothprovidea richcollectionofhistoricaldetailsthatmaketheirpapersworthyofclosereading. ReinhartandRogoffdefineabankingcrisisbytheexistenceofoneoftwotypesofevents:(1)bankruns thatleadtotheclosure,merging,ortakeoverbythepublicsectorofoneormorefinancialinstitutions; or (2) if there are no runs, the closure, merging, takeover, or largescale government assistance of an important financial institution (or group of institutions), that marks the start of a string of similar

7 outcomes for other financial institutions. Using this definition, the historical incidence of banking crisesisaboutthesameforadvancedeconomiesasforemergingmarkets,andwhilethisincidencehas beenlowersinceWorldWarII,asoftheirwritingonlyPortugalhadbeensparedinthatinterval. Theyfindseveralinterestingresults.First,externaldebtincreasessharplyinadvanceofbankingcrises. Second, banking crises tend to lead sovereigndebt crises. In fact, not only does external debt rise sharply, but so does domestic government debt a new data series built by the authors for their analysis.ThesecondfindingthatbankingcrisesleadsovereigndebtcrisesisalsosupportedbyaVAR analysis.Althoughthedirectionofcausalitycannotbeconclusivelydeterminedfromsuchanalyses,the consistentfindingsacrossmanydifferentcountriesandtimeperiodssuggeststhatbankingcrisesplayan importantacceleratorroleinbroaderdebtcrises. SchularickandTaylor(2012)provideanotherimportanthistoricalperspective,analyzingtherelationship offinancialcriseswithoverallcreditgrowthintheeconomy.Theybeginbybuildinga140yearpanel datasetfor14(currently)developedcountries.Themainnoveltyoftheirdatasetistheconstructionof creditandbankassetseriesforeachcountry,whereaggregatecreditisdefinedasthetotalamountof bank loans outstanding, and bank assets are defined as the sum of the balancesheet assets for all banks. Thesenewmeasurescanthenbecomparedtobroadmoneyaggregates (M2orM3),which havelongbeenavailableformostcountries. Thebasictimeseriesofcredit,assets,andbroadmoneycomparedtoGDPisshowninFigure1,taken from their paper. Prior to the Great Depression, all three money and credit aggregates have a stable relationship with GDP. All three increase sharply just before the depression and then collapse in its aftermath.Aspointedoutbytheauthors,priorto1950thestabilityoftheseserieswouldbeconsistent withthemonetaristview,andwouldnotsuggestanyneedtoanalyzebroadercreditaggregates. Things get more interesting in the postWWII period, when both bank loans and bank assets begin to steadilyincreaserelativetoGDP,whiletheratioofGDPtobroadmoneyremainedstable.Thisstriking changeunknownuntiltheirworkisdescribedbytheauthorsasheraldingasecondfinancialera wherecredititselfthenstartedtodecouplefrombroadmoneyandgrewrapidly,viaacombinationof increasedleverageandaugmentedfundingviathenonmonetaryliabilitiesofbanks. Their paper goes on to explore the impact of this change on the incidence and severity of financial crises.Theiranalysisadoptsanearlywarningsignalapproachthatisstandardinthisliterature,where macrovariablesareusedtopredicttheonsetofacrisis.Whilethisearlywarningapproachhasbeen

8 usedextensivelyonemergingmarketsforthepost1970period,onlythedatacollectioneffortsofthese authors allow for an extension to a longer time series while including credit aggregates as regressors. The results show that changes in credit supply (bank loans) are a strong predictor of financial crises, particularly when these changes are accelerating, an echo of the findings in Reinhart and Rogoff for external debt. Furthermore, broad money aggregates do not have the same predictive power, particularlyinthepostWWIIperiod.Thisfindingmotivatesthetitleoftheirpaperandtheirdescription offinancialcrisesasCreditBoomsGoneBust. ReinhartandRogoff(2011)andSchularickandTaylor(2012)provideaconsistentpictureoftherunup toafinancialcrisis:anaccelerationofdebtfrombothgovernmentsandfinancialintermediariesarethe mostimportantantecedents. 4.TheCrisisBuildUp Onthebuilduptothecrisis,wereviewfourdocuments,twothatwerewrittenbeforethecrisis,butare quiteprescient. The four are Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, by Zoltan Pozsar (2011); Ben Bernankes 2005 Sandridge Lecture, The Global Savings Glut and the U.S. Current AccountDeficit;IsThereaBubbleintheHousingMarket,byKarlCaseandRobertShiller(2003);and Carmen Reinhart and Kenneth Rogoffs 2008 paper Is the 2007 U.S. SubPrime Financial Crisis so Different?AnInternationalHistoricalComparison. Asdiscussedintheprevioussection,crisesareoftenprecededbycreditbooms.InthecaseoftheU.S. intherecentcrisis,thecreditboomtooktheformofanincreasetheissuanceofassetbackedsecurities, particularly mortgagebacked securities. This is related to the development and functioning of the shadowbankingsystem.Thegrowthintheshadowbankingsystemwastheoutcomeofseveralforces. The traditional banking model became less profitable in the face of competition from money market mutual funds and junk bonds. Securitization, the sale of loan pools to special purpose vehicles that financethepurchaseoftheloanpoolsviaissuanceofassetbackedsecuritiesinthecapitalmarkets,was an important response. Figure 2 shows the growth of U.S. privatelabel securitization issuance during 20002010:Q1.Althoughsecuritizationbeganinthe1990s,thefiguremakescleartheexplosivegrowth inthesixorsevenyearsbeforethecrisis,agrowthconsistentwiththenotionofacreditboom.Over theperiodportrayedinthefigure,theprivatelabelsecuritizationmarketgrewfromunder$500billion inissuancetoover$2trillioninissuancein2006,theyearbeforethecrisis.

9 Securitization is offbalance sheet financing for banks and other financial intermediaries. But, if these intermediariesarenotgoingtofinancetheseloanpoolsonbalancesheet,whoisgoingtobuytheasset backed securities? Pozsar describes institutional cash pools: . . . they are large (typically at least $1 billioninsize)andcentrallymanaged.Thecentralmanagementofcashpoolsreferstotheaggregation (or pooling) of cash balances from all subsidiaries worldwide in the case of global corporations, or all funds (including mutual and hedge funds and separate accounts) in the case of asset managers. Furthermore, the investment decisions that pertain to pooled balances are performed by a single decision maker (typically a treasurer) and through a fund that is a single legal person, but one that manages the cash balances of many legal persons (p. 5; emphasis in original). Pozsar documents a strikingriseinthefundsmanagedbythesepools,fromabout$200millionin1990tonearly$4trillion ontheeveofthecrisis. Thekeypointaboutthegrowthofinstitutionalcashpoolsisthattheyhaveanassociateddemandfor liquidity;inparticular,theyhaveademandforinsureddepositalternatives(Pozsarsterminology).The amountsofmoneythattheywantedtoallocatedtosafeassetclassesfarexceededtheamountthat could be insured in a demand deposit account. The problem was that there were not enough safe assets, U.S. Treasuries, for the pools to hold. Pozsar estimates that between 2003 and 2008, institutionalcashpoolsdemandforinsureddepositalternativesexceededtheoutstandingamountof shorttermgovernmentguaranteedinstrumentsnotheldbyforeignofficialinvestorsbyacumulativeof atleast$1.5trillion;theshadowbankingsystemrosetofillthisgap(p.3;emphasisinoriginal). Foreign official investors hold large amounts of U.S. Treasuries. And this is where the effects of the currentaccountimbalancemayhaveplayedarole.Bernanke(2005):Ifacountryssavingexceedsits investment during a particular year, the difference represents excess saving that can be lent on internationalcapitalmarkets.Bythesametoken,ifacountryssavingislessthantheamountrequired tofinancedomesticinvestment,thecountrycanclosethegapbyborrowingfromabroad.IntheUnited States,nationalsavingiscurrentlyquitelowandfallsconsiderablyshortofU.S.capitalinvestment.Of necessity,thisshortfallismadeupbyforeignnetborrowing(p.3).Therewerelargeandpersistent capital inflows from foreigners seeking U.S. assets as a store of value. It is not so clear why the foreignerswantrisklessassets,ratherthan,say,buylandandpropertyintheU.S. WithlargeamountsofU.S.Treasuriesheldabroad,institutionalcashpoolshadtofindsubstitutes.The substituteswereoftwoforms.First,shorttermbankdebtlikeproducts,suchasrepurchaseagreements and assetbacked commercial paper provided collateral that substituted for government guarantees.

10 Second, there were indirect holdings of unsecured private money market instruments through money marketmutualfunds,wherethefundsassetportfoliowasshorttermandgloballydiversified. Thejoiningtogetherofthesupplyofassetbackedsecuritieswiththedemandforprivatealternativesto insureddepositsledtotheshadowbankingsystem,agenuinebankingsystemprovidingproductswitha convenienceyield,shorttermdebtofintermediaries,oftenbasedonprivatelyproducedcollateral. Historically,fortheprivateproductionofhighqualityassetbackedsecurities,mortgageshavebeenthe preferred collateral. The increase in the production of assetbacked securities appears to be a credit boom. In credit booms, households and firms are borrowing money. What are they doing with this money?Onepossibilityisthattheyarebuyinghouses.Creditboomsseemtooftencoincidewithhouse priceincreases.Thecausalityisnotclear.Isitthatfinancialintermediarieslowertheirlendingstandards and fuel house price increases? Or, are house prices going up (for some other reason) and intermediariesarewillingtolendagainstcollateralthatisthenmorevaluable?Thisisanareaforfuture research. House prices were rising during the credit boom. Karl Case and Robert Shiller documented the house priceincreasesin2003.Asthetitleoftheirarticlesuggests,theirmainquestionconcernsthenatureof thehousepriceincreases:Isitabubble?Astheypointout,...themerefactofrapidpriceincreasesis notinitselfconclusiveevidenceofabubble(p.300).Theythinkofabubbleasasituationinwhich excessivepublicexpectationsoffuturepriceincreasescausepricestobetemporarilyelevated(p.299). How do we determine if expectations of large future price increases can account for price increases today?CaseandShillerexaminetwokindsofevidencetosuggestthatfundamentalscannotaccount for the price increases. They first examine U.S. state data on home prices and fundamentals, such as income and employment, over 1985 to 2002, seventyone quarters. Secondly, they directly elicit the viewsofhomebuyersbasedonasurveyconductedin2003ofpeoplewhoboughthomesin2002infour metropolitanareas:LosAngeles,SanFrancisco,Boston,andMilwaukee.Thesurveyreplicatesa1988 survey of the same metropolitan areas. For both analyses, Case and Schiller find evidence broadly consistentwithabubble.Whilethereisclearlymoreresearchtobedoneonbubbles,keepinmindthat thispaperwaspublishedin2003.Fromthevantagepointofhindsight,afterthefinancialcrisisandthe verysignificantdeclineinhouseprices,theCaseShillerevidenceisindeedveryprovocative. House price runups prior to crises are common. This is shown by Reinhart and Rogoff (2008). Their researchshowsthatthereareimportantsimilaritiesacrosscrises.Theystudyeighteenbankcentered

11 financial crises from the postWar period, including a subset which they call The Five Big Crises of Spain (1977), Norway (1987), Finland (1991), Sweden (1991), and Japan (1992) (starting year in parenthesis). The Big Five crises occurred in developed economies, and were prolonged events with largedeclinesineconomicperformanceoverextendedperiods. Althoughtheyexamineanumberofdifferentseries,wefocusontherunupinhousingprices.Figure3 shows the relationship between real housing prices and banking crises. Date t is the first year of the financialcrisis,andt1,t2,andsoon,tot4indicatesthepreviousfouryears,andt+1etc.arethepost crisis years. The figure confirms that there was a runup in housing prices in the U.S. that, in fact, exceededtherunuppriortotheBigFive. It is not only house prices, Reinhart and Rogoff further show striking similarities with respect to real rates of growth in equity price indices, current account balancetoGDP ratios, real GDP growth per capita,andpublicdebtgrowthandcrises.Itishardtoescapetheconclusionthatthefinancialcrisisof 20072009wasnotspecial,butfollowsapatternofbuildupsoffragilitythatistypical. 5.ThePanics Thissectiondiscussespapersrelatingtothetwomainpanicperiodsofthefinancialcrisis:August2007 andSeptemberOctober2008.Wediscussthreepapersthateachfocusonadifferentcomponentofthe shorttermdebtmarket.Covitz,Liang,andSuarez(2011)analyzerunsontheassetbackedcommercial papermarketthatbeganinAugust2007,whichrepresentedthefirstmajoreventofthefinancialcrisis. McCabe (2010) analyzes money market mutual funds (MMFs) and contrasts their behavior in August 2007(whenMMFslargelyavoidedruns)andinSeptember2008(whentheydidexperienceruns).An important link between these two crises worked through the repo market, which weakened considerably in August 2007, limped along for a year, and then partially collapsed after the failure of Lehman.GortonandMetrick(2012)analyzethesedynamicsandtiethemtothechangesinunsecured interbanklendingmarkets. Commercial paper (CP) has been an important security for the financing of industrial firms for many decades.InthetraditionalCPmarket,highlyratedfirmscanquicklyissuedebtwithminimaltransactions costs, and typically cover the risk that investors will suddenly disappear by obtaining a backup line of credit from a commercial bank. Demand for CP is high enough that financial intermediaries have increasingly made use of the market to finance longterm financial assets, in which case the debt is known as assetbacked commercial paper, or just ABCP. When CP is used this way, financial

12 institutions can bundle mortgages, creditcard receivables, and other loans into offbalancesheet vehicles. Like the related structure of securitization, such vehicles can be more transparent than full bankbalancesheets,whichcanthenenablelowerfundingcosts.Morecynically,suchvehiclescanbe used to move assets off balance sheets in name only, allowing banks to save on regulatory capital. Whateverthereason,byJuly2007therewasapproximately$1.2trillionofABCPoutstanding.Withthe majorityofthispaperheldbyMMFs,theABCPmarketwasdeeplyconnectedwithmorefamiliarpartsof thefinancialsystem(Covitz,Liang,andSuarez,2011). Covitz, Liang, and Suarez describe the unraveling of this market in great detail, drawing the analogy betweenarunonanABCPprogramandatraditionalbankrun.Conceptually,anABCPprogramwould suffer a run if lenders equivalent to depositors in a bank are unwilling to refinance CP when it comesdue.Mechanically,theauthorsdefinearunasoccurringinanyweekwhereaprogramdoesnot issueanynewpaperdespitehavingatleasttenpercentofitsCPmaturing.Ifaprogramisunableto issuenewpaper,thenitmusteitherrelyonbackupsupportfromtheprogramsponsor(typicallyabank orgroupofbanks),oritisforcedtosellassets. Figure4,reproducedfromtheirpaper,showsthepatternofrunsatABCPprogramsduring2007.Here, thepanicinAugust2007isclear.BeginningintheweekofAugust7,thefrequencyofrunsincreased dramatically,andthelikelihoodofexitingarunwithlaterissuancefellintandem.Bytheendof2007, about40percentofprogramswereinarunandunabletofinancethemselvesintheirtraditionalshort termmarkets. A nice feature of the ABCP data is that it allows for a crosssectional analysis on the determinants of runs. Such analysis is rarely possible for bank runs, since the historical record does not allow for the same detail as is present in this modern data. This crosssectional analysis yields a set of interesting findings,makingthispaperauniquecontributiontotheliteratureofbankruns,aboveandbeyondits import for the study of the recent crisis. This analysis shows that programs were more likely to experience a run if they had high credit risk (from holdings of subprimerelated securities) or high liquidityrisk(fromamissingorincompleteliquiditysupportfromtheplansponsor).But,importantly,in thefirstfewweeksofAugust,therewasalsoahighlevelofrunactivityunrelatedtoprogramspecific measures. Taken together, the evidence indicates that vulnerability to runs is strongly related to fundamentals, but it takes some time for investors to figure things out. Even in this market, with relativelysophisticatedinvestors,thefirstfewweekscouldfairlybecharacterizedasapanic.

13 Overall,theABCPmarketfellby$350billioninthesecondhalfof2007.Mostprogramsreliedonbackup support from their sponsors to cover this shortfall, with a significant impact on the balance sheets of thosesponsors.Someprogramsmadeuseofcontractualoptionstoextendthematurityoftheirpaper, effectively reducing the returns for their lenders as compared to market rates. To understand the contagion of the financial crisis, it is necessary to trace these impacts through the system. McCabe (2010)isthenextlinkinthischain,withafocusonMMFs,amajorholderofABCPandothersecurities directlyrelatedtothenowtroubledhousingsector. WehaveearliermentionedthekeyroleplayedbytheReservePrimaryFund,alargeMMFthatbroke thebuckafterthefailureofLehmaninSeptember2008.LesswellknownarethestrugglesofMMFsin theAugust2007panic.AsthemainholdersofABCP,MMFssawthevaluesoftheirstakesdeclinewhen ABCPyieldsroseforoutstandingpaper.Furthermore,shrinkingABCPprogramswereforcedtoselltheir underlyingassets,placingfurtherdownwardpressureonassetclassesheldbymanyMMFs.Asaresult ofthesedynamics,atleast43MMFsrequiredassistancefromtheirsponsorsinordertoavoidbreaking thebuck.Essentially,thesefundswerebailedoutbythebanksorfundfamiliesthatmanagedthem. McCabeanalysesthedriversofthesebailoutsandfindthattheyweresignificantlymorelikelytooccur whenthefundsheldABCPandwhentheyhadpreviouslyearnedaboveaverageyieldsontheirportfolio. Whilesuchsponsorassistancehadoccurredinearlierstressperiods,thescaleofinterventionin2007 wasunprecedented. ThesponsorbasedrescueofMMFsin2007preventedanyrunsbyinvestorsonthosefundsthatyear, butmayhavealsosolidifiedtheexpectationthatMMFswouldalwaysbebailedoutbytheirsponsors. SuchexpectationsaddtothebeliefthatMMFsaresupersafemoneylikeinstrumentsthatrequireno duediligencebyinvestors.Inthatenvironment,investorscanchasethehighestyieldingfundswithout anyperceivedrisk.Figure5,takenfromMcCabe(2010),illustratesthisdynamic. Panel A of the figure shows the growth of MMFs from 1998 to 2010. Funds are broken into three categoriesTaxexempt,governmentonly,andprimewherethelastcategoryistheleastrestrictive oninvestmentsandalsobyfarthelargest.ThetotalassetsofMMFswereover$2trillionbeforethe ABCPcrisis,afterwhichassetsactuallyrosesignificantlyforbothprimeandgovernmentonlyfunds.The flighttosafety in August 2007 benefitted both types of funds, as investors sought a safe haven from riskier asset classes. By September 2008, MMF assets had increased more than 50 percent since the ABCPpanic.

14 TheLehmanbankruptcywasamajorshocktoMMFs.ThedropfromparityoftheReservePrimaryFund ledtoarunonsimilarfunds,withFigure5showingthesharpoutflowfromprimeMMFs,withanalmost oneforonetransferintogovernmentonlyfunds.Thistransfercausedsignificantdisruptioninfunding markets. Prime MMFs are a crucial supplier of funds to corporations and to financial intermediaries. When these investors moved to governmentonly MMFs, this liquidity supply was lost from private creditmarkets. PanelsBandCofFigure5showhowReservePrimaryFund,traditionallyaconservativefund,beganto takeonmoreandmoreriskintheyearsbeforethecrisis.Priorto2001,thenetyieldtoinvestorsfrom thefundwasalwaysbelowaverageforprimefunds.(McCabefindsnoevidencethatyieldisrelatedto investmentskillinthesefunds;increasesinyieldseemdrivenentirelybyincreasesinrisk.)Beginningin 2001,however,relativeyieldsbegantocreepupwards,andthenincreasedsharplyin2007and2008. For MMFs, an increase in yields attracts new investors, and these new investors tend to be of the returnchasingtypethatarewillingtorapidlyleaveifperformanceslips.ThefigureshowsthatReserve Primarysassetsandrelativemarketshareroseintandemwithitsnetyields. As a holder of Lehman commercial paper, Reserve Primary was unable to maintain its value after the Lehman bankruptcy. McCabes analysis shows that the subsequent runs on MMFs happened disproportionately at funds that, like Reserve Primary, had high relative yields, had recently attracted newperformancesensitiveinvestors,andhadriskierfinancialinstitutions(asmeasuredbyCDSspreads) assponsors.TherunsonlystoppedaftergovernmentactiontoexplicitlyguaranteeMMFs. ThepapersbyMcCabeandbyCovitz,LiangandSuarezarecomprehensiveanalysesofthebreakdowns intwomajorcomponentsofshorttermdebtmarkets,andthelinkingofABCPandMMFshelpstoshow howcontagioninthesemarketscanspread.Butthereisstillamissingpiece,becausetheinitialABCP panic was driven by a weakness in subprime mortgages, whereas the eventual run on MMFs was triggered by the bankruptcy of Lehman. Indeed, the MMF market showed that it was capable of absorbingtheABCPlossesalbeitatsignificantcost.Sohowdidthereallossesinmortgageseventually leadtothemuchmoresignificantfailureofLehmanBrothersandnearcollapseofthewholefinancial system? We argue in Gorton and Metrick (2012) that the repo markets played a key role in this contagion. As discussed earlier, repo is the shadowbanking equivalent of a deposit market. Large institutional moneypools,whosecashholdingsfarexceedinsureddepositlimits,canlendshorttermtoafinancial

15 institutionandreceivecollateralasprotection.Forevery$100ofcollateral,aninstitutioncanreceive $(100x)inloans,with$xrepresentingthehaircutand1/xtheallowableleverage.Preciseestimates forthetotalsizeoftherepomarketarenotavailable,andimpreciseestimatescandifferbyalot,but theorderofmagnitudeisalwaysinthetrillionsofdollars.ThemainpieceofevidenceinGortonand Metrickistherisinghaircutindexonvarioustypesofrepocollateral,asillustratedinFigure6. Atthebeginningof2007,averagehaircutswerenearzeroonmosttypesofcollateral,allowingforvery high leverage for holdings of these securities. Haircuts get their first shock at the time of the ABCP panic,andcontinueasteadyrisethroughoutthenextyear.Foreverytrilliondollarsintherepomarket for these nongovernment assets, each one percent increase in haircuts is equivalent to a $10 billion withdrawalofliquidityfromthesystem,soa25percentrisefromJuly2007totheeveoftheLehman failure represents a large drain. Following the Lehman failure, the index rose by an additional 20 percentagepoints,including100percenthaircuts(=notradeatall)forsomeassets. It is important to note that haircuts rose and prices fell for many assets that had no direct connectiontosubprimesecurities.Thisisthekeystepthancanallowcontagionfromoneassetclassto thebroadermarketthatincludesmanyothertypesof(seeminglyunrelated)shorttermdebt.Themain regressions in Gorton and Metrick (2012) show that the value of nonsubprime assets moved closely with measures of distress in interbank funding markets, and not with an index of default risk on subprimesecurities. Howdidthedeclineinsubprimesecuritiesarelativelysmallcornerofthefinancialsectoreventually leadtothenearcollapseofglobalfinancialinstitutionsmanytimesthesize?Thepapersdiscussedin thissectiontraceoneimportantvectorofthiscontagion.First,thesubprimefailurehadadirecteffect onmanyABCPprograms,withrunsthatbeganinAugust2007eventuallyaffecting40percentofthat $1.2 trillion market. These runs and related price drops in other subprimerelated securities caused unprecedented problems for MMFs, where at least 43 funds required support from their sponsors. AftertheinitialpanicofAugust2007,interbankmarketswereslowtorecover,withspreadsbetween securedand unsecuredfundingremainingathighlevelsthroughoutthe next year.Thispressurealso manifested itself in repo markets, where haircuts grew steadily throughout the year, adding to the fundingpressureonfinancialintermediaries.WhenthispressurefinallyclaimedLehmanBrothersasa victim,thestressedinterbankmarketsnearlycollapsed,andonlyrecoveredaftersignificantgovernment intervention.Thisinterventionisdiscussedinthenextsection.

16 6.PolicyResponses BeginninginAugust2007,governmentsofalladvancednationstookavarietyofactionstomitigatethe financialcrisis.Giventhechaoticenvironmentandthewidevarietyofinterventions,itisunlikelywewill everhaveacompleteevaluationofthesepolicies.Giventhattheeconomicsprofessionisstilldebating theefficacyofactionsduringtheGreatDepression,itwouldbeatallordertohopeforclarityonour recentcrisis.Soourgoalhereisonlytoprovideanoverviewofthetypesofpolicyactionsundertaken, alongwithabriefreviewoftheevidenceontheshorttermimpactofthesepolicies.Inadditiontothe broadoverviewprovided here,thetimelineofthe crisisshowninTable1includessomeofthemajor policyactionstakenintheUnitedStates. IMF(2009)analyzestheeffectivenessofpolicyresponsesin13developedeconomies.Theydividethe crisisintothreeperiods:Period1(PreLehman),fromJune1,2007toSeptember15,2008;Period2 (GlobalCrisis1),fromSeptember15,2008toDecember31,2008;Period3(GlobalCrisis2),from January1,2009toJune30,2009.Ineachofthesethreeperiods,theyemployeventstudymethodology to measure the impact of five different kinds of policy actions, each of which was widely used across manycountriesinthesample.Table2,reproducedfromtheIMFreport,summarizesandclassifiesthese actions. Withthisclassificationasaguide,theyidentify153separatepolicyactionsacrosstheir13countries.In theUnitedStatesalone,theyidentify49actions,coveringalmosteverysubtypefromTable2ineachof thethreecrisisperiods.TherearemanyfuturePhDdissertationstobewrittenontheseinterventions, andtheworktodatecanonlyscratchthesurface.Ouronlyhopeatthispointistogetsomeguidance aboutshorttermefficacy,andeventherewewillneedtoconfineourselvestoanarrowsetofoutcome measures.TheIMFreportisanexcellentstartonthiswork,usingeventstudiestoevaluatetheshort run impact of each type of policy (listed in Table 2), with results tabulated separately for each crisis subperiod. To evaluate the efficacy of interest rate cuts, the IMF looked at the shortterm reaction of both an economicstressindex(ESI)andafinancialstressindex(FSI).TheESIisacompositeofconfidence measures(businessandconsumer),creditspreads,andstockpricesofnonfinancialcompanies.TheFSI isacompositeofseveralmeasuresofbankcredit,spreads,andstockprices.Centralbanksinallregions cutinterestratesinallthreecrisisperiods,buttheIMFfindsnoevidenceofshortrunimpactofinterest

17 ratecutsontheESI,andonlylimitedevidenceofapositiveeffectontheFSI.Ofcourse,eventstudies willnotidentifyanyeffectsifthesechangesareanticipatedamajorlimitationwhenevaluatingcentral bank actions. The story is better for liquidity support the second category in Table 2 where such actions often had a significant positive effect on interbank spreads and on the broader FSI measure duringthefirst(preLehman)period.Inlaterperiods,announcementsofliquiditysupportdidnothave reliableeffects,eitherbecausesuchannouncementswereanticipatedorbecauseconcernsweremore aboutsolvencythanliquidity. To measure the shortterm impacts of other financial sector policies recapitalizations, liquidity guarantees,andassetpurchasestheIMFlookstoboththeFSIandtoanindexofcreditdefaultswaps ondomesticbanksintherelevantcountry.Ofthesetypesofinterventions,recapitalizationsarefound tobeparticularlyeffective,withsignificantimprovementsinanindexofbankCDSspreadsinalmostall countries during the second and third crisis periods. (There were few recapitalizations in the first period.)TheseresultsarenotasstrongwhenthebroaderFSIisusedastheoutcomemeasure,which may be because the benefits of recapitalizations fall mostly to bondholders. Asset purchases and liabilityguaranteesalsoshowweakerresults,withtheexceptionofnotablesuccessesintheU.K.sasset protectionscheme(announcedJanuary2009)andintheSwissgovernmentspurchaseofUBSassets. Overall,theevidencesuggeststhatliquiditysupportintheformsdescribedinTable2waseffective atcalminginterbankcreditmarketsintheearlystagesofthecrisis,butnotafterthefallofLehman.In theselaterstages,capitalinjectionswerethemosteffectivepolicy. 7.RealEffectsoftheFinancialCrisis The run on shortterm debt created fear across the financial intermediary sector, especially after the failureofLehmanBrothers.Thewidespreadlossofconfidence,concernsaboutsolvencyandliquidityof counterparties,reachedtherealsectoroftheeconomywhenintermediariesbegantohoardcashand stop lending. The real effects of the financial crisis were global in nature. In this section we review three papers that document these phenomena. These papers are Bank Lending during the Financial Crisisof2008,byIvashinaandScharfstein(2010);GlobalRetailLendingintheAftermathoftheU.S. FinancialCrisis:DistinguishingbetweenSupplyandDemandEffects,byPuri,RochollandSteffen(2012); andTheRealEffectsofFinancialConstraints:EvidencefromaFinancialCrisis,byCampello,Graham, andHarvey(2010.

18 Ivashina and Scharfstein study the supply of credit during the crisis in order to understand the real effectsofthepaniconthecorporatesector.Theylookatsyndicatedloans,amarketwhichhasevolved over the last thirty years to become the main portal for large corporations to get loans. The market includes banks, but also a wide range of entities other than regulated commercial banks, such as investmentbanks,institutionalinvestors,hedgefunds,mutualfunds,insurancecompaniesandpension funds.Theirfirstfindingisthatsyndicatedlendingstartedtofallinmid2007,withthefallaccelerating duringthebankingpanicthatbeganinSeptember2008.Lendingvolumeinthefourthquarterof2008 (2008:Q4)was47%lowerthanitwasinthepriorquarterand79%lowerthanatthepeakofthecredit boom (2007:Q2). Lending fell across all types of loans: investment grade and noninvestment grade; termloansandcreditlines;andthoseusedforcorporaterestructuringaswellasthoseusedforgeneral corporatepurposesandworkingcapital(p.320). Syndicated lending fell, but commercial and industrial loans reported by the U.S. regulated banking sectorrosebyabout$100billionfromSeptembertomidOctober2008.But,IvashinaandScharfstein showthatthisincreasewasnotduetoanincreaseinnewloans.Insteadit wascorporateborrowers drawingdownexistingcreditlines,thatis,creditlinesthathadbeennegotiatedpriortothecrisis. Toshowtheeffectsofthecrisistheauthorsfirstshowthatbanksthatweremorevulnerabletoarun, thosethatweretoagreaterextentfinancedbyshorttermdebtotherthaninsureddeposits,cuttheir syndicatedlendingbymore.Theyfindthat:Abankwiththemediandepositstoassetsratioreduced itsmonthlynumberofloanoriginationsby36%intheperiodAugustandDecemberof2008,relativeto theprioryear.However,abankwithadepositstoassetsratioonestandarddeviationabovethemean reduced its loan by 49%, while a bank with deposits ratio one standard deviation above the mean reduceditsloanoriginationslendingbyonly21%(p.320). It is harder to demonstrate the effects of creditline drawdowns on syndicated lending because there are no data measuring creditline drawdowns. The authors consider the possibility that banks in syndicatedcreditlineswhereLehmanBrotherswaspartofthesyndicatemightexperiencelargercredit linedrawdownsafterthefailureofLehman.Theideaisthatcommitmentsthatwouldotherwisehave beenmetbytheothermembersofthesyndicatewouldbemorelikelytobedrawnon.They,infact, find that banks that cosyndicated a large fraction of their credit lines with Lehman reduced their lendingmore(p.320).

19 Animportantissueforthesefindingshastodowiththefactthatinarecessionthedemandforcredit falls.Toaccountfortheabovefindings,thefallindemandmustalsoexplainwhythemorevulnerable banksreducedthelendingmorethantheotherbanks.But,astheauthorspointout,thismaybethe case.Theypointtotheexampleofinvestmentbanks,whichhavenodemanddepositfunding,lending moreforcorporateacquisitions.Sincecorporateacquisitionsdeclinedintherecession,perhapsthisfall indemandaccountsfortheresults,ratherthanthesupplyofloans.Theauthorsfind,however,thatthe results continue to hold for commercial banks and for loans that are not used for acquisitions. Their main conclusion then is that the decline in lending was in large part an effect of reduced bank loan supply. TheissueofthesupplyofcreditisalsothefocusofPuri,RochollandSteffen(2012)whoexaminethe effectsoftheU.S.financialcrisisonlendingtoretailcustomersinGermany.Theyarealsointerestedin whethertherearedetectablereductionsinthesupplyofcreditbybanks,evenwhenoveralldemandis going down. The setting they study is German savings banks, which operate in defined geographical areasandaremandatedbylawtoserveonlytheirlocalcustomers.Ineachgeographicalareathereisa regional bank, a Landesbank, owned by the savings banks in that area. These German Landesbanken (theregionalbanks,eachinaprovince)hadexposurestoU.S.subprimemortgagestovaryingdegrees. TheauthorsexploitthefactthattheLandesbankensuffertodifferentextentsduetotheirexposuresto U.S. subprime mortgages. Importantly, the savings banks had to guarantee or make equity injections into some of the stricken Landesbanken. The authors make use of this natural experiment in which some savings banks faced a shock because their Landesbanken had to be assisted. The authors empirical strategy is to look at whether savings banks that are affected at the onset of the crisis (becausetheirLandesbankenneededhelp)reducetheirlendingbymorethanthe(relatively)unaffected savingsbanks.Thedataareespeciallyrich,includingtheuniverseofallloanapplicationsandthecredit scores,andinformationaboutwhichapplicationsweregrantedandwhichwereturneddown. There was an overall decrease in demand for consumer loans, as measured by applications to both affectedandunaffectedsavingsbanks.But,withrespecttothesupplyofcredit,theaveragerejection rateofaffectedsavingsbanksissignificantlyhigherthanofnonaffectedsavingsbanks(p.34).The effectisstrongerformortgages,ascomparedtoconsumerloans.Ifaborrowerhadapriorrelationship with the savings bank, the effect is mitigated, that is, those customers are less likely to have their applications rejected compared to new customers. Overall, their evidence is consistent with that of IvashinaandScharfstein:banksreducedthesupplyofcredit.

20 Whateffectdidareducedbankloansupplyhaveontherealeconomy,ontheactivitiesofnonfinancial firms?ThisbringsustothestudyofCampello,GrahamandHarvey(2010).Toanswerthisquestionof effectsonnonfinancialfirms,theseauthorsdirectlyask1,050chieffinancialofficersin39countriesin NorthAmerica,EuropeandAsiainDecember2008whethertheywerefinanciallyconstrainedduringthe crisis.Theirsurveyasksaboutthecostandavailabilityofcredit,andabouttheeffectsontheirdecisions and actions, as well as many other questions. The survey asks whether a firms operations are not affected, somewhat affected, or very affected by the turmoil in the credit markets. Firms that described themselves as somewhat affected or very affected were then further probed with questionsconcerningthenatureoftheeffects,e.g.,highercostsofexternalfunds,limitationsoncredit. For U.S. firms, 244 indicated that they were unaffected by credit constraints, 210 indicated that they were somewhat affected, and 115 said they were very affected (In Europe, the numbers respectively were92,71,and26;andinAsia,thenumberswere147,112,and24). Figure7,fromCampello,GrahamandHarvey(2010),givesasenseoftheeffectsofcreditconstraints. Thefigureshowsaveragesforeachtypeofactionfortheconstrainedfirmsandtheunconstrainedfirms (constrained is only very affected, while unconstrained is the other two categories). While all firms cut back on expenditure and dividend payments and see their cash holdings and the number of employeesdecline,theconstrainedfirmscontractthesepoliciesmuchmore,inaverynoticeable(and statisticallysignificantway).Forexample,unconstrainedfirmsreducethenumberoftheiremployees by2.7percentonaverage,whileconstrainedfirmsreducethenumberoftheiremployeesbyalmost11 percent. What are the constraints that firms face? Eightyone percent of the very affected firms reported that theyexperiencedlessaccesstocredit;twentypercentciteproblemswithlinesofcredit.Inotherwords, it seems that the reductions in credit that Ivashina and Scharfstein reported in their study of banks resultintheconstraintsstudiedbyCampello,GrahamandHarvey. Thecategorizationoffirmsintoconstrainedandunconstrainedmayconfoundanumberoffactors. Theauthorsaddressthisproblemeconometricallybymatchingconstrainedfirmswithanunconstrained matchbasedonsize,ownershipform,creditrating,profitability,andsoon,sothatthereisasample of firms that only differs on the degree of access to credit. Tests based on this approach show the differential effect of financial constraints on corporate policies. Firms that are constrained show importantdifferencesevenbeforethecrisis,andincreaseverynoticeablyduringthepeakofthecrisis.

21 The authors also delve into firms liquidity management and investment decisions. For example, the IvashinaandScharfsteinresultthattherewasarunonthebanks,byfirmsdrawingdownontheircredit linesjustincase,isconfirmed.Thirteenpercentoftheconstrainedfirmssaidthattheywoulddraw downontheircreditlinesnowtohavecashinthefutures.And17percentdrewdowntheircreditlines asaprecaution,comparedtosixpercentoftheunconstrainedfirms.Withrespecttoinvestmentduring the crisis, 86 percent of constrained U.S. firms reported that they bypassed attractive investments, comparedto44percentofunconstrainedfirms. Overall,theevidencesuggeststhatbankscutbackoncreditsupply,althoughthedemandforcreditalso fell.Theresultingreductionincreditsupplyhadsignificantimpactsoncreditconstrainedfirms. 8.Conclusion The financial crisis of 20072009 was perhaps the most important economic event since the Great Depression.Allprofessionaleconomistsneedaworkingknowledgeofthekeydetailsofthiscrisis.This papersummarizesthesedetailsusing16papers,reports,andotherdocuments.Fromthesedocuments, anarrativeemergesthatisverysimilartohistoricalcrises,whilecloakedininstitutionaldetailnovelto thiscentury. Onestrongsimilaritytohistorycomesintheaccelerationofsystemwideleveragejustbeforethecrisis, thestrongestpredictorofcrisesinthepasttwocenturies.Furthermore,therecentcrisiswaspreceded byrapidincreasesinhousingprices,alsoafeatureofallmajorcrisessinceWorldWarII.Atthismacro level,thepattern(butnotthescale)ofourcrisisisveryordinary. The crisis was exacerbated by panics in the banking system, where various types of shortterm debt suddenlybecamesubjecttoruns.This,also,wasatypicalpartofhistoricalcrises.Thenoveltyherewas in the location of runs, which took place mostly in the newly evolving shadow banking system, including moneymarket mutual funds, commercial paper, securitized bonds, and repurchase agreements. This new source of systemic vulnerability came as a surprise to policymakers and economists, and some knowledge of its details is necessary for understanding the contagion that eventuallyspreadtotherealeconomy.

22 References BankforInternationalSettlements(BIS)(2009),79thAnnualReport(April1,2008March31,2009); Seehttp://www.bis.org/publ/arpdf/ar2009e2.pdf.

Bernanke, Ben (2005), The Global Saving Glut and the U.S. Current Account Deficit, The Sandridge Lecture,April14,2005; seehttp://www.federalreserve.gov/boarddocs/speeches/2005/200503102/. Bernanke, Ben (2010), Causes of the Recent Financial and Economic Crisis, Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, before the Financial CrisisInquiryCommission,WashingtonD.C.(September2,2010); seehttp://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm

Campello, Murillo, John R. Graham, and Campbell Harvey (2010), The Real Effects of Financial Constraints:EvidencefromaFinancialCrisis,JournalofFinancialEconomics97,470487. Case,KarlandRobertShiller(2003),IsThereaBubbleintheHousingMarket?,BrookingsPaperson EconomicActivity2,299362. Covitz,Daniel,NellieLiang,andGustavoSuarez(2011),TheEvolutionofaFinancialCrisis:Panicinthe AssetBackedCommercialPaperMarket,FederalReserveBoard,FinanceandDiscussionSeries #200936;seehttp://www.federalreserve.gov/pubs/feds/2009/200936/200936pap.pdf. Gorton, Gary and Andrew Metrick (2012), Securitized Banking and the Run on Repo, Journal of FinancialEconomics,forthcoming. InternationalMonetaryFund(2009),NavigatingtheFinancialChallengesAhead(October2009),Chapter III;seehttp://www.imf.org/external/pubs/ft/gfsr/2009/02/index.htm. InternationalMonetaryFund(2010),GlobalFinancialStabilityReport:Sovereigns,Funding,andSystemic Liquidity(October2010);seehttp://www.imf.org/external/pubs/ft/gfsr/2010/02/index.htm. Ivashina, Victoria and David Scharfstein (2010), Bank Lending during the Financial Crisis of 2008, JournalofFinancialEconomics97,319338.

23 McCabe,Patrick(2010),TheCrossSectionofMoneyMarketFundRisksandFinancialCrises,Federal Reserve Board, Finance and Economics Discussion Series #201051; see

http://www.federalreserve.gov/pubs/feds/2010/201051/201051pap.pdf. Pozsar, Zoltan (2011), Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, InternationalMonetaryFund,workingpaper#WP/11/190; seehttp://www.imf.org/external/pubs/cat/longres.aspx?sk=25155. Puri,Manju,JrgRochollandSaschaSteffen(2012);GlobalRetailLendingintheAftermathoftheU.S. Financial Crisis: Distinguishing between Supply and Demand Effects, Journal of Financial Economics,forthcoming. Reinhart,CarmenandKennethRogoff(2008),Isthe2007U.S.SubprimeFinancialCrisisSoDifferent? AnInternationalComparison,AmericanEconomicReview98,339344. Reinhart,CarmenandKennethRogoff(2011),FromFinancialCrashtoDebtCrisis,AmericanEconomic Review101,16761706. Schularick, Moritz and Alan M. Taylor (2012), Credit Booms Gone Bust: Monetary Policy, Leverage CyclesandFinancialCrises,18702008,AmericanEconomicReview,forthcoming.

24

Table1:FinancialCrisisMajorEventsTimeline
2007 Jan.July SubprimemortgageunderwritersOwnit MortgageSolutionsandNewCenturyFinancialCorp. file for bankruptcy. Massive downgrades of mortgagebacked securities by rating agencies. Kreditanstalt fr Wiederaufbau (KfW), a German governmentowned development bank, supportsGermanbankIKB. Problemsinmortgageandcreditmarketsspilloverintointerbankmarkets;haircutsonrepo collateralrise;assetbackedcommercialpaper(ABCP)issuershavetroublerollingovertheir outstandingpaper;largeinvestmentfundsinFrancefreezeredemptions. RunonU.S.subprimeoriginatorCountrywide. RunonU.K.bankNorthernRock Citibank announces it will take its seven structured investment vehicles onto its balance sheet,$49billion. NationalBureauofEconomicResearchsubsequentlydeclaresDecembertobethebusiness cyclepeak. Federal Reserve announces creation of the Term Securities Lending Facility to promote liquidity. JPMorgan Chase agrees to buy Bear Stearns, with Federal Reserve Assistance, and Federal ReserveannouncescreationofthePrimaryDealerCreditFacility. MonolineinsurersMBIAandAMBACaredowngradedbyMoodysandS&P. U.S. Securities and Exchange Commission issues an order banning naked shortselling of financialstocks. FederalgovernmenttakesoverFannieMaeandFreddieMac. LehmanBrothersfilesforbankruptcy. TheReservePrimaryFund,amoneymarketfund, breaksthebuck,causingarunonMMFs. FederalReservelends$85billiontoAIGtoavoidbankruptcy. U.S.TreasuryannouncestemporaryguaranteeofMMFs,andFederalReserveannouncesthe AssetBackedCommercialPaperMoneyMarketMutualFundsLiquidityFacility.. Washington Mutual, the largest savings and loan in the U.S. with $300 billion in assets, is seizedbytheauthorities. FinancialcrisisspreadstoEurope. U.S.CongressapprovestheTroubledAssetReliefProgram(TARP),authorizingexpenditures of$700billion. CentralbanksinUS,England,China,Canada,Sweden,Switzerland,andtheEuropeanCentral Bankcutinterestratesinacoordinatedefforttoaidworldeconomy. MajorcentralbanksannouncedunlimitedprovisionofliquiditytoU.S.dollarfunds;European governmentsannouncesystemwidebankrecapitalizationplans. U.S.Treasuryinvests$250billioninninemajorbanks. ResultsoftheSupervisoryCapitalAssessmentProgram(stresstests)announced. NationalBureauofEconomicResearchsubsequentlydeclaresJunetobethebusinesscycle trough. Unemploymentratepeaksat10.0percent.

August

August17 September9 December15 December 2008 March11 March16 June4 July15 September7 September15 September16 September19 September25 October October3 October8 October13 October14 2009 May June October

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Table2:ClassificationofEvents
CentralBankMonetaryPolicyandLiquiditySupport
Interestratechange Reductionofinterestrates Liquiditysupport ReserveRequirements,longerfundingterms,moreauctionsand/orhighercreditlines

GovernmentFinancialSectorStabilizationMeasures
Recapitalization Capitalinjection(commonstock/preferredequity) Capitalinjection(subordinateddebt) Liabilityguarantees1 Enhancementofdepositorprotection Debtguarantee(allliabilities) Debtguarantee(newliabilities) Governmentlendingtoanindividualinstitution Assetpurchases2 Assetpurchases(individualassets,bankbybank) Assetpurchases(individualbadbank) Provisionsofliquidityincontextofbadassetpurchases/removal Onbalancesheetringfencingwithtoxicassetskeptinthebank Offbalancesheetringfencingwithtoxicassetsmovedtoabadbank Assetguarantees Source:Table3.1,IMF(2009)
1

IncludestheFederalReservesliquiditysupporttoAIGfortoxicassetremovaltoaspecialpurposevehicle,coupledwith governmentslosssharing.

Includesbusinessloanguaranteesaspartoffinancialsectorstabilizationmeasures(e.g.theUnitedKingdom,Germany);for somecountries,assetpurchaseswerenotconductedbythegovernment,but(also)bythecentralbank(oracentralbank sponsored)agentsuchastheUnitedStatesandSwitzerland.

26

Figure 1: Money and Credit Aggregates Relative to GDP (14-country averages by year)

2
Bank loans/GDP Bank assets/GDP Broad money/GDP

1.5

0.5

0 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Source:SchularickandTaylor(2012).

27

Figure2:U.S.PrivateLabelTermSecuritizationIssuancebyType (InbillionsofU.S.dollars)

2500 CDO2 2000 CDO RMBS 1500 ABS

1000

500

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 20092010Q1
Sources:IMF(2010).

28

Figure3:RealHousingPricesandBankingCrises
135 130 125 120 115 110 105 100 Index t-4=100 95 t4 t3 t2 t1 T t+1 t+2 t+3
Source:ReinhartandRogoff(2008).

US, 2003=100

Index

Average for banking crises in

Average for the "Big 5" Crises

29

Figure4:RunsonAssetBackedCommercialPaperPrograms
60 Weekly 50 Fraction of ABCP programs experiencing runs

40 Percent

30

20

10

17-

31-

14-

28-

14-

28-

11-

25-

23-

20-

18-

15-

29-

12-

26-

10-

24-

21-

0 3-Jan-07

4-Jul-07

19-

9-

6-

1-

7-

5-

Thesolidlineplotsthepercentofprogramsexperiencingarun.Wedefinethataprogramexperiencesa runinweekswhenitdoesnotissuepaperbuthasatleast10%ofpapermaturingorwhentheprogram continuestonotissueafterexperiencingaruninthepreviousweek(seeequation(1)inthetext).The dotted line plots the unconditional probability of not experiencing a run in a given week after having experienced a run in the previous week (i.e., the hazard rate of leaving the run state). The figure is basedonweeklydatafromDTCConpaperoutstanding,maturities,andissuancefor339ABCPprograms in2007. Source:Covitz,Liang,andSuarez(2011).

30

Figure5:MoneyMarketFunds(McCabe(2010))

31

Figure6:AverageHaircuts(onnineassetclasses;equallyweighted)
50% 45% 40% 35% Percentage 30% 25% 20% 15% 10% 5% 0%

Source:GortonandMetrick(2012).

32

Figure7:PlansofConstrainedvs.UnconstrainedFirms

10

0 0.6 4.5 %Change 10 9.1 10.9 15 14.2 22 30 32.4 40 ConstrainedUnconstrained Techexpenditures Marketingexpenditures Cashholdings Capitalexpenditures Numberofemployees Dividendpayments 9 2.7 2.7 2.9

20

Source:Campello,GrahamandHarvey(2010).