The Credit Crisis

We are now in a position to explore the crux of the financial crisis, when private lending dried up in a number of important credit markets.  Since bills come due at different times than revenues are received, credit is critical for the functioning of nearly every business, from Mom and Pop grocery stores, to Fortune 500 corporations.  As a consequence, businesses need “working capital,” sometimes savings but more often credit.  When lending markets dried up, as we will explain in detail below, businesses found it difficult or impossible to obtain the credit required to function normally.  The lack of credit slowed down the firms’ ability to make payroll and pay other bills, which played a major role in contributing to the recession which was starting at that time.

One way to measure the degree of liquidity (i.e. the availability of credit) in financial markets is with the TED Spread.  The TED Spread indicates the difference between the 3-month LIBOR (the London Interbank Offered Rate) and 3-month US Treasury bill interest rates.   The LIBOR is a measure of the cost of borrowing between large banks.  The Treasury bill rate measures the cost of essentially risk-free lending.  The TED Spread thus measures how willing big banks are to lend to each other given the amount of risk currently perceived in the market.  Bloomberg has an excellent, dynamic graphic here showing the TED Spread, which allows you to choose different timeframes.  From that graphic, you can see that historically, the TED Spread has been around 0.5%, which is to say that large banks charged each other half a percent over the cost of borrowing to compensate for the (small) risk of the loan.

By this measure the financial crisis began in August 2007.

On August 3, the secondary market for subprime (and Alt-A) mortgage-backed securities froze as trading all but halted.  Banks could make new loans, but they couldn’t securitize them and sell them off.  In a contemporaneous account, Scott Valentin, a mortgage company analyst said. “No one wants to bid on these things and then find out that the loans are worthless tomorrow.” Only the AAA parts of the MBS-market were selling and those were selling at higher interest rates.

Over an eleven day period (August 9 to August 20), the TED spread went from under 0.5% to 2.4%, nearly five times the norm.  August 9 was the date BNP Paribas, one of the largest European banks, declared that three of its investment funds were illiquid due to losses in the U.S. subprime mortgage market, triggering € 96.8 billion (roughly $140 billion) in lines of credit by the European Central Bank to cover potential losses.  This came on the heels, two weeks earlier, of the failure of two Bear Sterns hedge funds, which had similarly invested in subprime securities.  On August 10, Countrywide Financial, suffered a bank run.  Countrywide was the nation’s largest subprime mortgage lender, with nearly $100 billion dollars in loans outstanding.  A few days later, Fitch Ratings downgraded Countrywide’s debt to its third lowest investment grade rating.¹

The TED spread stayed mostly above 1.0% from August 9 to late-April 2009, a period of more than 16 months.  The increased TED Spread shows clearly the effects of the drying up of credit.  At the peak of the credit crisis, banks were reluctant to lend to each other, and they were even less willing to lend to other businesses.  They were, in short, unwilling to accept normal credit risk.  The cause of this was the implosion of the CMO market, which prompted the execution of a multitude of  credit default swaps, dragging down the balance sheets of the major players in investment banking.  Banking and credit work on trust.  The evaporation of trust meant that no private financial institution was willing to lend its scarce cash, since the lenders couldn’t trust that the borrowers had revealed the full extent of their CMO holdings.  Even if they had revealed their holdings, since no one was trading CMOs, it was no longer clear what those holdings were worth.  This is why credit markets dried up.

What happened in 2007, however, was just a precursor to the events during Fall 2008.

On September 15, 2008, Lehman Brothers, a major US investment bank, filed for bankruptcy protection, but was subsequently liquidated.  The next day, the Reserve Fund, a money market fund, “broke the buck”.  Money market funds are mutual funds that invest exclusively in short term debt instruments, like bank CDs and commercial paper.  They are structured as highly liquid, market interest paying accounts, in which their net asset value is maintained at one dollar, and all variations in asset values are manifested through changes in the interest rate they pay.

The Reserve Fund had purchased more than $750 million in commercial paper from Lehman Brothers.  When Lehman Brothers declared bankruptcy, the commercial paper became worthless and the Reserve Fund found itself unable to maintain its net asset value at one dollar.   This extraordinary event (only the second time a money market fund had broken the buck) sparked a run on money market funds as depositors began to remove their deposits.

Since money market funds are the major purchasers in the commercial paper market, their retrenchment helped freeze commercial paper.  Commercial paper is short term debt that large businesses sell to cover daily cash flow needs.  The commercial paper market exists as a less expensive source of credit than bank loans for businesses that are large enough to have a safe reputation.  Commercial paper is described as a “vital funding source for US business.”

The freeze lasted 12 hours, after which credit became available again but at a substantially higher interest rate, 8% instead of 2% the week previous.

Between September 18 and October 20, the TED spread stayed above 3% – or roughly six times the norm..  On September 19, 2008 the US Treasury responded to the freeze with a temporary program to insure investments in money market funds to stop the run, similar to the way FDIC obviates the need for bank depositors to withdraw their deposits.

On October 7, the Federal Reserve created the Commercial Paper Funding Facility (CPFF), enabling issuers of commercial paper to borrow against those assets, to provide liquidity in the commercial paper market.  On the same day, to stem the potential for bank runs, FDIC raised the deposit insurance limit to $250,000 per depositor.

On October 21, the Federal Reserve Board created the Money Market Investor Funding Facility (MMIFF) to enable the purchase of CDs, commercial paper and other assets from money market funds to provide liquidity to cover any withdrawals.

Since mid-October, the TED spread has improved, dropping to 1% in mid-January 2009 and dropping further to 0.5% in late-May.

[ next section:  The Federal Bailout ]

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