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Over the Cliff: from the Subprime to the Global Financial Crisis

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Journal of Economic Perspectives—Volume 25, Number 1—Winter 2011—Pages 49–70 Over the Cliff: From the Subprime to the Global Financial Crisis Frederic S. Mishkin hhee fi nnancialancial ccrisisrisis ooff 22007007 ttoo 22009009 ccanan bbee ddividedivided iintonto ttwowo ddistinctistinct pphases.hases. TThehe fi rrstst aandnd mmoreore llimitedimited pphasehase ffromrom AAugustugust 22007007 ttoo AAugustugust 22008008 sstemmedtemmed T ffromrom llossesosses iinn oonene rrelativelyelatively ssmallmall ssegmentegment ooff tthehe UU.S..S. fi nnancialancial ssystem—ystem— nnamely,amely, ssubprimeubprime rresidentialesidential mmortgages.ortgages. DDespiteespite tthishis ddisruptionisruption ttoo fi nnancialancial mmarkets,arkets, rrealeal GDPGDP iinn tthehe UUnitednited SStatestates ccontinuedontinued ttoo rriseise iintonto tthehe ssecondecond qquarteruarter ooff 22008,008, aandnd fforecastersorecasters wwereere ppredictingredicting oonlynly a mmildild rrecession.ecession. FForor eexample,xample, tthehe CCongres-ongres- ssionalional BBudgetudget OOffiffi ccee ((2008)2008) rreleasedeleased oonene ooff iitsts pperiodiceriodic ““TheThe BBudgetudget aandnd EEconomicconomic OOutlook:utlook: AAnn UUpdate”pdate” rreportseports oonn SSeptembereptember 88,, 22008.008. IItt ssaid:aid: ““AccorAccor ddinging ttoo CCBO’sBO’s uupdatedpdated fforecastorecast fforor tthehe rrestest ooff 22008008 aandnd fforor 22009,009, tthehe eeconomyconomy iiss aaboutbout hhalfwayalfway tthroughhrough aann eextendedxtended pperioderiod ooff vveryery sslowlow ggrowth.rowth. WWhetherhether oorr nnotot tthathat pperioderiod ooff sslowlow ggrowthrowth wwillill uultimatelyltimately bbee ddesignatedesignated a rrecessionecession iiss sstilltill uuncertain.ncertain. HHowever,owever, tthehe iincreasencrease iinn tthehe uunemploymentnemployment rrateate aandnd tthehe ppaceace ooff eeconomicconomic ggrowthrowth aarere ssimilarimilar ttoo cconditionsonditions dduringuring ppreviousrevious mmildild rrecessions.”ecessions.” IInn kkeepingeeping wwithith tthathat vview,iew, CCBOBO pprojectedrojected tthathat uunemploymentnemployment wwouldould rriseise mmodestlyodestly ffromrom 55.4.4 ppercentercent iinn 20082008 ttoo 66.2.2 ppercentercent iinn 22009009 aandnd tthathat ffourth-quarterourth-quarter ttoo ffourth-quarterourth-quarter rrealeal GGDPDP wwouldould ggrowrow oonlynly 00.9.9 ppercentercent iinn 20082008 bbutut wwouldould rreboundebound mmodestlyodestly ttoo 11.8.8 ppercentercent ggrowthrowth iinn 22009.009. IInn ssummerummer ooff 22008,008, wwhenhen I wwasas sservingerving oonn tthehe FFederalederal RReserveeserve BBoardoard ooff GGovernors,overnors, ttherehere wwasas eevenven ttalkalk tthathat tthehe FFeded mmightight nneedeed ttoo rraiseaise iinterestnterest rratesates ttoo kkeepeep iinflnfl aationtion uundernder ccontrol.ontrol. IInn mmid-Septemberid-September 22008,008, hhowever,owever, tthehe fi nancialnancial crisiscrisis enteredentered a farfar moremore vvirulentirulent pphase.hase. IInn rrapidapid ssuccession,uccession, tthehe iinvestmentnvestment bbankank LehmanLehman BBrothersrothers ■ FFredericrederic SS.. MMishkinishkin iiss AAlfredlfred LLernererner PProfessorrofessor ofof BBankinganking andand FinancialFinancial IInstitutions,nstitutions, GGraduateraduate SSchoolchool ooff BBusiness,usiness, CColumbiaolumbia University,University, NewNew YorkYork City,City, NewNew York.York. HeHe isis alsoalso a RResearchesearch AAssociate,ssociate, NNationalational BBureauureau ooff EEconomicconomic RResearch,esearch, CCambridge,ambridge, MMassachusetts.assachusetts. FFromrom SSeptembereptember 22006006 ttoo AAugustugust 22008,008, hhee wwasas a MMember,ember, BBoardoard ooff GGovernorsovernors ooff tthehe FFederalederal RReserveeserve SSystem,ystem, WWashington,ashington, DD.C..C. HHisis ee-mail-mail aaddressddress iiss 〈 [email protected]@columbia.edu〉. doi=10.1257/jep.25.1.49 50 Journal of Economic Perspectives eenteredntered bankruptcybankruptcy oonn SSeptembereptember 115,5, 22008;008; thethe iinsurancensurance fi rmrm AIGAIG collapsedcollapsed onon SSeptembereptember 116,6, 22008;008; ttherehere wwasas a runrun oonn thethe ReserveReserve PPrimaryrimary FundFund moneymoney mmarketarket ffundund oonn tthehe ssameame dday;ay; aandnd tthehe hhighlyighly ppublicizedublicized sstruggletruggle ttoo ppassass tthehe TTroubledroubled AAssetsset RReliefelief PProgramrogram ((TARP)TARP) bbegan.egan. HHowow ddidid ssomethingomething tthathat aappearedppeared iinn mmid-2008id-2008 ttoo bbee a ssignifiignifi cantcant butbut fairlyfairly mmildild fi nnancialancial ddisruptionisruption ttransformransform intointo a ffull-flull-fl edgededged globalglobal fi nancialnancial crisis?crisis? WhatWhat ccausedaused tthishis ttransformation?ransformation? DDidid thethe ggovernmentovernment rresponsesesponses ttoo tthehe globalglobal fi nancialnancial ccrisisrisis hhelpelp aavoidvoid a wworldwideorldwide depression?depression? WhatWhat challengeschallenges dodo thesethese governmentgovernment iinterventionsnterventions rraiseaise fforor tthehe wworldorld fi nancialnancial systemsystem andand thethe economyeconomy goinggoing forward?forward? LLet’set’s sstarttart wwithith a bbriefrief ssteptep bbackack ttoo tthehe fi rstrst phasephase ofof thethe globalglobal fi nancialnancial crisis.crisis. TThehe FFirstirst PPhase:hase: TThehe SSubprimeubprime MMortgageortgage CCrisisrisis TThehe fi rrstst ddisruptionisruption ooff ccreditredit mmarketsarkets iinn tthehe rrecentecent fi nnancialancial ccrisisrisis iiss ooftenften ddatedated ttoo AAugustugust 77,, 22007,007, wwhenhen tthehe FFrenchrench bbankank BBNPNP PParibasaribas ssuspendeduspended rredemptionedemption ooff sshareshares hheldeld iinn ssomeome ooff iitsts mmoneyoney mmarketarket ffunds.unds. A bboomoom iinn UU.S..S. hhousingousing ppricesrices hhadad ppeakedeaked aaroundround 22005.005. AAss hhousingousing ppricesrices sstartedtarted ttoo ddecline,ecline, mmortgage-backedortgage-backed fi nnan-an- ccialial ssecurities—inecurities—in mmanyany ccases,ases, ssecuritiesecurities bbasedased oonn ssubprimeubprime rresidentialesidential mmortgagesortgages bbutut tthenhen ddividedivided iintonto mmoreore sseniorenior cclaimslaims tthathat wwereere ssupposedlyupposedly ssafeafe aandnd jjuniorunior cclaimslaims tthathat wwereere rrecognizedecognized ttoo bbee rrisky—beganisky—began ttoo eexperiencexperience hhugeuge llosses.osses. BByy eearlyarly 22008,008, llossesosses oonn tthesehese ssecuritiesecurities wwereere eestimatedstimated ttoo bbee oonn tthehe oorderrder ooff $$500500 bbillionillion ddollarsollars ((forfor eexample,xample, GGreenlaw,reenlaw, HHatzius,atzius, KKashyap,ashyap, aandnd SShin,hin, 22008).008). WWhathat ddevelopedeveloped iinn llateate 22007007 aandnd iintonto 22008008 wwasas a sserieseries ooff rrunsuns oonn fi nnancialancial iinstitutions.nstitutions. BButut iinsteadnstead ooff tthehe cclassiclassic bbankank rrun,un, iitt wwas,as, aass ddescribedescribed bbyy GGortonorton aandnd MMetricketrick ((2009),2009), a rrunun oonn tthehe sshadowhadow bbankinganking ssystem.ystem. A bbankank hhasas ddepositseposits tthathat aarere sshort-termhort-term lliabilitiesiabilities aandnd aassetsssets tthathat aarere llong-termong-term lloans.oans. TThus,hus, iinn a cclassiclassic bbankank rrun,un, whenwhen bbankank ddepositorsepositors rrunun ttoo wwithdrawithdraw ddeposits,eposits, tthehe bbankank ccannotannot rreadilyeadily cconvertonvert iitsts llong-termong-term aassetsssets iintonto cash.cash. IInn tthehe sshadowhadow bbankinganking ssystem,ystem, iinstitutionsnstitutions hhaveave sshort-termhort-term lliabilitiesiabilities iinn tthehe fformorm ooff sshort-termhort-term bborrowing,orrowing, llikeike rrepurchaseepurchase aagreementsgreements ((oror rrepos),epos), wwhichhich uusese llonger-termonger-term aassetsssets llikeike mmortgage-backedortgage-backed ssecuri-ecuri- ttiesies aass ccollateral.ollateral. A kkeyey eelementlement ooff tthishis bborrowingorrowing iiss tthehe uusese ooff a ““haircut,”haircut,” tthathat iis,s, a rrequirementequirement tthathat bborrowersorrowers ppostost ccollateralollateral tthathat iiss vvaluedalued aatt mmoreore tthanhan tthehe lloan.oan. FForor eexample,xample, iiff a bborrowerorrower ttookook ooutut a $$100100 mmillionillion lloanoan iinn a rrepoepo aagreement,greement, iitt mmightight hhaveave ttoo ppostost $$105105 mmillionillion ooff mmortgage-backedortgage-backed ssecuritiesecurities aass ccollateral,ollateral, aandnd tthehe hhaircutaircut wwouldould tthenhen bbee 5 ppercent.ercent. AAss tthehe vvaluealue ooff mmortgage-backedortgage-backed ssecuritiesecurities ffellell aandnd uuncertaintyncertainty aaboutbout ttheirheir ffutureuture vvaluealue iincreased,ncreased, hhaircutsaircuts rroseose ttoo llevelsevels aass hhighigh asas 5500 ppercent.ercent. TThehe rresultesult wwasas tthathat tthehe ssameame aamountmount ooff ccollateralollateral wwouldould nnowow ssupportupport llessess bborrowing,orrowing, lleadingeading ttoo deleveragingdeleveraging inin wwhichhich fi nnancialancial iinstitutionsnstitutions hhadad ttoo ssellell ooffff aassets.ssets. TThehe rresultingesulting ““fifi rree ssale”ale” ddynamicynamic ((discusseddiscussed bbyy SShleiferhleifer aandnd VVishnyishny iinn tthishis iissue)ssue) lleded ttoo aann aadversedverse ffeedbackeedback lloopoop iinn wwhichhich tthehe ddeclineecline iinn aassetsset vvaluesalues lloweredowered tthehe ccollateral’sollateral’s vvaluealue wwhilehile ffurtherurther rraisingaising uuncertainty,ncertainty, ccausingausing hhaircutsaircuts ttoo rriseise ffurther,urther,
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