History Lesson No. 1: Global Financial Crisis 2007-2009, Part 1

I thought I’d start off by discussing the Global Financial Crisis (GFC), which is arguably the most catastrophic economic event since the Great Depression. It is important for us to understand the implications of the GFC and how it affects us. Five years after the GFC, the global economy is still suffering from the aftermath of the GFC; the fiscal cliff in the US, the debt crisis in Europe and slow growth in developing countries. Evidently, the health of the financial system is crucial to the economy, which is intimately linked to our daily lives.

In the event of Lehman Brothers bankruptcy, there was widespread panic and the stability of the financial system was threatened, triggering the GFC, in which financial market problems soon spread into the real economy. The collapse of Lehman Brothers saw public trust in banks and in the financial system plummet, inciting a run on banks. The banking crisis spreads into the real economy as other businesses (non- financial institutions) are unable to obtain a line of credit to fund their daily operations. This is when the crisis affects you and me. The banking crisis freezes credit lines to businesses that cannot fund their operations and pay their employees. Businesses start laying off their employees, increasing uncertainty in job security. Consumer sentiment falls as people increase savings and decrease consumption spending, resulting in lower profits for businesses. Businesses lay off more people and put a freeze on hiring. The average person like you and me struggle to keep our jobs or find jobs.

In 2007, the sub-prime mortgage crisis and securitization built the foundations of the global financial crisis, contributing to the collapse of Lehman Brothers, also threatened the collapse of other financial institutions such as Bear Stearns, Merrill Lynch, Fannie Mae and Freddie Mac, which were effectively bailed out. Detailed discussion on the subprime mortgage crisis and the role of securitization leading up to the GFC will be discussed in the next post. However, the event that triggered the financial crisis was the collapse of Lehman Brothers. On 15th September 2008, the failure of Hank Paulson, the US Treasury Secretary at the time to rescue Lehman Brothers (based on the reason of moral hazard) sent ripple effects through the financial system, posing systemic risk and triggering the GFC.

The stability of the financial system is built on public trust in the financial institutions. When Lehman filed for bankruptcy, it came as a shock. It was expected that Lehman Brothers would be bailed out, as Bear Stearns was in March earlier that year. Lehman Brothers was one of the oldest (over 100 years old) and one of the four biggest investment banks in the US. The public operates under the assumption that all banks are safe or “too big to fail”, hence when Lehman was allowed to fail, there was widespread fear that other banks were also unsafe. The collapse of Lehman saw sharp deterioration in confidence in financial institutions and widespread panic that induced bank runs, posing systemic risk that led to the onset of the GFC.

The bank runs during the GFC were unlike the traditional bank runs, where depositors lined up to withdraw their funds. The panic during the GFC was a run on the sale and repurchase market (the repo market). In traditional bank runs, people line up to withdraw their funds, but since banks only hold a proportion of their deposits, whilst the rest were loaned out, mass withdrawals will lead to the bank’s collapse. The repo market provides short term financing, and a run would imply the withdrawal of repurchase agreements.

During the sub-prime mortgage crisis, investors started doubting the safety of the MBS, thus they began withdrawing from the repurchase market, selling their securities at a lower price. The downwards pressure on prices cause the assets on the financial institutions’ balance sheet fall in value. The falling asset values raised fears that banks would not be able to meet their obligations, hence banks could not renew their borrowings from the capital markets to fund their operations. Without funding, the banks could not get enough cash to continue their day to day business. This is what is called a liquidity crisis in the financial system. In 2007, Bear Stearns hedge funds fell 28 percent in value and in March 2008, the investment bank faced insolvency problems due to the decline in value of its mortgage backed securities holdings. They were bailed out by JP Morgan in a fire sale with government backing. However, when Lehman collapsed, investors panicked, pulling funds from all forms of investments, as we can see a massive plummet in the S&P 500 Index Chart around the end of September into October 2008.

(S&P 500 Index Chart from Yahoo Finance)

Problems in the financial system spread into the real economy following the failure of Lehman Brothers. A credit crisis arose when banks were reluctant to provide loans after having had billions of dollars written off their balance sheets. Healthy companies such as General Electric that manufacture light bulbs and engines could not obtain lines of credit to fund their daily operations. Economic growth declined and unemployment rose following the drying up of credit. Bail-out packages were organized for some industries (ie automobile industry) in addition to the financial sector. When unemployment rises, the average person would reduce consumption spending due to the uncertainty in job security. As consumer sentiment fell, business profits declined, slashing even more jobs. The government realized the severity of the Lehman collapse in time, and attempted to remedy their actions by purchasing assets and equity worth up to US$700 billion from financial institutions under the Troubled Asset Relief Program (TARP) on 3rd October 2008. This is an attempt to solve the credit crisis by providing cheap credit to banks in hope that banks will lend the money out.

Evidently, the financial crisis has severe implications and affects all of us. The GFC has demonstrated that the flow of credit is so crucial to the economy; and if the financial system fails, the economy cannot function. Not only do the investors lose investment funds, when the crisis spreads into the real economy, the increased economic uncertainty leads to businesses laying off workers and putting on a hiring freeze, people like you and I will struggle to keep our jobs or to find jobs.