The Great Recession

These are notes from the video [https://www.youtube.com/watch?v=2TuJkp1z8PM]

The 9th August 2007, the French bank BNP Paribas announced that it was suspending the calculation of the Net Asset Value (NAV) of three of its funds, because “the complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating”. Which is just a fancy way to say: “if an investor would like to get his money back, we cannot pay”.

This was one of the first events that marked the beginning of a global financial crisis. The financial crisis was followed by a crisis of the world economy, known as the Great Recession. The financial crisis was caused primarily by the banks’ behavior with derivatives. Between 2008 and 2009, the governments played a crucial role in limiting the damage to the economy and promoting recovery.

The financial crisis spread over the world due to interconnectedness of the financial markets. To understand this phrase, we need to know what is the interbank market. First, let us distinguish between investment banks and commercial banks.

We refer now to the banking act of 1933, also known as the Glass-Steagall Act, a law enacted by US. It defines the commercial banks as the ones dealing with families and companies, while the investment banks do something else. The idea was that the commercial banks should be a relatively safe place to put your money, because they were not allowed to invest nor lend the money. Indeed, what the commercial banks were doing was to deposit the money in the central banks, and somehow for each dollar deposited, they were allowed to lend 40 dollars to the families and companies. If they needed more liquidity, they could borrow money from the central banks at an interest rate called the discount rate. The investment banks are not allowed to accept money from the families and companies, and they cannot borrow money from the central banks. So, how do they gather liquidity? The way the investment banks have to gather liquidity is to emit obligations. They do this in the interbank market, a virtual place in which banks exchange liquidity. Every morning, Deutsche Bank, BNP Paribas, JP Morgan, and all the other banks, they meet in the interbank market, and they exchange liquidity. A bank that needs liquidity ask for a loan at a certain interest rate (typically something more than the discount rate), and another bank typically lends the money. It is a familiar place, and the banks know each other, so they trust each other. But if the voice spreads that a bank is in trouble, the other banks will ask for a higher interest rate. This happened in 2007, when the banks stopped lending money to each other in the interbank market, because they did not trust each other anymore. Well, in the case in which no bank lends money to another bank, the bank who need liquidity can ask for a loan at the central bank. But the bank does not want to show that the other banks do not trust it. The reason why the banks did not trust each other is because most banks had invested in “toxic assets”. The credit crunch.

What is a toxic asset? For example, I am the Lehman Brother, an investment bank, and I need liquidity. How do I get it? I could go to the interbank market, or emit obligations. But in the late 80s, the investment banks discovered a new way to gather liquidity, and it has all to do with house mortgages. Mortgages are a risk for the banks. Not matter how much you asses the private income, there is always a risk that the family will not be able to pay the mortgage. Someone had an idea: why not to sell the mortgages to someone else? Create and distribute the risk.

A subprime mortgage is a mortgage made to a very risky subject. The bank (Lehman Brothers) posses by the way a company which sells houses. Don’t you worry, the value of house will increase, it has always increased a lot. So they sell houses to everyone, prime mortgage, subprime mortgage. Then they send all the mortgages they made to the lawyers of the banks. With ~2500 mortgage contracts, called the “substrate”, they make a new contract, called the “derivative”. The derivative says: there is a substrate that generates money. Those money will be used to pay whoever wants to buy the derivative. This product is also called “asset bank security”. These securities yields good money, so all the banks want to buy them.

If there is not credit, is no one lends money, the economy stops.

The investment banks have some traders. The traders receive a certain salary, plus bonuses dependent on how much they make the bank earn. The traders were used to make the bank earn with the obligations from the state, but the interested rates were going down a lot, so they were incentivated to take big risks with the derivatives.

The majority of economists agree that the credit crunch resulted from 4 factors:

The liquidity arriving from China. China exported more than it imported. Let us say that US purchased 100 from China, while China purchased only 80. Then US had to give 20 liquidity to China. The central bank of China was investing that money in US obligations, which had a good return. But if China buys a lot of such obligations, their price goes up, and so the return goes down. Damn it, the US obligations were the classic way for banks’ traders to make profit and earn their bonus. They were used to 7% return, but now it gets down a to 6, 5, 4, ecc.
The Expansionary Monetary Policy in the US from 2000 to 2006. In the 2000 there was the crisis of “dot coms”. Apart from families, the investors invest in the following way: they go to the bank, they say buy 100k of these, but I do not have the money, the bank says give me 10k of loss margin (this investment is called “at margin”), and so it goes. If the investment goes down close to 90k, the bank calls the investor and says it will sell unless he gives some more margin. To avoid losses the investor might sell. To avoid massive disinvestement when the internet bubble crashes, the US central bank cut the discount rate. In this case, the bank can lend some low-interests money to the investor, to put back his margin instead of selling. Come on! So you will see in the early 2000 a sharp decrease of the federal discount rate. Then in 2001 there is the twin towers thing, everybody is scared, and when people is scare wants to sell and put liquidity under the bed. To avoid this, the president of US central bank shuts down the market for three days! And, of course, the discount rate is cut again. The important concept here is that the cut of discount rate slows down the selling of the marginal investors during crisis, like the crisis of dotcoms, the twin towers. The concept of low discount rate is also connected to the increase of “domanda aggregata”. The first thing that families buy when there is “easy money” to borrow, is houses of course. Here comes the bubble of the houses. And of course, as we are repeating for a while now, the other effect of low discount rate is that the bank investors cannot use country titles to earn their bonuses, so they buy more derivatives.
In 1999, the distinction between commercial and investment banks is abolished.