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Why did it happen? What went wrong?

Why did the liquidity crisis happen? Some people claim to have been taken some by surprise by the eruption in credit market turmoil. Alan Greenspan, former Chairman of the US Fed, asked at a meeting of the Brookings Papers on Economic Activity on September 7th “I ask you if anybody in early June could contemplate what we are now confronted with?” referring to the eruption in credit market turmoil and risk aversion that originated with rising delinquencies on subprime mortgages.

At another occasion, trying to sell his new book, Greenspan claimed he "really didn’t get it (the severe economic consequences posed by questionable subprime lending tactics) until very late in 2005 and 2006.” So maybe he was not so surprised any more in June this year. We really don’t know – no surprise for us. There is his famous quote:

“Since I have become a central banker, I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”

But at least Ben Bernanke, Chairman of the US Fed, did not seem to realise. Indeed, mid of May, at the Annual Conference on Bank Structure and Competition in Chicago, he stated firmly:

“We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

On June 5, 2007, he again reassured the markets:

 “At this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.”

In contrast, others, observing first the amazing boom in mortgage loan originations and then the meltdown in the US subprime sector, have been puzzled that it really took so long to trigger fire sales. Tons of facts have been consistently provided on blogs like CALCULATEDRISK and in the weekly magazine Economist.

Raghu Rajan, now Graduate School of Business at the University of Chicago, at that time research director at the IMF (now back at Chicago Business School) presented a sceptical view at a  speech at Jackson Hole (PDF 332 KB) in September 2005 "Has Financial Development Made the World Riskier?".

Claudio Borio from Bank for International Settlements (BIS) has consistently warned for a long time that large swings in asset prices figure prominently in many accounts of financial instability. See his paper “Towards a Macroprudential Framework for Financial Supervision and Regulation?

Hyun Shin, initially at LSE, London, now at Princeton University, frequently warned against the risk of fire sales in the real estate market. Just as an example, have a look at his paper “Risk and Liquidity in a System Context”

In a research paper last year on “Risk Transfer with CDOs and Systemic Risk in Banking” Jan Pieter Krahnen and Christian Wilde from the CFS in Frankfurt argued that credit securitizations contribute to an increase in the systematic risk of banks.

I myself expressed concern (PDF 698 KB) about the risk that financial fragility may have caught the Fed in an interest rate trap back in June 2004 at a Bundesbank Conference. The Economist followed 1st of July 2004. No surprise now to see that John Taylor finds (PDF 321 KB) the actual Fed rate has been below what a Taylor rate would have suggested during that period. Last November, at a conference on Central Banks as Economic Institutions at the Centre Cournot in Paris, I again pointed to the moral hazard issue involved. For a long time, the economist warned against the Greenspan put.

Some dismissed that as cheap finance talk. After all, our models do tell us that we are now closer to the wonderful efficient world of globalised financial markets, spreading risks to those who are most able to bear it. But you should have a careful look at the assumptions of such models. If you really need a model to be convinced about the moral hazard problem, click my recent paper with Jin Cao on Liquidity Shortages and Monetary Policy (PDF 442 KB) and Stephan Sauer’s paper on Liquidity Risk and Monetary Policy.

Sound economic theory has been interested in fire sales for quite a long time. In 1997, Andrei Shleifer and Robert W. Vishny (1997) published a famous paper on "The Limits of Arbitrage" in the Journal of Finance, 52:1, pp. 35-55

Unfortunately, economists have not written many papers providing ex ante a sound theory predicting something which did not yet happen at that time but later indeed turned out to become reality. Most economists are better in explaining ex post what happened in the past. Edmund Phelps and Milton Friedman did predict the breakdown of the Phillips curve end of the 60’s. They have been confirmed by the great inflation during the 70s. Both deserved to get the Nobel price. In their paper on Limits of Arbitrage, Shleifer and Vishny analysed the breakdown of arbitrage during periods of market turmoil. At that time, hardly anybody thought this strange model could ever turn into reality. But it was the perfect model to predict the LTCM crisis in September 1998. I strongly recommend reading the bestseller by Roger Lowenstein "When Genius Failed. The Rise and Fall of Long Term Capital Management”.

It gives a fascinating account of the personalities and academic expertise behind the failure of the hedge fund Long-Term Capital Management, having been advised by the two Nobel price winners Robert C. Merton and Myron Scholes. You will notice frightening parallels to the recent events.

Referring to that paper was exactly the reason why Brad de Long boasted on August 10 on his blog: “Today Is a Great Day in Finance!” I don’t think he is right. I think it was a sad day for finance, showing that we did not draw the right lessons from former experience. The more so since, recently, there indeed has been lots of research in this area. One of the most interesting recent papers on liquidity freezes is the work by Markus Brunnermeier and Lars Pedersen (2007), "Market Liquidity and Funding Liquidity" NBER Working Papers 12939.

So the real puzzle is why it all happened in slow motion, rather than as speedy as the theory of fire sales would have predicted. It took amazingly long from Bear Stern’s hedge funds collapsing till the breakdown of the markets for CDO’s. One reason may be that there have been a few key players with market power being well aware about these risks, trying to sort them out in a different way. It was fascinating to see a US state secretary running to Beijing mid of July urging China's central bank to buy more government-backed mortgage bonds in an effort to sustain financing for U.S. home loans.

Another reason may be that markets relied on central banks acting as needed.

Read next section: Lender of Last Resort Policy – The Risks Involved