Vol. 6, No.1
Photo by Mike Ciesielski
Jon Faust, Louis J. Maccini Professor of Economics and director of the Center for Financial Economics, and economics professor Jonathan Wright together have nearly 30 years of experience working with the Federal Reserve Board, giving them a great vantage point from which to consider the economic crisis that has gripped the country. One big question they can help us answer: How exactly did we get in this mess?
Q:The recent international economic turmoil began with about $500 billion in losses on subprime mortgage loans. That's a big number, but modest relative to the country's wealth: That amount is made or lost whenever the stock market moves by a few percentage points. But since the crisis began in August 2007, about $25 trillion—50 times the original mortgage losses—has been lost on stock markets worldwide. How did the comparatively small losses have such cataclysmic effects?
A:The key reason is that the losses were concentrated in highly leveraged financial institutions—institutions that borrowed heavily to acquire assets. Suppose a bank has acquired $100 billion in assets by borrowing $97 billion, implying equity of $3 billion. A 1 percent gain in the value of assets is $1 billion, a 33 percent return on equity! High leverage supported immense returns on Wall Street. Conversely, a 2 percent fall in asset values severely depletes equity; a 3 percent drop leaves this firm insolvent. Thus, modest losses can severely weaken or bankrupt a highly leveraged firm. Weakness in the financial sector can precipitate several further problems. First, financial institutions are highly interconnected—many liabilities of a failing firm will be assets of another highly-leveraged institution. Thus, default of one institution can cause problems for others. It was largely the concern about a cascade of defaults that led the government to bail out Bear Stearns and AIG, and these interconnections are part of why the crisis accelerated after the collapse of Lehman. Second, variations on bank runs can emerge. The highly leveraged firms funded their asset positions by continually rolling over short-term loans. If an institution becomes shaky, it may find that it cannot roll over these loans, which could lead to default. Indeed, the mere fear that the firm may be unable to roll over its loans tomorrow can lead lenders to stop lending today, and collapse may become a self-fulfilling prophecy. Bear Stearns and Lehman faced this sort of run. The U.S. government has expanded deposit insurance for commercial banks and offered a limited extension to money market mutual funds to reduce the chance of runs on these institutions. Third, the problems just described put pressure on institutions to reduce leverage. They could do this by raising new capital—difficult in the current environment—or by reducing lending. Financial institutions have collectively restricted lending, especially to one another. But many aspects of normal business in the non-financial sector rely on lending among financial institutions. As the financial sector has become less effective in supporting normal economic activity, all businesses and property values have suffered, putting more strain on financial institutions. This type of "adverse feedback loop" can explain how a relatively modest financial shock can have immense effects, why people with no direct exposure to subprime mortgages have lost so much wealth, and why many economists agree that extraordinary government intervention is warranted.