Deciphering the Liquidity and
Credit Crunch
Journal of Economic Perspectives Vol. 23, Number 1-Winter 2009 pp., 77-100
Markus L. Brunnermeier
Princeton University
• Bursting of housing bubble forced banks to write down
several hundred billion dollars in bad loans caused by
mortgage delinquencies
• Stock market capitalization of major banks declined by
more than twice as much:
• $8 trillion of U.S. stock market wealth lost between
Oct. 2007 and Oct. 2008
• Factors leading up to the housing bubble: low interest
rate environment , Fed didn’t counteract the buildup of
the housing bubble, and transformation of banking
model
Parts of the paper:
1. Trend towards “originate and distribute model”
2. Event Logbook
3. Causes: Housing Crisis Financial Crisis
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Borrower’s Balance Sheet Effects
Lending Channel
Runs on Banks
Network Effects
Trends
1. Rather than holding loans, banks repackaged them
and passed them on to various other financial
investors: “Structured products”
• Sliced into “tranches”:
– Super senior(least risk) --mezzanine– equity (toxic)
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Buyers can protect themselves by buying CDS (credit
default swaps): insure against the default of a particular
bond or tranche
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Estimated value of CDSs in 2007-08: $45-$62 Trillion!!!
2. Banks shortened maturity of assets
• In traditional banking model, banks finance loans
with deposits
• This changed into a “shadow” banking system that
was made up of off balance sheet investment
vehicles financed by asset backed commercial
paper.
• Shadow banks (Structured Investment Vehicles/SIV)
exposed to funding liquidity risk if investors stop
buying,
– Sponsoring banks grant credit lines to these SIVs
Rise in popularity
• Securitized and structured products led to lower interest rates
– Senior tranches of structured products become “investment
grade”
– allowed certain funds to invest in assets they previously could not
buy
• Regulatory and ratings arbitrage
• Over-optimism regarding structured finance products: based on
historically low mortgage default and delinquency rates
• Rating “at the edge” – “banks worked closely with the rating agencies
to ensure that AAA tranches were always sliced so the just crossed
the dividing line to reach the AAA rating”
• This rise in popularity of securitized products let to a flood of cheap
credit---falling lending standards
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Subprime Mortgage Crisis
Asset Backed commercial paper
The LIBOR, Repo, and Federal Funds Market
Central Banks Step Forward- August 2007
– Hedge funds suffer large losses perceived
default and liquidity risk rises  “freezing up” of
markets credit injections from European Central
bank and US Fed, reduced discount rate.
– Reduce again September 18th
• Continuing Write-downs of Mortgage –
related securities
• Monoline insurers downgrade-January 2008
– Ambac
– Markets down worldwide
– Fed’s first emergency rate cut since 1982 - 75 bps to 3.50%
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Bear Stearns-March 2008-acquired by JP Morgan Chase
Fannie Mae & Freddie Mac
Lehman Brothers, Merrill Lynch, and AIG
Bailout, Stock Market Decline…
– $8 trillion in wealth disappeared since the peak of the
market in October 2007
• $700 bn. Bailout plan, Fed’s balance sheet almost
doubled from $1.2 trillion to $2.3 trillion (toxic assets)
Liquidity
• Events demonstrate that shocks can be amplified into crisis
when liquidity goes away. Liquidity dries up when frictions
limit optimal risk sharing and hinder flows of funds to
expert investors.
• Funding liquidity-the ease with which expert investors can
obtain funding from financiers
– Risk associated with this type of liquidity is only detrimental
when market liquidity is low
• Market Liquidity-difficulty or ease with which as asset can
be sold. How easy it is to find someone on the other end of
a trade.
Borrower’s Balance Sheet Effects
• Loss spiral-for leveraged investors, occurs because the
decline in value of assets erodes the investors’ net
worth faster than their gross worth (they can borrow
less, are forced to sell, which causes the price of the
assets to drop even further)
• Margin/haircut spiral-reinforces the loss spiral. As
margins (haircuts) rise, investors forced to sell even
more to reduce their leverage ratio
• Most structured assets have low market liquidity, so
sale causes a greater price drop (distress)
– no reliable price because not often traded
• Lending Channel, a la Bernanke
– When lenders also have limited capital, they are
forced to restrict lending.
– Mechanisms
• Moral Hazard in monitoring
• Precautionary hoarding
• Runs on Financial Institutions
– Virtually nonexistent for commercial banks due
to deposit insurance
– can occur to other financial institutions (on
instruments backed with illiquid assets)
Network Effects
• Most banks are both lenders and borrowers
• Interwoven risk: banks hedge risk against each
other.
Conclusion
• “An increase in mortgage delinquencies due to a nationwide
decline in housing prices was the trigger for a full-blown
liquidity crisis that emerged in 2007 and might well drag on
over the next few years. While each crisis has its own
specificities, the current on had been surprisingly close to a
“classical banking crisis.” What is new about this crisis is the
extent of securitizations which led to an opaque we b of
interconnected obligations…”