This Time isn’t Different: Part I
I think I’ve seen this film before, and I didn’t like the ending.
June 20, 2007.
That’s the day Bear Stearns bailed out two of its hedge funds. It marked the first sign that the subprime mortgage crisis had spread beyond just the housing markets, past the lenders and securitisers, all the way to one of the big Wall Street investment banks.
It would take 9 more months before Bear Stearns faced bankruptcy, and another year after that before the Dow Jones hit its lowest point in March 6, 2009. However gloomy financial markets might have looked in mid-2007, they got a lot worse before they got better.
It’s been exactly 15 years since that day, and storm clouds are now gathering in the world of cryptocurrencies and decentralised finance. In that spirit, let’s revisit the Global Financial Crisis, and see if defi has anything learn from the most severe crisis in tradfi since 1929.
Safety via diversification
The Global Financial Crisis marked the end of the Great Moderation. During the preceding three decades, there was an unparalleled bull market and a 4x rise in housing prices. Across the board, people were irrationally exuberant and assumed that housing could only appreciate. Thus banks began offering subprime mortgages and lending to people with bad credit, on the assumption that in the worst case, you could just take the house as collateral. Since it would be worth more, the risk seemed pretty small.
Simultaneously, there was a global savings glut as investors looked for places to put their money. To meet this demand, banks decided to manufacture more safe assets for investors to buy, packaging mortgages into mortgage-backed securities. These were financial instruments which provided payments depending on the underlying mortgages. Investors might not have been willing to buy individual mortgages, but MBSs seemed like a much more attractive proposition. Instead of needing to worry about the risk of any particular mortgage, they could just buy a pool of many different mortgages. One homeowner might default, but when in the world would everyone default at the same time? It was “diversified” - in other words, it was safe.
How about the rare cases where the mortgages were of such poor quality that even MBSs didn’t seem safe? Well, banks would just repackage them into a collateralised debt obligation, bundling enough together till even a pool of bad MBSs seemed “diversified” enough. It wasn’t just mortgages, however - other loans were being packaged into asset-backed securities. For example, car companies would make loans to help people finance their car purchases, and bundle these loans into ABSs, which were in turn put into CDOs too.
Once these ABSs and CDOs were seen as safe assets, they were used everywhere, beyond just the balance sheets of investment banks. To fund their operations, ordinary companies often issued asset-backed commercial paper, which were essentially short-term loans. These ABCPs were backed by the ABSs and CDOs. For example, companies like General Electric would use the CDOs derived from their car loans to collateralise these ABCPs, which they used to pay for day-to-day costs.
Money market mutual funds, which aimed to keep the value of every dollar of investment at a dollar, bought up these ABCPs in droves, since they were backed by seemingly risk-free assets. Even insurance companies like AIG got a piece of the action, offering insurance on ABSs and CDOs for investment banks which wanted to offload their risk.
Everywhere you looked in the financial system, there was a massive web of obligations connected by these so-called “safe assets”.
Housing theory of everything
Then all of a sudden, the housing bubble popped.
The immediate effect was that subprime mortgages fell in value. That meant real estate investors got screwed. For example, New Century was the second largest subprime mortgage issuer in the world. With their assets disappearing in value, they filed for Chapter 11 bankruptcy on April 2, 2007.
Soon enough, investment banks which owned ABSs and CDOs saw their balance sheets plunge into the red. Bear Stearns would liquidate their aforementioned hedge funds in July, due to their exposure to these assets. By August, BNP Paribas considered it impossible to even value these financial instruments, preventing any investor withdrawals from its own hedge funds. In September, Northern Rock, a British bank which had bought up huge swathes of these assets, faced a run from depositors. By early 2008, Northern Rock was nationalised by the British government, while Bear Stearns was bought out by JPMorgan Chase alongside the Federal Reserve.
Meanwhile, the government-sponsored enterprises of Fannie Mae and Freddie Mac began to buy up subprime mortgages from the banks, in an attempt to take some of the risk off their books. None of this was enough to stem the bleeding, and by September 7, Fannie and Freddie themselves had to be taken over by the Federal Reserve. On September 15, Lehman Brothers went bankrupt and Merrill Lynch was purchased by Bank of America. Just like that, three of the five largest investment banks (Bear Stearns, Lehman Brothers and Merrill Lynch) had disappeared.
The next day, the huge insurance payouts from ABSs and CDOs collapsing meant AIG was taken over by the Fed too, while the Reserve Primary Fund, the oldest MMMF, lost the one-to-one parity which every MMMF is expected to maintain. In other words, it had “broken the buck” due to its exposure to ABCPs which were becoming as worthless as their underlying assets. Unsurprisingly, investors everywhere pulled $144 billion out of US MMMFs the following day, causing companies to face issues in covering their costs as they struggled to roll over their ABCP.
With the interbank lending market, the ABCP lending market and the MMMF lending market under pressure, there was only one remaining source of short-term funding: the secured repo lending market. Unlike the other three, borrowing on the repo market required handing over collateral. But as investors sold their other assets to compensate for ABS and CDO losses, even those who weren’t exposed to those assets saw their balance sheets plumment and their collateral lose value, putting pressure on the repo market.
If it was clear whose balance sheets were genuinely worthless and insolvent and who was simply temporarily illiquid, perhaps they could have been isolated and contained. But with the fog of war making it impossible to figure that out, the costs of borrowing skyrocketed across the board. Banks stopped lending and credit dried up, bringing the real economy to a standstill.
Thus the housing crisis became a global financial crisis.
How does this relate to the crypto crisis? Find out in Part II!