OIS

Ten Years After Bear

Ten years ago this week, the run on Bear Stearns kicked off the second of three phases of the Great Financial Crisis (GFC) of 2007-2009. In an earlier post, we argued that the crisis began in earnest on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime mortgage debt. In that first phase of the crisis, the financial strains reflected a scramble for liquidity combined with doubts about the capital adequacy of a widening circle of intermediaries.

In responding to the run on Bear, the Federal Reserve transformed itself into a modern version of Bagehot’s lender of last resort (LOLR) directed at managing a pure liquidity crisis (see, for example, Madigan). Consequently, in the second phase of the GFC—in the period between Bear’s March 14 rescue and the September 15 failure of Lehman—the persistence of financial strains was, in our view, primarily an emerging solvency crisis. In the third phase, following Lehman’s collapse, the focus necessarily turned to recapitalization of the financial system—far beyond the role (or authority) of any LOLR.

In this post, we trace the evolution of the Federal Reserve during the period between Paribas and Bear, as it became a Bagehot LOLR. This sets the stage for a future analysis of the solvency issues that threatened to convert the GFC into another Great Depression.

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Looking Back: The Financial Crisis Began 10 Years Ago This Week

In his memorable review of 21 books about the 2007-09 financial crisis, Andrew Lo evoked Kurosawa’s classic film, Rashomon, to characterize the remarkable differences between these crisis accounts. Not only were the interpretations in dispute, but the facts were as well: “Even its starting date is unclear. Should we mark its beginning at the crest of the U.S. housing bubble in mid-2006, or with the liquidity crunch in the shadow banking system in late 2007, or with the bankruptcy filing of Lehman Brothers and the ‘breaking of the buck’ by the Reserve Primary Fund in September 2008?”

In our view, the crisis began in earnest 10 years ago this week. On August 9, 2007, BNP Paribas announced that, because their fund managers could not value the assets in three mutual funds, they were suspending redemptions. With a decade’s worth of hindsight, we view this as a propitious moment to review both the precursors and the start of the worst financial crisis since the Great Depression of the 1930s.

But, first things first: What is a financial crisis? In our view, the term refers to a sudden, unanticipated shift from a reasonably healthy equilibrium—characterized by highly liquid financial markets, low risk premia, easily available credit, and low asset price volatility—to a very unhealthy one with precisely the opposite features. We use the term “equilibrium” to reflect a persistent state of financial conditions and note that—as was the case for Humpty Dumpty—it is easy to shift from a good financial state to a bad one, but very difficult to shift back again....

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