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....Read More