Then and now: historical perspectives on the 2007 financial crisis
What’s at stake
The mortgage boom of the late 19th century in the US, the German and French financial crises in the 1880s and the build up of consumer debt in the run-up to the Great Depression provide interesting parallels with the subprime crisis of 2007. It is also noteworthy to look at the extent to which the Fed followed the Bagehot rule in its provision of liquidity when the boom went bust. As a recent paper argued, although the Fed somewhat deviated from the Bagehot rule by providing liquidity without charging a penalty rate and requesting safe collateral, its actions followed closely the recommendations of Milton Friedman for dealing with such emergency situations.
Run-up to the crisis: global imbalances, search for yields and the financial intermediation chain
A 1995 NBER paper providing an account of the agricultural mortgage boom and bust of the 1880s and 1890s, Ken Snowden suggests parallels with the subprime crisis along several dimensions: the macroeconomic preconditions to the boom; the burst of financial innovation and the development of new intermediaries; and the informational imperfections and perverse incentive structures.
The parallels between the macroeconomic preconditions to the boom of the 1880s and that of the 2000s are striking. Snowden – respectively Ben Bernanke – argues that excess savings accruing from Europe and the Northeast regions of the US – respectively Asia and other emerging countries – had to be recycled in the South and West areas of settlement – respectively to the US. Then as now, this search for yields generated a reduction in the dispersion of uncertainty discounts. Lance Davis documents the contraction of credit spreads between assets of different regions that occurred in the late 19th century. In the run-up to the subprime crisis, the contraction in credit spread took place between different types of assets in the run-up to the subprime crisis.
In both periods, several types of new intermediaries arose to facilitate the flow of credit from the surplus to the deficit regions. Between 1870 and 1890, Ken Snowden documents the expansion of the intermediation chain to facilitate the flow of credit from distant investors to property owners. Mortgage companies – for example – arose to monitor loan agents for distant investors thanks to their ability to diversify enforcement risks through a geographical expansion of their coverage. In his recent attempt to incorporate financial intermediation in the macroeconomic framework, Michael Woodford point to parallel developments in the intermediation chain with the growth of the “market-based financial intermediaries” or what is more commonly referred as the shadow banking sector. Chapter 6 of the 2010 Economic Report to the President, for instance, shows that the percentage of financial sector assets held by banks has fallen by almost 50% from the early 1980s to the late 2000s. Woodford points that money market mutual funds, asset-backed securities issuers, and other market-based financial institutions accounted for the two third of the contribution to U.S. total net lending in the late 2000s.
In both periods, over lending occurred in response to competitive pressures due to the increase in the supply of mortgage funds. Ken Snowden argues that the incentive structure of the increased intermediation chain worked well as long as the loan agents “expected to lose something of value if they walked away from a bad loan”. As the supply of mortgage funds and the demand for agents’ services, however, increased dramatically in the 1880s, this threat became non credible and loan agents started to inflate appraisals and provide mortgages to borrowers that would likely end-up underwater when the price of their assets would stop rising. Although the chain of intermediation was somewhat different in the run-up to the subprime crisis – Anton Brender and Florence Pisani have a very good account of the current episode – the originate and distribute model of banking created an incentive structure similar to that of the loan agent – mortgage company – investor relationship of the 19th century mortgage market. As the loan agent – respectively the bank – originated the mortgage but did not hold it, he – respectively it – did not face downside risks and therefore had an incentive to over lend.
In a recent presentation at Bruegel, Carsten Burhop pointed out that the German financial crisis of 1873 also came after an upswing phase during which the German economy which saw a dramatic increase in financial intermediation with the establishment of 140 new joint stock banks. Burhop stressed that the emergence of new financial products and new intermediary vehicles combined to a huge amount of liquidity available to the financial markets is a feature that the German crisis and the recent financial crisis have in common. He pointed out that the asymmetric information problem might have been less disruptive, had the financial intermediaries selling companies’ stocks been trustworthy. Unfortunately, dealers were newly established banks – with no reputational capital yet – that had invested themselves a large fraction of their assets into shares. Pierre-Cyrille Hautcoeur notes a similar pattern ahead of the French 1882 crisis: France had experienced a decade of low interest rates and high investment, during which the financial sector developed considerably with the creation of many investment banks and new companies.
In a 2003 paper, Barry Eichengreen and Kris Mitchener argue that the Great Depression can also be viewed as a credit boom gone wrong. The authors argue that the endogeneous response of the foreign exchange component of global reserves – which increased from 27% to 42% over the ‘roaring twenties’ – allowed credit to expand more rapidly than would have been otherwise possible under traditional gold standard arrangements. They namely show that the aggressive competition between banks and Savings and Loans corporations had a significant influence on the tripling of mortgage debt that occurred between 1919 and 1929 in the US. The intensively competitive nature of the financial sector in the US also had an important influence on the development of consumer debt, which increased from 4.5% to 9% of personal income from 1920 to 1929. Such an expansion of consumer credit did not occur in other countries – namely in Australia – where authorities curtailed the expansion of installment credit as they had previously gone through painful episodes of credit booms gone wrong (Australia saw 13 of its 23 banks failed in a previous credit boom gone bust).
Following and deviating from Bagehot Rule: liquidity provision in the current crisis
In his 1873 book Lombard Street, Walter Bagehot argues that the first thing that the “ultimate bank reserve” has to do in a crisis is “to lend to all that bring good securities, freely, and readily”. Bagehot, however, advised applying a lending rate sufficiently high to avoid exhausting the Bank’s reserves. Bagehot’s restrictive provisions that the Bank should only lend freely against good collateral and at penalty rates were supposed to limit aid to otherwise solvent firms that the panic had rendered illiquid and were supposed limit moral hazard.
In the current crisis, the Fed followed the spirit of Bagehot rule but deviated from it along several dimensions. First, the Fed did not charge a penalty rate for those needing liquidity. Instead, it encouraged the use of the discount window by bringing into line the discount rate to the level of the FFR – as noted by Ben Bernanke in his 2009 Stamp Lecture at the LSE – lowering the spread between the discount rate and the FFR from 100 basis points to 25 basis points. It furthermore increased the term of the discount window loans from overnight to 90 days, created the Term Auction Facility to further lengthen the terms of loans from the Federal Reserve to the banking system, and channeled liquidity to nonbanks by creating facilities – authorized under the Federal Reserve’s 13(3) authority – such as the Primary Dealer Credit Facility.
In a recent paper that argues that the overall monetary and financial policy response to the crisis can be viewed as Friedman’s monetary economics in practice, Edward Nelson– chief of the monetary studies section of the Fed’s monetary affairs division – also notes that the generous provision of liquidity to the commercial banking system does meet aspects of the Bagehot-Thornton stipulations concerning a central bank’s response to an emergency. But the Federal Reserve did not provide liquidity at an interest rate that was high relative to pre-crisis rates; in addition, in responding to the crisis, it widened its conception of the institutions and collateral eligible for the discount window. The author argues that this follows exactly what Friedman and Schwartz recommended in their Monetary History. Friedman and Schwartz praise Bagehot, and Friedman’s position was that the discount rate should normally be a penalty rate. In an emergency situation, however, Friedman and Schwartz argued that making the discount rate low relative to prevailing market rates was necessary to bolster asset prices and the money stock. They criticized the Federal Reserve for allowing the commercial paper rate to fall below the discount rate, and cited the failure to reduce the discount rate as a factor that kept up long-term interest rates during the 1930s. Friedman and Schwartz thus viewed discount lending at low rates as an important mechanism for creating downward pressure on market interest rates and maintaining the money stock in a financial crisis.
In a recent presentation at Bruegel, Pierre-Cyrille Hautcoeur stressed that the French Central Bank acted as lender of a last resort in the 1882 crisis but in an unconventional way. The bank crisis was triggered by the bankruptcy of one leading investment bank – Union Générale – whose accumulated risky positions became completely illiquid when the stock market crashed. The characteristic feature of 1882 crisis was the role played by the French stock market, which was at the same time very risky (due to the importance of derivative products) and very fragile (as the law was giving no legal status to forward contracts). As more banks that had provided substantial credit to the forward market started to suffer from their illiquid exposures, the entire stock exchange went on the edge of collapse. Banque de France decided not to bail-out Union Générale but provided instead liquidity to other banks that were considered solvent but likely to be affected by panic. Moreover, the Central Bank engaged in the rescue of the stock exchange itself, although not in its entirety (the Lyon stock exchange was denied credit whereas in Paris loans were given to a small group of banks).
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