One of the primary questions related to the recent financial crisis is how losses on subprime mortgage assets of roughly $500 billion led to rapid and deep drops in both the value of a wide range of other financial assets and, increasingly, real economic output. The disproportionate size of total losses compared to the relatively small size of the initial trigger points to the presence of amplification mechanisms that allowed losses centered in one market to cause a system-wide downturn. A further question is why subprime mortgage backed securities (MBS) in particular, rather than any other asset, led to the downturn. Blanchard (2009) identifies the interaction between general market conditions, such as high leverage, under-pricing of risk, and high interconnectedness, with particular features of subprime MBS, such as opacity and a belief in ever rising housing prices, as key factors leading to the crisis.
In this paper, we examine how these conditions identified by Blanchard and others led to widespread losses in financial markets by focusing on two financial amplification mechanisms of relevance to the crisis. We also interpret the actions of the Federal Reserve (the “Fed”) in the context of these mechanisms, and we provide new empirical evidence on the effectiveness of the Fed’s liquidity supply during the crisis.
As the discussion above indicates, by a “financial amplification mechanism,” we mean the process whereby an initial shock occurring within the financial sector triggers substantially larger shocks in the financial sector and the real economy. While a number of such mechanisms have been proposed in the literature, we focus on two: balance sheet and adverse selection amplifiers.
The balance sheet mechanism is often cited as an explanation for liquidity crises. For example, it has been used to explain the stock market crash of 1987 (Brunnermeier and Pedersen (2009)), the LTCM crisis of 1998 (Gromb and Vayanos (2002) and the current crisis (Bernanke (2009)). The Bank of England (BOE) incorporates this mechanism into their quantitative Risk Assessment Model for Systemic Institutions RAMSI (Aikman et al (2009)). In all of these cases, the initial trigger was relatively small in magnitude and local (e.g. the Russian default in 1998 and mergers and acquisitions related news in 1987) but spread rapidly and broadly to other markets globally. The amplification underlying these events is suggested to operate as follows: an initial shock tightens funding constraints, causing net worth of institutions to decrease, and funding conditions to tighten further. We discuss the different ways proposed in the literature for funding shocks to lower net worth (e.g. higher margins, lower value of collateral, lower asset market prices and higher volatility). Since the literature is extensive, we focus on a small number of key contributions that introduce alternative feedback loops between funding shocks and changes in net worth (or, more generally, balance sheet conditions).
Central Banks appear well-placed to mitigate funding constraints as the Lender of Last Resort (LOLR). Since banks typically fund long-term assets with short-term money, a loss of confidence would force them to engage in fire-sale of assets. By providing a liquidity backstop, this potential fire-sale is avoided. Bernanke (2009) describes the stages of the Federal Reserve’s responses in the current crisis. The first stage programs, introduced between December 2007 and March 2008 (see Figure 1), involved the provision of short-term liquidity to sound financial institutions, in line with the Fed’s traditional role of LOLR.
