IGTA Journal - Autumn 2017

1. Compensation practices at financial firms that rewarded volume and short-term performance over longer-term, sustainable returns; 2. The conflict of interest inherent in the willingness of the credit rating agencies to designate tranches of subprime mortgages triple-A in exchange for fees; 3. The ability of Fannie Mae and Freddie Mac to use their implicit government support to take on large amounts of mortgage risk with very little capital backing; and, 4. The ability of AIG to use its triple-A rating to provide credit protection to banks and securities firms against complex mortgage obligations with little direct capital support or an adequate liquidity backstop. Culmination of the crisis Once the housing bust got underway, stress on the financial system increased sharply as asset prices fell and bank earnings plunged. In the spring of 2008, such pressures led to a forced sale of Bear Stearns to JPMorgan Chase. Later in the year, the government placed Fannie Mae and Freddie Mac into conservatorship. In September, Lehman Brothers failed. And, a day later, AIG was rescued in order to protect the rest of the financial system against further losses and even broader contagion. With confidence in financial markets and financial intermediaries badly frayed, the Federal Reserve and the U.S. government intervened and provided a range of liquidity backstops, debt guarantees, and capital infusions to forestall a complete collapse of the financial system and the economy. The bust exposed many structural flaws in the financial system that exacerbated its instability. Without being exhaustive, these included the instability of the tri-party repo system, which supported the nation’s short-term funding markets; the risks of runs in the money market mutual fund industry; and the risk of contagion caused by the huge volume of outstanding bilateral (non- centrally cleared) over-the-counter (OTC) derivative obligations between the major financial intermediaries. The tri-party repo system was centered on two of the major U.S. banks. The system matched investors and borrowers each day—with the investors lending cash, secured by Treasuries and other collateral, to the major securities firms. But, the system was unstable. In times of stress, clearing banks could be faced with very large single-firm exposures—of potentially hundreds of billions of dollars. Not surprisingly, when such counterparties became troubled, the clearing banks were less willing to take on these large intraday exposures. As a result, repo investors, who were primarily worried about getting repaid each morning, were motivated to simply withdraw from the market. As short-term investors withdrew funding, the liquidity buffer of the troubled securities firm was quickly exhausted, particularly as other counterparties to that firm demanded additional collateral to secure their own exposures. Structural weaknesses in the money market mutual fund industry—which was a major source of short-term wholesale funding to the securities industry and various non-bank financial corporations—also exacerbated the crisis. When Lehman Brothers failed, the value of its outstanding short-term obligations collapsed. The Reserve Primary Fund “broke the buck,” and investors rushed to withdraw their funds from prime institutional money market mutual funds in a modern version of a classic “bank run.” The funds generally did not have sufficient cash available to meet these runs because they offered overnight liquidity at par value against a portfolio of assets with weighted average maturities that were considerably longer. Another important source of instability was the large volume of bilateral OTC derivatives positions outstanding among the major firms and the right of a firm to immediately close out such positions if their counterparty became insolvent. For example, when Lehman Brothers failed in September 2008, counterparties to Lehman terminated OTC derivatives in which the contract was in the money (i.e., Lehman owed money to the counterparty) and liquidated the collateral held against 3 / 7 BIS central bankers' speeches IGTA eJournal | Autumn 2017 | 55