How panic caused the great financial crisis and what to look for to see if it is happening again.
In this episode you’ll learn:
- What is commercial paper.
- What are shadow banks.
- How central banks stopped the 2008 financial panic.
- How financial indicators such as commercial paper-T-bill spreads, the Libor-OIS spread and the spread between credit default swaps and bond yields can help identify if the risk of financial panic is increasing.
How Panic Causes Recessions
Ten years ago this summer, the first signs of financial distress surfaced that culminated in the global financial crisis including the deepest economic recession since the Great Depression and the near collapse of the financial system.
Those signs went unnoticed by most investors. At the time, I was managing money professionally for institutions, and while I noticed the changes, I didn’t realize their severity.
On August 15, 2007, I wrote on our firm’s internal blog that “It is interesting to see the jump in spreads [i.e. incremental yield] for commercial paper and other short-term vehicles relative to Treasuries. The commercial paper yields minus [U.S. Treasury bill] yields are as high as they have been since 2000; meaning we are seeing some dislocation in the short-term credit market.”
How could a jump in yields for an obscure debt instrument lead to a financial crisis?
Commercial paper is short-term debt issued by companies with maturities usually less than nine months. Issuers of commercial paper find it to be an attractive way to fund their ongoing operations because yields are low due to the short maturity.
These issuers don’t have to register the securities with the Securities and Exchange Commission as long as the maturities are less than nine months. This significantly reduces the regulatory burden.
Institutional purchasers of commercial paper find it an attractive cash equivalent because its short maturity means its value is stable and doesn’t fluctuate like longer-term bonds.
Commercial paper is a convenient place for investors to park cash and get a little higher yield than U.S. Treasury bills (“T-bills”). That incremental yield is called a spread. Between 1997 and 2007, the average spread for 3-month commercial paper relative to 3-month T-bills was 0.25%.
While institutional investors can purchase commercial paper directly, individual investors primarily get exposure to commercial paper through investments in money market mutual funds.
Commercial paper and money market funds are cash substitutes. They are liquid, have low risk of default and generally are stable in value in that prices don’t fluctuate significantly from day-to-day.
The commercial paper market is part of what is known as the shadow banking system. According to Morgan Ricks, a Vanderbilt University Law professor and former senior policy advisor at the U.S. Treasury Department, a shadow bank is an entity that is not a chartered deposit bank and uses large quantities of short-term debt to fund a portfolio of financial assets.
In other words, shadow banks are financial entities that continually issue short-term debt instruments such as commercial paper, repurchase agreements, and auction rate securities and then use the proceeds from that debt issuance to fund longer-term assets.
This use of leverage can be extremely profitable given the assets held by the shadow banks are higher yielding than the interest rate paid on the short-term debt.
At the beginning of 2007, there was $1.97 trillion of commercial paper outstanding in the U.S. with the financial sector accounting for 92% of the issuance.
Asset-backed Commercial Paper
Just over half of the commercial paper was a specific type called asset-backed commercial paper, which is short-term debt issued by special-purpose conduits, including structured investment vehicles, that is then invested in longer-term bonds.
These structured investment vehicles took the proceeds from the commercial paper issuance and invested in sub-prime mortgage backed securities and other debt obligations.
Ricks writes in his book, “The Money Problem: Rethinking Financial Regulation,” that “the U.S. shadow banking system has existed outside the explicit banking safety net and for the most part with minimal regulatory constraints. Naturally, this freedom has been conducive to high returns, but the system has also proved fragile. The crisis that began in 2007 eventually tore through the entire shadow banking sector.”
On August 1 2007, U.S. 30-day Treasury bills were yielding 5.06%. The day before, two Bear Stearns hedge funds that invested in subprime mortgages filed for bankruptcy. A week later, PNB Paribas suspended withdrawal from three investment funds because it could no longer determine the value of mortgages and other investments held by the fund.
Those events caused some investors who had invested in asset-backed commercial paper to begin to doubt the value of the financial collateral, such as mortgage-backed securities, that backed the commercial paper.
Holders of short-term debt such as commercial paper must decide on an ongoing basis whether to redeem the instrument for cash or roll it over and continue investing.
Investors know the issuer doesn’t have sufficient cash to meet redemptions if everyone redeems at once, but as Ricks writes “as long as each account holder thinks it is extremely unlikely that others will redeem en masse, no account holder has reason to redeem.”
By mid August, more and more investors elected to redeem their short-term debt holdings including commercial paper and move the money into U.S. Treasury bills.
On August 14, 2007, T-bill yields had declined modestly to 4.6%, but two days later as the panic began to build yields plummeted to 3.03% and by August 20 T-bill yields fell to 2.35%, before climbing to over 4% a few days later.
Meanwhile, even though the yield on the T-bill was dropping, commercial paper yields barely budged so spreads widened to 0.8%. Later that year, as commercial paper rates rose and T-bill yields fell, the spread between the two would surpass 2.0% and in September 2008, following the bankruptcy of Lehman Brothers, the average spread for 3-month commercial paper relative to 3-month T-bills was over 5%.
On September 16, 2008, the Reserve Primary Fund, a money market fund with $65 billion in assets announced it had incurred significant losses due to its holdings of Lehman Brothers commercial paper.
As a result, it lowered its price per share from $1.00 to 97 cents. A 3% decline might not seem like much, but keep in mind investors see commercial paper and money market funds as cash equivalents because their values are stable.
Suddenly, the stability of money market funds and other short-term debt instruments was in doubt. Investors redeemed en masse. It was a modern day bank run.
Within days, $172 billion was redeemed from the $3.45 trillion money market sector. Those money market funds and other holders of short-term debt were likewise redeeming their holdings.
Fire Sale and Recession
In order to raise cash, shadow bank issuers of short-term debt dumped any and all assets they could sell in a fire sale.
This caused yields for all bond instruments to rise to unprecedented levels as their prices fell.
The rise in yields meant borrowing costs for corporations and individuals soared while lenders willingness to extend credit fell sharply given the uncertainty.
The ability of companies to finance their output of goods and services was severely restricted as was the ability and willingness of households and businesses to buy that output.
This decline in output as measured by Gross Domestic Product (“GDP”) is the textbook definition of a recession.
The financial crisis and severe recession was not caused by falling home prices. It was caused by a financial panic in the short-term debt markets with shadow banks being the dominant issuer.
Stopping the Panic
In 1873, Walter Bagehot wrote in his book titled “Lombard Street: A Description of the Money Market” that “Theory suggests, and experience proves, that in a panic the holders of the ultimate [central bank] should lend to all that bring good securities quickly, freely and readily. By that policy they allay a panic; by every other policy, they intensify it.”
He continued, “The only safe plan for the [central bank] is the brave plan, to lend in a panic on every kind of current security, or every sort on which money is ordinarily and usually lent.”
135 years later that is exactly the course the U.S. Federal Reserve took. Not only did the central bank announce on September 19, 2008 that it would provide deposit insurance on money market fund investments, but on October 26, 2008 it started buying commercial paper directly.
In other words, the Federal Reserve acted as the lender of last resort, purchasing billions of dollars of commercial paper and other assets from traditional banks, shadow banks and other entities.
The Fed’s actions stemmed the panic. The recession itself wouldn’t end until mid 2009.